JS: Oh, it’s happened in many emerging markets. Mexico was one of the cases where it happened, and that was just before I arrived at the World Bank and we were seeing some of the consequences there. But what happens in the process of bailouts is that money goes from public purse to somewhere else. And you have to trace the money and what you discover is the money goes from the public, from the taxpayer, and it inevitably winds up in the hands of some of the same people who caused the crisis. And it’s often done in a very obscure way, just like the creation of the crisis itself, into things that are hard to detect — off-balance sheet transactions and the like.
What has absolutely amazed me about this crisis is the lack of transparency that created it is now being reflected in the lack of transparency in the bailouts. And the Federal Reserve is saying that it’s not subjected even to the Freedom of Information Act. Here we have a public organization that is refusing to disclose where the money went.
ZC: The public’s money, at that.
JS: That’s right. Bloomberg [News] had to sue, Bloomberg won the suit and rather than saying, “We made a judgement call that wasn’t right,” the Fed said, “No, we’re going to appeal because we don’t want people to know.” It’s not like anyone has been advocating to have every scrap of information immediately available in the moment of the crisis. That obviously could cause a little bit of a turmoil. But now we’re more than a year after Lehman Brothers. It’s no longer a question of market stability but a question of accountability.
ZC: Are other central banks this secretive?
JS: This is part of the mentality of central banks. Remember, the central bankers are often people from the banking community, the same community that has been involved in the inventive, creative use of these off-balance-sheet kinds of non-transparent vehicles. So they know that information is money, and the best way to profit is to try and keep everything quiet.
ZC:’Too big to fail’ has become a household term, but how did things really play out when Lehman Brothers went under? If policymakers had just looked at Lehman’s involvement in the commercial paper market, it’s at least conceivable that the bankruptcy could have been managed without so much fallout. Could Lehman have gone through a prepackaged bankruptcy similar to what Chrysler and GM experienced? And if so, what would it have looked like?
JS: Clearly, we could have managed an orderly resolution for Lehman. You know, there have been big financial companies – Continental Illinois – that have gone bankrupt without any trauma to our economic system. And so we know how to manage these things. There is a little bit of a question about whether there was legal authority to do it because Lehman was an investment bank not a commercial bank, so the ordinary FDIC process wouldn’t apply.
ZC: Well, Lehman was a lot bigger than Continental Illinois, but we still managed to come up with something for Chrysler and GM, and the FDIC process didn’t apply to them.
JS: The point I was going to make is that everybody knew that there was going to be a problem with Lehman Brothers several months before it actually went under. If there really wasn’t any legal authority to deal with it, Bernanke and Paulson should have gone to Congress and said they needed it. So the fact is, this legal authority issue was just an excuse for policymakers. The bailouts of AIG and Bear Stearns involved very unusual measures. These guys were willing to bend the law, and they could have done a lot more than they did on Lehman Brothers. But they were in the business of picking winners and losers. There were a lot of discussions about how they decided who to bail out and who to not, and the sheer recklessness of the process is just inexcusable.
ZC: But what do we do now? After Lehman, the government can say it will let these mega-banks fail, but the credit markets won’t buy it. The big banks are still able to raise money at lower interest rates and take bigger risks because investors think the government will spare them from losses. Is there a way to establish a fair playing field in finance that doesn’t involve breaking up these banks?
JS: It’s very difficult. You know, the studies have shown very clearly that the very big banks, the banks that we call too big to fail, have a competitive advantage not because they are more efficient, but because they can get access to capital at lower costs. Everybody knows that they’re effectively guaranteed by the U.S. government. And that really tilts the playing field and leads to a very adverse dynamic in which the big banks actually get bigger. The bigger you are, the better the implied government insurance, and that accelerates the process of concentration in a few banks. It’s very, very unhealthy from an economic standpoint. It undermines competition and drives up interest rates. We want low interest rates to get our economy recovering. This goes in exactly the opposite direction because it weakens competition.
So in my mind you have to do something. Both because of this distorted playing field, but also because the too-big-to-fail banks have this bias toward risk-taking. If they gamble and they win they walk off with the profits. They lose, we, the taxpayers, pick up the losses.
So something has to be done. Taxes can make a big difference, they can help level the playing field, and there have been proposals for that. I’m not sure, though, that that’s going to be enough, and here’s why. Those who run the banks have interests that are not necessarily coincident with the banks’ shareholders and bondholders. We saw that over and over and over again. The bankers have done very well, but the shareholders and bondholders have not always done so well. So we probably need to go further than tax policy.
I argue that we need a three-pronged approach. Higher taxes and higher capital adequacy requirements to level the playing field are the first prong. The second thing we need to do is take serious structural measures like breaking them up. We should not allow banks that accept deposits to engage in proprietary trading. We shouldn’t allow them to own insurance companies, and so forth either. By forcing companies to focus on one thing rather than allowing them to conduct four different kinds of financial business, we will actually increase the efficiency of our economy. And finally, at the end, we have to make sure that they don’t undertake excessive risk.