By James Kwak

We’ve cited Thomas Hoenig, president of the Kansas City Fed, a number of times on this blog for his calls to be tougher on rescued banks and to break up banks that are too big to fail. This has been a bit unfair to Richard Fisher, president of the Dallas Fed, who has been equally outspoken on the TBTF issue (although we do cite him a couple of times in our book).

Bloomberg reports that Fisher recently called for an international agreement to break up banks that are too big to fail. Here are some quotations, taken from the Bloomberg article (the full speech is here):

“The disagreeable but sound thing to do” for firms regarded as “too big to fail” would be to “dismantle them over time into institutions that can be prudently managed and regulated across borders.”

“Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach: an international accord to break up these institutions into ones of more manageable size. If we have to do this unilaterally, we should.”

“The existing rules and oversight are not up to the acute regulatory challenge imposed by the biggest banks. Because of their deep and wide connections to other banks and financial institutions, a few really big banks can send tidal waves of troubles through the financial system if they falter.”

This is not the first time that Fisher has sounded this alarm. Last fall, he called too-big-to-fail banks a “the blob that ate monetary policy,” arguing that they distorted the economy in ways that made it harder for the Fed to fight the economic downturn. This was the core of his conclusion:

“To craft a smart solution to this vexing problem of banks considered too big to fail requires that we deal with the way people and businesses really are. To me this means finding ways not to live with ’em and getting on with developing the least disruptive way to have them divest those parts of the ‘franchise,’ such as proprietary trading, that place the deposit and lending function at risk and otherwise present conflicts of interest.”

The TBTF debate is mainly between people like Fisher and Hoenig (and Paul Volcker and Mervyn King) who think that the problems posed by megabanks (implicit government guarantee, competitive distortion, etc.) cannot be regulated away, and people like Ben Bernanke and Tim Geithner who think that they can. (There are also a few people in free market fantasy land who think that the government can simply promise never to bail out another bank and that market forces will take care of the rest.)

Seen in an abstract light, we can have no assurance that any new regulations will actually work to prevent a financial crisis or defuse one, so the safer option (and isn’t that what regulators should want?) is to break up the big banks. Most of the arguments against this course of action have something to do with international competitiveness (smaller U.S. banks would hurt American companies in the globalized world). I think those arguments are obviously flawed; globalization means that American companies can get their financial services from banks that happen to be headquartered anywhere in the world, not just U.S. banks. But even if we grant them for the sake of argument, the international agreement that Fisher suggests should take care of that issue. And the only way to get such an international agreement is for the U.S. to take the lead.

Politically, breaking up TBTF banks is something that should on paper be able to attract a bipartisan majority. Many progressives are in favor of cutting “Wall Street” down to size; so are some conservatives, on the grounds that TBTF banks enjoy an implicit government subsidy and would require a bailout in the event of a crisis. Thomas Hoenig is generally considered a relatively conservative Fed bank president, at least when it comes to monetary policy. (Of course, such a bipartisan majority would require some Republicans to vote for something that might be popular with the electorate, which might be impossible in the current political climate.)

For whatever reason, the administration and Christopher Dodd seem to be going for the other kind of majority — one that cobbles together a least-common-denominator reform package that leaves the basic financial system intact. Even if they succeed, at best we will have lost our best opportunity for real change in decades.

By Simon Johnson

In 2006 Robert Rubin and his allies created the Hamilton Project, housed at the Brookings Institution, to think about what a future Democratic administration would do.  (Senator Obama attended the opening.)

From a tactical standpoint, this was a brilliant move.  It developed people, including Peter Orszag and Jason Furman (directors of the project),  trained a team, and created an agenda.

Unfortunately, financial reform was not – and perhaps still is not – on this agenda.  The financial crisis more than blindsided them; it overturned their entire way of thinking about the world.  At least in part, this explains their slow, partial, and unsatisfactory response.  In any case, it hasn’t worked out for them – or for us.

Wednesday morning there is a potential step in another direction.  (Alternative link.)  There are many questions.

Can would-be reformers agree?  This is probably the easy part, at least for now.

Will there be continuity and personnel development, for example in the Institute for New Economic Thinking and the Roosevelt Institute?

Where’s the “Geithner wing” of this movement – i.e., the people with practical policy experience inside the regulatory machine, who can be brought in to senior government positions?

And who will provide the political leadership?  All eyes are on the Senate – but who exactly will step up and on what basis?

By James Kwak

Donald Kohn recently announced that he is resigning as vice chair of the Federal Reserve Board of Governors, after forty years in the Federal Reserve system, most of it in Washington. Articles about Kohn have generally been positive, like this one in The Wall Street Journal. The picture you get is of a dedicated, competent civil servant who has been a crucial player, primarily behind the scenes, in the operation of the Fed.

It’s a bit interesting that Kohn is generally getting the soft touch given that he was the right-hand man of both Alan Greenspan and Ben Bernanke. Here are some passages from the WSJ article:

“‘Don was my first mentor at the Fed,’ Mr. Greenspan says. Mr. Kohn told Mr. Greenspan how to run his first Federal Open Market Committee meeting, the forum at which the Fed sets interest rates. He became one of Mr. Greenspan’s closest advisers and defender of Mr. Greenspan’s policies.”

“Mr. Kohn has spent the past 18 months helping to remake the central bank on the fly as Chairman Ben Bernanke’s loyal No. 2 and primary troubleshooter.”

“Mr. Kohn has been at Mr. Bernanke’s side for nearly every critical decision during the crisis. He also has been asked to solve some of Mr. Bernanke’s biggest challenges — from finding a way to melt frozen commercial-paper markets to keeping peace among occasionally warring factions inside the Fed.”

Let’s not mince words. Kohn was one of the leading cheerleaders for the Greenspan Doctrine. Here’s one example. In 2005, Raghuram Rajan gave a now-famous paper at the Fed’s Jackson Hole conference warning of the impending financial crisis. Kohn gave a response, which we describe this way in 13 Bankers:

“Fed vice chair Donald Kohn responded by restating what he called the ‘Greenspan doctrine.’ Kohn argued that self-regulation is preferable to government regulation (“the actions of private parties to protect themselves . . . are generally quite effective. Government regulation risks undermining private regulation and financial stability”); financial innovation reduces risk (“As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market”); and Greenspan’s monetary policy resulted in a safer world (“To the extent that these policy strategies reduce the amplitude of fluctuations in output and prices and contain financial crises, risks are genuinely lower”). Kohn’s conclusion reflected the prevailing view of Greenspan at the time: “such policies [recommended by Rajan] would result in less accurate asset pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.”

(Emphasis added.) Now this does not mean that Donald Kohn is a bad person; it just means that he was wrong, along with Alan Greenspan and Ben Bernanke. If recent accounts are to be believed, he, like Bernanke, was relatively quick to shift gears when the crisis exploded and figure out effective responses, for which he deserves credit. (He also oversaw the stress tests, for better or worse.) But from where I’m sitting, the fewer members of the old guard, the better.

So now the question is, who will fill Kohn’s seat — and the other two empty seats on the Board of Governors? The Board is supposed to have seven members, and they matter because they have seven of the twelve seats on the Open Market Committee, which sets the fed funds rate. Business Week says that the search is being led by Tim Geithner and Larry Summers, and that the likely goal is to find people to back Bernanke.

This confuses me for a few reasons.

First, it’s not clear what Bernanke stands for. He was a Greenspan clone for about two years; then he turned into a pragmatic firefighter; and recently he’s been avoiding taking positions on issues, except to say that he’s against anything that reduces the power of the Fed (like an independent CFPA). So even if you wanted to find three mini-Bens, how would you even identify them? For starters, is he an inflation hawk or a dove?

Second, why is the Democratic establishment uniting behind Bernanke? Bernanke was a Bush appointee to the board, a chair of the Bush Council of Economic Advisers, and then Bush’s pick to replace Greenspan. He’s a Republican whose main selling point to Obama was that he was already in the job and accepted by “the markets,” and he was the clear choice of Wall Street this winter. Does this mean that Obama is going to appoint three centrists who follow the (recent) central banking orthodoxy of putting inflation control over economic growth, and who oppose tighter regulation of banks? For anyone who thinks that there is such a thing as a coherent Democratic economic policy, that seems like shooting yourself in the foot.

Finally, and I know I’m in the minority here, why are we trying to increase the power of the Fed chair — especially a Fed chair from the opposite party? Leaving aside policy questions, I think the deification of the Fed chair in the past two decades has been a decidedly bad thing. The sensitivity of the markets to one man’s pronouncements (and, just imagine, his health) is a bad thing; the fact that an unelected person is widely considered the second-most powerful person in the country is a bad thing; and if our economic fate actually depends on one person’s wisdom, that’s also a bad thing. The point of a committee is to have differing views, arguments, and a vote — not to have a bunch of suck-ups and yes men. If we put some real progressives on the board, then that’s what you would have — diversity of opinion and meaningful votes. (Including Bernanke, three of the four current members are Bush appointees, including a former investment banker and a former chair of the ABA.)

I know people will say I don’t understand, and if we had debate on the board the markets would be spooked. I think that effectively amounts to saying that dictatorship is good for the markets, so we should have a dictator.