Multinational Monitor

NOV/DEC 2008
VOL 29 No. 3


The 10 Worst Corporations of 2008
by Robert Weissman

Carbon Market Fundamentalism
by Daphne Wysham

A Last Chance to Avert Disaster
testimony of James Hansen


Plunge: How Banks Aim to Obscure Their Losses
an interview with Lynn Turner

The Financial Crisis and the Developing World
an interview with Jomo K.S.

The Centralization of Financial Power
an interview with Bert Foer

“Everyone Needs to Rethink Everything”
an interview with Simon Johnson

Toxic Waste Build-Up
an interview with Lee Pickard

“Before That, They Made A Lot of Money”
an interview with Nomi Prins


Behind the Lines

Public Ownership, Public Control

The Front
Thirsty for Justice - Whitewashing Honda

The Lawrence Summers Memorial Award

Greed At a Glance

Commercial Alert

Names In the News


“Everyone Needs to Rethink Everything”: Reflections from the IMF’s Former Chief Economist

An Interview With Simon Johnson

Simon Johnson is former chief economist of the International Monetary Fund. He is a professor at the Massachusetts Institute of Technology Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. He is a co-founder of The Baseline Scenario, a website dedicated to providing a "baseline" view of the current economic crisis. (

Multinational Monitor: In a nutshell, what's the reason for the current financial crisis?

Simon Johnson: The severity of the crisis, which I think is the interesting point in question, is because confidence in credit markets and financial institutions collapsed in the middle of September due to the actions the government took with regard to first Lehman and then AIG.

They decided to let Lehman fail, which was a pretty big judgment call, and then they decided to save AIG two days later, but they saved it in a way that took a lot of value away from the creditors. The creditors were very shocked by this. Creditors, and the credit market, interpreted this as meaning that while companies were too big to fail, no one was big enough to protect its creditors. That generated a wave of panic around the world that cascaded. And [Treasury Secretary Henry] Paulson's response was slow. By the time Mr. Paulson acted [in October, when he announced the Treasury Department would buy shares in banks, not just buy their troubled assets], it seemed it was too late.

MM: Is it correct to say that your interpretation of events is that the financial crisis is driving the bigger-scale economic problems?

Johnson: Yes. A little more than a month ago [in early September], I would have told you that we were heading toward a mild recession because of the problems that had emerged out of the housing sector and the difficulties the financial sector was having. I think that was the more or less correct view at the time, or at least a sensible baseline view to have.

What no one could anticipate was the actions that the government would take and the way that would cause global confidence to disintegrate. We've never seen anything like that in our lives. That has already triggered lots of adverse economic consequences, and there may be a lot more coming.

MM: In terms of the recent actions from the Europeans and the revised actions by the Treasury and the Fed and FDIC, do you believe they are now going down the right path?

Johnson: Yes. We talked about this privately for quite a long time and went public with a document on September 29 on our website. We laid out what we thought was going on, and made a case for more radical policy actions, including a kind of bank recapitalization. If they had adopted our measures on September 29, I can't tell you that that would have definitely saved the day. What I can tell you is they waited two weeks and it doesn't seemed to have saved the day.

MM: Now, a few weeks later, is it too late to deal with the confidence problem, to undo the loss of confidence?

Johnson: Well, you certainly can't put the genie back in the bottle. Any last hope that that might be possible disintegrated after the G-7 [the group of seven leading industrial nations] and their close friends did the right thing with bank recapitalization and put a lot of public funds on the line. It seemed as if the markets looked at this and decided that there was a severe recession coming anyway. That triggers a lot of adjustment in asset prices that then has consequences for emerging markets and for developing countries, and then comes back and feeds further downward movement in the U.S. and in Europe.

Confidence will return, obviously. It's not the end of the world or the end of the world economy. Nothing ends with a financial crisis. But it is going to be a pretty long way down and a pretty painful climb back up.

MM: Are the lenders being rational in being so reluctant to extend credit?

Johnson: Yes, of course. Everyone is being pretty rational. With the information they have and all the uncertainties around them, they want to hold on to their cash - that's why they don't lend.

I think the measures put in place in the U.S. and probably in Europe will make you feel confident that the core banks will be solvent. With that will come more lending between banks. But that, at this point, is more of a symptom rather than anything deeper.

Underlying the issue is, will the banks lend to non-bank institutions or organizations? There, the story is very clear. They're already cutting back quite drastically on loans to all kinds of categories. We see it in auto loans, we see it in student loans and small business loans, and I imagine we'll see it in credit cards fairly soon. We'll probably see it in mortgage application approvals.

The banks are overleveraged. They have a small amount of capital on a very large balance sheet. And what they'd like to do right now is unwind on the loans side and make themselves smaller. Smaller is less vulnerable in this kind of situation. That will take some time and is going to be quite painful.

MM: Is there something wrong with the way the financial system is set up that a difference of two weeks of when the government takes what is, by any recent standard, a very bold action has this massive impact? Is the world on too much of a hair-trigger system?

Johnson: Yes, absolutely. We didn't know it was a hair-trigger. The government, to give it some credit, didn't know it was some big tripwire that they would set off, otherwise they wouldn't have done it. They didn't do it intentionally.

By our calculations, all the things the Fed and Treasury are doing amount to close to 70 percent of GDP [gross domestic product]. A few months ago, if I told you they'd do this for 5 percent of GDP, it would have been shocking. In fact, in September when they asked 5 percent of GDP [$700 billion] it was shocking. Now they're doing 70 percent. That's not going to be the total final increase in debt burden, but that's the amount of stuff the Fed is now guaranteeing one way or another, or promising to buy if necessary.

A few months ago, that would have been revolutionary, and I could have been expelled from the American Economic Association for suggesting it.

If this was a novel on the beach that you were reading, this summer, you'd have put it down in disgust and said, "This is a really bad novel. I'm going to go read something less sensational."

MM: If the financial system has these kinds of hair triggers, is there something that should be done to make it less hypersensitive? What are those things?

Johnson: First of all, it's a bit late. The horse has bolted; the horse has left the stable. We should go back and spend a lot of time studying stable doors and understanding why this one sprang open as it did. But to try and prevent it from happening again is not a top priority now, to be honest. A top priority is to try and push into the recession and try to get a recovery underway sooner rather than later. And that's a heck of a lot of work.

Down the road, we definitely have to look at what went wrong and how to avoid it. Presumably, the key thing is you can't let people take hard-to-understand risks, on any kind of scale relative to the national economy. It could also be that, perhaps, you shouldn't let your banks get too big relative to the national economy. You have in the U.K. a situation where bank assets and liabilities are about six times GDP. If those banks go into trouble, and the government is guaranteeing their liabilities, that's a lot of debt the government has to take on. That's not an attractive way to run an economy. I don't care if it gives you 10 years of good growth, or 20 years of good growth, at the end of the day there's going to be a reckoning and you're going to be quite miserable for five years, in a good scenario.

MM: The governments have made a lot of commitments, but there are clearly going to be a lot more problems in the banking sector. How would you recommend managing it? Do you see a need to start closing down banks?

Johnson: Potentially not. I think you need to go further down the road they started with the bank recapitalizations. They have the TARP money - the Troubled Asset Release Program - which is $700 billion. And they say they're going to put $250 billion into bank recapitalization and use the rest to buy troubled assets. We published a piece in the Washington Post saying that that split doesn't make sense. The auctions to buy troubled assets are completely irrelevant right now, and at worse, a signal that the government doesn't understand what's really going on. What you should do is put the remaining $450 billion in a war chest in the president's office with a big label on the top that says, "open in case of severe recession," because then you will need more capital for the banks. That, first and foremost, should be done.

In addition, the Fed is doing a lot of things to support the financial system, including buying commercial paper, providing various kinds of guarantees for money market funds and the like. They have a lot of pieces in place, but they need to stay focused on providing capital.

MM: What are the similarities and differences in the problems facing the European financial institutions? Is it the same set of problems?

Johnson: Yes, but worse, because their banks are more highly leveraged. Their asset-to-capital ratio is more like 30- or 50-to-one, compared to the United States, which is somewhere between 10- and 20-to-one. They have more potential deleveraging. And their banks are also bigger relative to the size of their economy.

MM: If the financial panic was the thing that's taken the recession from mild to severe, and the panic is being quieted, why can't a severe recession be avoided?

Johnson: This is the idea that you can't put the genie back in the bottle. If you could suddenly, miraculously, make everyone confident enough to lend, then yes, you could avoid recession. But that's not going to happen. Once these organizations turn and the markets turn, then it takes years to get back.

I was recently on a panel at the Council for Foreign Relations, and some prominent people told me that I'm far too optimistic about the prospects for recovery in the United States. These people are not just interesting, smart people. They actually move a lot of money around the world. I am just an academic and a former official. These guys are actually the decision makers. They say, "The psychology is ruined. It won't come back for a long time." And if they believe that, of course, it's self-fulfilling.

I'm not saying that they are causing the problem. They are reading the market situation correctly.

MM: How do you expect that the financial crisis and the recession will affect developing countries?

Johnson: It's going to be very bad. They're going to be hit in a two-fold way. First, commodity prices are going to go down a lot. That's part of the adjustment we're already seeing both in commodity prices and the prices of mineral-producing companies. Second, they will not get as much aid as they have become accustomed to, because everyone will cut their aid budgets.

Developing countries are in for a very tough half decade, at least.

MM: You've also written that developing countries will have problems as capital flows dry up.

Johnson: Most of them don't have that many reserves. China has a lot of reserves, as do a few others, but most developing countries do not. And of the ones which do have reserves, many let their private sectors borrow quite heavily. In the case of Russia, the government has a lot of reserves and very little debt. The private sector has a lot of debt in foreign currency. So when things start to fall apart and the currency comes under pressure, the government either has to let the private sector fail, or it has to step in and take over that debt. Then the question is, who do they choose to let survive? They are picking winners as we speak.

MM: Are those countries helpless victims in this or are there things that they might have done to position themselves differently?

Johnson: They probably could have been more conservative. But what we're looking at here is a once in a hundred years storm, and nobody runs their economy - aside from one or two countries - anticipating the once in a hundred years storm.

We built a system that was much more dangerous than anyone thought, than anyone realized.

A few people, no doubt, did criticize the system, and it turns out they were right. And even those people didn't fully understand what was going to happen.

MM: The standard storyline now is that deregulation really helped drive this problem. Is that one you agree with?

Johnson: Yes, certainly deregulation played a role. There's something for everyone in this crisis. It's hard to find any entity or person who was involved in major macro regulatory decision making that can't have some piece of the blame.

There's a nice piece that recently appeared in the Washington Post that traced some of the deregulation back to the Democrats under Clinton. But there are lots of other people, including Republicans in Congress and in the Bush administration, who fully supported deregulation.

Deregulation has worked well in some industries. But deregulation turns out to have had rather unfortunate unintended consequences in the financial sector.

MM: Looking back on your old job as chief economist at the IMF, do you think that the IMF needs to rethink support for financial liberalization?

Johnson: I think everyone needs to rethink everything, to be honest. Not just financial liberalization, but financial development.

One of the mantras of the last 15 or 20 years has been that more financial development is good. Allowing your banks to grow and doing away with what's called financial repression - where you keep interest rates artificially low - was considered to be a good thing. Now I think we have to question that.

I don't think you want to go back to the repressed financial systems of the 1950s and 1960s, but maybe you have to think about the kinds of constraints you put on financial activities and you have to keep finance more plain vanilla. One constraint might be that no bank should do anything that it can't explain in an 800 word op-ed, or that its CEO does not understand.

MM: What do you think governments in the United States and elsewhere ought to be doing to lessen the severity of the recession?

Johnson: There's a lot. There's a bit more that you could do with monetary policy in the U.S., though it won't have that much effect at this stage. You could do a pretty big fiscal expansion. Getting money into the hands of state and local governments strikes me as being pretty important because they're starting to cut back already. Putting money into education would also strike me as being a very smart short-term move, because we know that classroom sizes are going up as people move out of fee-paying schools to public schools. Some sort of income transfer scheme could be worth consideration. People will tend to save the extra money you give them, not spend it in this context, so you have to take that into consideration. In the U.S. context, I would want to link that very closely with spending public money on mortgage restructuring programs. You've got to find ways to break this death spiral of declining house prices, foreclosures, forced sales and further house price declines.

In Europe, I think there's big room for monetary policy easing. It's remarkable they haven't cut interest rates so far this week [October 13] - it tells you that they don't really get the situation. There is also some room for fiscal expansion. The problem is their government balance sheets aren't that good to start with, and they've taken on these massive banks, so that is really going to constrain them. Obviously, if you go way overboard with fiscal, you're going to undermine confidence. It's a very fickle beast, confidence.

So, priorities are: U.S., fiscal; Europe, monetary and fiscal; mortgage restructuring in the U.S. and in some European countries, particularly in the U.K., Ireland and Spain. A number of Asian countries could do fiscal expansions also. They're scope is limited; they're not that big; and the amount of fiscal expansion China could actually put on the table in the next 12 months, just as a practical matter, is pretty small.

MM: Why is Europe so reluctant to loosen up on the monetary side?

Johnson: They're still obsessed with inflation. They are reliving the 1970s in their own minds. That was a formative experience for many of them and for their institutions. In the 1970s, you had recession and you had inflation for a particular circumstance related to the oil price shocks and wage-price dynamics. They think that's going to happen again, so they think they must guard against inflation while trying to be somewhat more helpful now on the real economy.

I think it's a mistake. I think we're heading into a deflationary spiral. I think inflation is the last thing to worry about at this stage.

MM: Do the middle-income countries and the poor countries have any policy flexibility at this point?

Johnson: They have a bit. They have to decide when to use their reserves, that's an important decision. Do you hold the exchange rate at where it is, or do you let it go to some degree? Letting it go often means people are going to fail, and then you have to decide who to save and how to organize workouts and so on.

The classic mistake would be to try and hold exchange rates at what is now an overvalued level, or a level you can't defend. Then people attack the exchange rate, you lose your reserves, you have a big depreciation anyway, and you no longer have the reserves - making it much harder to bring stability back into the picture.

So there are lots of tough choices ahead for them, and those choices do actually make a difference.


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