Treasury Secretary Timothy Geithner has a deeply disturbing vision of the nature of world economic growth and the role of the U.S. financial sector. His view amounts to a huge, uninformed gamble with the future of the American economy—and suggests that Geithner is the senior public official worldwide most in thrall to the self-serving ideology of big banks.
Geithner recently told the New Republic that the world will 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. 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.
But then Geithner takes a leap. He wants U.S. 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 U.S. firms to benefit from that. … Now, financial firms are different because of the risk, but you can contain that through regulation.
There are three serious problems with this. 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 Treasury Department, the International Monetary Fund, and the New York Federal Reserve, his naiveté on this point is simply stunning.
Second, Geithner assumes that risks at the largest U.S. 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 went only part of the 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." And 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, while taxpayers (as well as those who lose their jobs as credit is disrupted) get the downside.
The U.S. financial sector went mad for high-risk loans to emerging markets during the 1970s, arguing that this was the new frontier. This loan portfolio blew up in the debt crisis of 1982. A version of the same thoughtless cross-border lending is again underway, extolled by leading financial-sector executives (such as Jamie Dimon from JPMorgan Chase). They have apparently persuaded Geithner to tag along intellectually.
Third, Geithner completely overlooks what has brought significant parts of Europe to its economic knees. He should spend more time with the authorities in Iceland or Ireland or Switzerland, countries where "financial globalization" allowed banks to become big relative to the economy.
In Iceland, the three largest banks built global balance sheets that were between 11 and 13 times the size of the economy. And then they collapsed. In Ireland, the three largest banks went crazy for commercial real estate—financed by large-scale borrowing from other eurozone countries (including Germany). The politicians looked the other way (or were paid off, some claim) while these banks built balance sheets valued at two times Irish GDP. And then they collapsed, causing enormous damage to the government's own solvency. In Switzerland, the two largest banks (UBS and Credit Suisse) had a combined balance sheet in fall 2008 of around eight times Swiss GDP—mostly based on their global activities. Mortgage traders in London, not many of whom were Swiss, took on enormous risks that almost brought down UBS. The Swiss government could afford the bailout—barely. And now the Swiss National Bank is moving in the exact opposite direction to Geithner by pushing these big banks to become smaller and to finance more of their activities with equity rather than debt.