Simon Johnson on the Unconscionable Risks We Face

Simon Johnson is a professor of economics at MIT and a senior fellow at the Peterson Institute for International Economics.  He was the chief economist for the International Monetary Fund from March 2007 through August 2008.  Johnson is the co-author, with James Kwak, of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown, a bestselling assessment of the dangers the US financial sector now poses (published by Pantheon in March 2010).

Dan Richards interviewed Johnson at the American Economic Association in late January.

A video of this interview is available here.

You have said that the global approach to creating financial stability among banks under Basel III – specifically, raising capital requirements – was not sufficient.  Can you elaborate?

Capital is the buffer that banks have against loss.  It is the shareholder's equity.  The shareholders absorb the losses before you go into a situation of insolvency.  Well, you are talking about very risky activities.  Does anyone think that these big banks are less risky than the overall US economy?  No.  Surely they've demonstrated if anything they are more risky. 

Average leverage, average equity financing, and average debt are around 50% for the corporate sector in the United States; 50% equity, 50% debt.  We let the financial sector con us into thinking that was relatively safe, and that banks should be allowed to have a lot of debt and relatively little equity.  This is the situation going forward.  This is where the Basel III process will take us.  It's pretty clear. 

This is an unconscionable social risk.  It's unnecessary.  It's not needed for productivity.  It's not needed for growth.  It's not needed for jobs.  The arguments that raising capital requirements would have adverse social effects are completely specious and fallacious.  There is a wonderful study showing this by Anat Admati and her colleagues at Stanford University.  Everybody has to take a look at that work.

You are suggesting that we need to dramatically raise capital requirements.  Let's talk about some alternative proposals.  There have been a number of suggestions that we create a new capital structure, contingent capital, which would be debt until it’s needed, at which point it would become equity.  What are your thoughts on that as a solution, in part or in whole, to the problem?

As a theoretical proposition it has some attraction, but empirically when you look at how this kind of contingent debt works, it's very complex.  It is very hard to implement.  It's very hard to get that debt to convert into equity when you need it.  You can go through the blow-by-blow.  We talk about this on our website

What about the Volcker Rule that proposed to take the risky forms of bank activity and set them aside and segregate them from the less risky components of bank activity?

That's a good idea.  It's a step in the right direction.  I've supported it in testimony to Congress and in an opinion I've submitted to the Financial Stability Oversight Counsel, but it is not enough.  We need to go beyond that.  We've seen a deal just announced in the past few days, with Goldman Sachs’ involvement in Facebook, which apparently they believe will comply with the Volcker Rule that is not yet officially written. 

So Goldman is taking what looks like a risky bet on a company that could go up or go down a lot in value.  It is a bank holding company.  It is a financial institution with access to the Federal Reserve discount window.  This is a too-big-to-fail financial institution.  They have a subsidy.  They have an unfair, nontransparent, and dangerous subsidy, and we let them take these kinds of risky bets.  It makes no sense.