Sat, Feb 26, 2011 - Page 9 News List

Geithner’s ‘gamble’ a clear indication of his naivete

By Simon Johnson

In a recent interview, US Treasury Secretary Tim Geithner laid out his view of the nature of world economic growth and the role of the US financial sector. It is a deeply disturbing vision, one that amounts to a huge, uninformed gamble with the future of the US economy — and that suggests that Geithner remains the senior public official worldwide who is most in thrall to the self-serving ideology of big banks.

Geithner says the world will now experience a major “financial deepening,” owing to growing demand in emerging markets for financial products and services. He is thinking, of course, of “middle income” countries like India, China and Brazil. And he is right to emphasize that all have made terrific progress and now offer great opportunities for the rising middle class, which wants to accumulate savings, borrow more easily (for productive investment, home purchases, education, etc) and, more generally, smooth out consumption.

However, Geithner then takes a leap. He wants US banks to take the lead in these countries’ financial development. His words are worth quoting at length.

“I don’t have any enthusiasm for … trying to shrink the relative importance of the financial system in our economy as a test of reform, because we have to think about the fact that we operate in the broader world … It’s the same thing for Microsoft or anything else. We want US firms to benefit from that … Now, financial firms are different because of the risk, but you can contain that through regulation,” he said.

There are three serious problems with this view. First, Geithner ignores everything that we know about the pattern of financial development around the world. It is very rare for financial systems to develop without major crises. In fact, experience in recent decades confirms what should have been obvious from previous centuries: As countries grow and accumulate savings, they become increasingly prone to financial collapse.

Given Geithner’s extensive international crisis-fighting experience at the US Treasury, the IMF and the New York Federal Reserve, his current naivete on this point is simply stunning.

Second, Geithner assumes that risks at the largest US firms can be contained through regulation, when all our knowledge points directly to the contrary. Even the strongest supporters of the Dodd-Frank reform legislation emphasize that it only went part way toward reducing the incentives for major financial institutions to take big risks. Looking at the combined effect of the new law, plus the weak additional capital requirements agreed under Basel III and the hands-off approach already signaled by the Financial Stability Oversight Council (which Geithner chairs), it is hard to believe that anything has really improved.

In fact, given that our largest banks are now undoubtedly too big to fail, they have even more incentive to increase their debt levels relative to their equity. Higher leverage increases their payoffs when times are good — as executives and traders are paid based on their “return on equity.”

When times are bad, for example in a crisis episode, losses are transferred to creditors. If those creditor losses are large and spread so as to undermine the broader financial system, pressure for a government bailout will mount. Bankers get the upside and taxpayers (and people laid off as credit is disrupted) get the downside.

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