Financial Oligarchy and the Crisis
Simon Johnson
Professor
MIT
An Interview with Harvey Stephenson
Grand Cayman, Cayman Islands, 20 January 2010
Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at Massachusetts
Institute of Technology Sloan School of Management. From March 2007 through the end of
August 2008, he was the International Monetary Fund’s Economic Counselor (chief economist) and Director of its Research Department. He is also a co-founder of BaslineScenario.
com. He is the co-author, with James Kwak, of 13 Bankers, in which he addresses many
of the issues discussed in this interview.
Brown Journal of World Affairs: Can you explain to us, in a nutshell, the role of
political capture and financial oligarchy in the financial crisis of 2008?
Simon Johnson: The financial crisis of 2008–2009 was primarily a result of reckless
risk-taking by the world’s largest banks. The essence of the problem is that they have
not changed their behavior. You could argue that before the crisis they saw themselves
as too big to fail. Now, post-crisis, the surviving banks are definitely too big to fail. All
of the incentive problems—the distorted perceptions—that existed before September
2008 remain with us. In fact, they are actually worse; the problem has been worsened
by the crisis.
Journal: You have argued that the crisis was a result of an unfortunate relationship
between the financial sector and the government?
Johnson: It is obviously something that has developed over a very long period of time.
One needs to go back to the Reagan revolution at the very beginning of the 1980s
and look at the move towards deregulation more broadly in the U.S. economy. In that
context, some of the deregulation was sensible but the deregulation of banks had the
unfortunate consequence of making them generate more money, which they plowed
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back into developing critical connections and convincing people they were invincible
and the front of unstoppable growth. All of that turns out to be not only wrong but
also a very dangerous set of beliefs.
Journal: In your article, “The Quiet Coup,” which appeared in The Atlantic (May 2009),
you refer to this phenomenon as cultural capture. Could you explain this term?
Johnson: It refers to a particularly unusual form of oligarchy in the financial industry
that rules not through intimidation or corruption, but through convincing people that
more finance is good, more unfettered finance is better, and completely unregulated
finance is best.
Journal: You have dealt with similar crises, if on a somewhat smaller scale, in the
context of the emerging economies while you were the Chief Economist at the International Monetary Fund (IMF). Did you ever expect to find a comparable situation
in an advanced economy?
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Johnson: No. It is fair to say that, at least prior to 2005–2006, very few people expected
these kinds of problems in the United States. The view that many of us had was that
the United States had experienced problems in the past but had matured to a political
and financial point at which it could experience problems without repercussions anywhere near as severe as what we are observing today. Obviously we had seen Long Term
Capital Management—the collapse of a large hedge fund in 1998—and we have seen
U.S. involvement in international financial crises. But to have a crisis of confidence in
the heart of the global financial system—that was unexpected. Going back to when I
was working at the IMF as Chief Economist in early 2007, it became clear to me that
there were deep problems at the heart of the system. I would not say that the crisis of
September 2008 was a big surprise coming from that perspective. Journal: How do you think political capture has affected the policy response during
the crisis and in the run-up to the crisis? Johnson: It had a big effect. The rescue package provided by the U.S. government,
both under the Bush administration and again under the Obama administration was
one of the most generous in the history of financial bailouts. While shareholders did
take some losses, creditors were almost entirely protected. The key is the insiders—
the managers the of the big banks who have brought their institutions into massive
crisis—who were largely left intact financially, to the extent that they walked away
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Financial Oligarchy and the Crisis
with enormous compensation packages, and, in many cases, kept their jobs. This is
reflected in the bonuses that they paid themselves—large bonuses for 2008 and even
larger bonuses for 2009—which really reflects the return of risk-taking. Because of
their track record, and because we know very little has changed about their practices,
we need to be worried that risk-taking is becoming reckless again. Journal: Would your ideal policy response have been substantially different than that
of the Bush Administration or the Obama Administration? Johnson: Yes, absolutely. But this is not just
my idea—this is best practice in a banking The big banks today, I can assure
crisis in any situation, and this is what was y o u , h a v e a n e x p e c t a t i o n o f
really pushed for by the U.S. treasury, for
bailouts without any conditions.
example, in the 1990s. I do not agree with
everything that they advised countries on—the Asian Financial Crisis, for example,
in 1997 and 1998—but on this point they were absolutely right that you should take
the moment of crisis and seize it as an opportunity to clean up and fix the financial
system, addressing the underlying incentive problems that brought forth the crisis.
That was the position of Larry Summers, who was Deputy Treasury Secretary, and later
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Treasury Secretary—he is the leading economic guru of the Obama administration. He
gave a lecture to the American Economic Association in January 2000—the so-called
Ely Lecture—where he laid out these principles in a clear and sensible fashion. In my
opinion, these principles have not been followed in the U.S. case, and we will regret
it. Summers said in that lecture that no sustainable financial system could be based on
the expectation of unconditional bailouts. The big banks today, I can assure you, have
an expectation of bailouts without any conditions.
Journal: Ben Bernanke once suggested that a “global savings glut”—i.e., savings from
emerging economies flowing into the United States—was the cause of the low long-term
interest rates in the U.S. economy. Do you think that policy decisions from emerging
economies like China were the cause of the housing bubble?
Johnson: It certainly lowered long-term interest rates around the world, but it was not
a primary cause. People who argue this disagree on the exact numbers, but you might
say a reduction in interest rates by 0.5 to 0.75 percentage points occurred from the fact
that emerging markets wanted to save more after the experience of the Asian Financial
Crisis in the 1990s, which was partly due to debt that had accumulated in their financial
systems. We can argue about why they wanted to save more, but the fact of the matter
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Simon Johnson
is they did save more. It is not only about China but also about oil producers who had
big savings. Those factors affected rates, but to link that to sub-prime crisis—to say
that just because interest rates are lower people go out and make crazy irresponsible
loans and then structure them in ways that will cause damage to their own banks and
to their customers—is an extraordinary leap. It is not consistent with the last 500 years
of history of organized financial markets. Sometimes these kinds of asset price bubbles
emerge, and there is no reason why cutting interest rates particularly leads to financial
frenzy, excess, and collapse. Journal: What do you think was the primary cause of the housing bubble?
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Johnson: The primary cause was a lack of effective consumer protection. We have increasing documentation that people who would have or could have qualified for prime
mortgages were strongly encouraged to take subprime mortgages. The incentives for
mortgage brokers, for example, pushed them into certain kinds of products that are
actually dangerous and harmful. It is much like the pharmaceutical industry—150 years
ago you could sell anything you wanted on the street corner in the United States and
you could tell people that it was patent medicine. If you do that today, that is a very
serious crime in the United States—and the same thing has to happen with regard to
consumer products. There are certain standards for safety—and those by the way change
over time. So one cannot sell a car today that would have been world class in terms of
safety in 1920 or even 1950. You have to have standards, they have to be enforced, there
has to be effective consumer protection, and you have got to keep moving—otherwise
you will destroy your entire economy.
Journal: In your article “The Next Financial Crisis,” which you co-authored with Peter
Boone in The New Republic (September 2009), you describe the U.S. Federal Reserve
as a sort of perpetual bubble blower in the way it cleans up crises following asset price
collapses—not to mention some economists have discussing a positive inflation rate
target. What do you think the cure to this bubble-cycle could be?
Johnson: Well, I think we have to break this cycle, what we call the doom cycle or
doomsday cycle. Andrew Haldane, at the Bank of England, calls it the “doom loop,”
and it really requires a change in the structure of the financial system, higher capital,
and other tightening of the regulation around the largest banks. Unless you do that,
our view is that you will run through these repeated cycles—ultimately resulting in
either inflation or bankruptcy.
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Journal: Financial markets in emerging economies did not escape from the crisis unscathed. What do you think emerging economies can do to protect themselves from
the negative impact of financial globalization?
Johnson: I think that emerging markets are the new frontier—people are very enthusiastic about them now. There will likely be an economic boom coming out of this crisis
in which people are focused on China, Brazil, Russia, and other emerging markets.
These countries have to look closely at the extent of their integration in global capital
markets and the extent to which they want capital to flow in. The unfortunate fact
of the matter is that even if they want to keep capital out, they will still probably get
sucked into this way of thinking one way or another. It is difficult to isolate yourself
from these risks. There is a global financial system, and it is very tempting to get involved; it is alluring but dangerous.
The best policy in these emerging economies would be to require domestic banks
to have very high capital requirements and to tighten credit standards as the boom goes
on, which is not what most people do. In almost all cases credit standards relax as the
boom goes on because people become more and more convinced that things are going
to go well, so to the extent which emerging markets can lean against this tendency, they
should do it. You can also feel in some situations they should raise interest rates. The
problem is that if you are open to capital flows you raise interest rates, and if you are,
let’s say, India, you are just going to attract even more foreign capital—so you have to use
regulatory mechanisms in order to offset this flow of capital into emerging markets.
Journal: In other words, capital controls are not the answer in the case of emerging
economies?
Johnson: Capital controls in some instances may be the answer, but capital controls can
also go very badly—they can distort capital. Remember, we have a situation in which
many countries have their own oligarchs—people with resources and power that like to
grab the good opportunities for themselves and make money off of them. If you totally
exclude foreign capital you are probably playing into the hands of these people because
they have the local capital already, so one has to weigh the costs and benefits very carefully. To the extent that you can let in long-term capital, capital investing in the real
economy, and capital that is backing new enterprises and entrepreneurs, it should be
encouraged. To the extent that an economy is attracting capital that is relatively shortterm and can move in and out quite easily, you have to be really careful in ensuring
that your institutions can withstand those kinds of inward and outward flows. Most
emerging markets, unfortunately, are not yet in that position.
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Journal: A number of emerging market economies have used an export promotion
strategy in order to induce economic growth. Do you think that is a strategy they will
continue to use in the future?
Johnson: Yes, absolutely. I think that, in general, in emerging markets this is not a crisis
of globalization. Very few of them are worried about what happened to their economy
or feel that this calls for any kind of fundamental rethinking of their model. The model
that really attracts them—with variation depending on the type of economy and their
place in the global value chain—is some
I think China is creating problems for sort of the export-oriented strategy. This is
itself by not revaluing, but good luck fine, except, of course, that this means that
explaining that to the Communist Party. someone has to import. You could have an
export strategy that is consistent with a
more or less balanced current account—which would be the case if imports increased
with exports—but in general when they say an export-oriented strategy they mean a
current account surplus, and that is consistent with the notion that they do not really
trust the IMF and are reluctant to put themselves in a position that they would ever
need to go to the IMF.
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Journal: Does having a current account surplus also make them net lenders?
Johnson: Yes—if you run a current account surplus you are a net lender to the international financial system. Now it has to add up. Somebody has to be a net borrower.
So who is that net borrower? It has been the United States—the U.S. consumer—and
that is unlikely to be the case going forward. So who is it going to be? Is it the U.S.
corporate sector? Is it Europe? Is it other emerging markets, for example? We do not
know, but that pattern is one that fuels the instability, at whose core are the “too big
to fail” banks.
Journal: Some economists, like Financial Times columnist Martin Wolf, have called
for China to revalue its currency in order to avoid the global imbalance issue that you
raised. Do you think that course of action is absolutely necessary to resolve the problem?
Is this good for China?
Johnson: It is a good idea, and I think China is creating problems for itself by not revaluing, but good luck explaining that to the Communist Party. They are committed to
their current exchange rate policy; they like accumulating reserves, and I think Martin
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Wolf is right to raise important flags over this issue. This could be a bigger element of
the next crisis, or it could well interact with another mechanism for crises: big current
account surpluses from certain emerging markets that get pushed through the global
financial system and emerge as asset price bubbles in other emerging markets. As a
historical example, take the Latin American debt crisis of the 1970s. That crisis was
largely based on the so-called recycling of petro-dollars: the petroleum and oil-exporting countries had big current account surpluses, and they parked that money in U.S.
and European banks, who then lent it to Eastern Europe and Latin America, leading
to these dire consequences.
Journal: Is the “too-big-to-fail” phenomena becoming more prevalent among the
emerging markets’ financial institutions?
Johnson: Well emerging market economies have always had some aspects of this
phenomenon. Take the Korean chaebol—their large conglomerates—in 1997. Look
at the role played by President Suharto’s family in Indonesia during the 1990s. Look
at Russian oligarchs in the 1990s. Emerging markets do frequently have an oligarchic
structure. Oligarchs often try to build up this “too-big-to-fail” position because it means
that you can make money when things go up and when things go bad you can get a
pretty good bailout. That is an issue that we all have to confront.
Journal: What role would an emerging markets monetary fund (EMF), which you
have proposed, have in encouraging economic growth?
Johnson: The IMF has, has worked hard to rebuild its prestige and credibility, but the
progress so far is limited. They have, for example, a very good lending instrument called
the “flexible credit line,” which is basically a no-strings-attached loan if the fund feels,
in broad terms, that your policies are good. The flexible credit line is exactly what the
world needs because it encourages countries not to run current account surpluses since
they can draw on this line. And it has exactly three customers right now: Poland, Mexico
(where the finance minister is a former senior IMF official), and Colombia. The reason
it is not taken up more broadly is not because it is badly designed. It is because most
countries do not want newspapers to report that Korea, or whatever the county is, is
borrowing money from the IMF. Even though you can explain that it is not an ordinary
standby loan—it does not have the same conditions—that connotation is absolutely
not what you want in the minds of voters, the broader public, and investors.
What we should do is move to a situation where the IMF is in charge of, let’s
say, the global economic “emergency room.” That would be the case of Iceland, for
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Simon Johnson
example, which had a complete collapse. There was no way that they could borrow
money on any terms from anyone, including friendly parts of Scandinavia. At the same
time I think that an emerging markets fund could provide a flexible credit line type
instrument. It could be like a first line of defense, a preemptive kind of mechanism.
And of course the difference between today and even 10 years ago, let alone 20, 30, or
40 years ago is that the emerging markets themselves have big reserves. So the fact that
China has accumulated $2 trillion in reserves enables them to capitalize, in dollars,
a financial institution of the kind that I am talking about. We have to work out the
mechanisms for ownership and control, but that would be for them to sort out. The
idea that you either go to the IMF, you fend for yourself, or you have total collapse, is
a false division. Governments have other options, including pooling reserves or having
an emerging market fund. The emerging markets have a justifiable complaint about the
governance of the IMF and the World Bank. The Europeans are a major problem, and
of course the United States has a veto that it would never give up. At the same time,
the emerging markets at some point need to stop complaining and start acting, and I
think that the action that is required is collective action. It requires some leadership,
but they should get on with it if they really want to live in a more stable, economically
sustainable world. 166
Journal: Is the U.S. dollar losing its position as an international reserve currency a highly
unlikely outcome, even with the Chinese overtures for global monetary reform?
Johnson: Absolutely. The Chinese are rattling the cage of the United States; it is not
a particularly bad thing, but it is not particularly constructive either. The question is,
what is the alternative? You have to hold something and cling on to someone. You
could accumulate gold, but there is only a limited amount. You could hold Euros, feel
free, but people seem rather skittish recently, particularly in light of problems with the
Greek government, and other governments within the eurozone. The British Pound is
not widely regarded as having great appeal; Britain has serious problems. The Japanese
Yen was, at one time, a serious reserve currency, but people find it rather too volatile
for that purposes. So what is it going to be? The Chinese Renminbi is not sufficiently
convertible. Creating an international currency is largely illusory because it has to be a
currency you can convert into something you can buy. You have to be able to go and
buy goods, which means ultimately it is a claim on something like the U.S. dollar, or
the ability to buy goods in the United States. Then you have just come back around
full circle to the U.S. dollar.
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Journal: Do you have any particular predictions for this year in terms of the global
economy?
Johnson: Yes, I think global growth is going to be good. We are in a rebound phase.
You throw massive unconditional subsidies at any industry and they are going to do
well—for a while. Madeleine Albright actually proposed in 1997 that the United States
do this for South Korea. This is documented in Paul Blustein’s book The Chastening;
it is a very good account of what the IMF did, what the Treasury did, and what the
Treasury told the IMF to do. Madeleine Albright proposed unconditional bailout
money. The Treasury team—which included Larry Summers, Tim Geithner, and David
Lipton—dismissed it in a derisive manner, according to Blustein. But that is exactly
what they have done today: they have put unconditional bailout money into the biggest banks. Of course they will do fine for
If banks turn themselves into wella while, but their incentives are massively
behaved, responsible entities that
distorted.
The real test for economies was not the never cause another financial
housing crisis, it is right now. If the banks
crisis, economics will have failed.
take these distorted incentives and turn
themselves into well-behaved, responsible entities that never cause another financial
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crisis, then economics will have failed. Economics is ultimately about incentives—it is
about the view that people’s actions and behaviors are going to be shaped substantially
by these incentives. Incentives say, “go out and take a lot of risk,” and I think that is
what will happen. That does not mean that there is going to be another crisis right
away—back to back international crises are unusual. Jamie Diamond, the CEO of J.P.
Morgan, told the U.S. Financial Crisis Inquiry Commission that major crises occur, in
his view, every five to seven years. Larry Summers is on the record in the past as saying
every three to five years. You can pick which one you want. The longer we go on, the
bigger the next crisis will probably be.
Journal: What role does political economy play in the discipline of economics? Your
work has showed that economists have something to say about political economy.
Johnson: Along with behavioral economics, political economy is the new frontier. In
the study of emerging markets, it is already the case that people regard the concepts
and the tools of political economy as essential to economic analysis of those countries.
What people balked at before—and some people still have reservations about today—is
applying those same tools to think about the United States. There was a view—there is a
view—that the United States is somehow different, better, less political, less about inter-
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Simon Johnson
est groups, less about political capture than emerging markets. That view is wrong—the
distinction, which we draw in our mind between emerging markets and developed
countries, is a completely artificial distinction. It is just a conceptual framework that
we put on the data. We should return to those basic principles and examine the incentives in the structure of the financial system, judge them on that basis, without looking
at the names of the countries. Then you can put the name on the countries and draw
A
your own conclusions for the likelihood of a serious crisis going forward. W
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