I committed to reading and reviewing every single serious book that is written about the 2008 financial crisis over a year ago because I am afraid of history recording lessons from the crisis that are entirely false, and because I am afraid of economists prescribing solutions that are utterly catastrophic. In a sense, my project was presciently motivated by 13 Bankers by Simon Johnson. Dr. Johnson is an MIT economist and was for a time the Chief Economist of the International Monetary Fund. More important for our purposes, though, Simon Johnson is a rank statist. While I may respect much of his intellectual pedigree, his statist presuppositions have helped to create the single worst book I have yet read on the financial crisis of 2008. More interesting, though, is the fact that it is the most self-refuting web of contradictions I think I have ever read.
The book is drippingly full of rhetoric, which is quite necessary as the book is remarkably short of argumentation. Readers do not make it through the introduction without depictions of Wall Street as a medieval sort of oligarchy. We also do not make it through the introduction without getting a glimpse of the author’s willingness to fudge the truth, or at least a severe lack of understanding about that truth (I wish it were the latter but I believe it is the former).
The basic orthodoxy of the 2008 crisis is this: Wall Street was so unregulated (untrue) and so greedy (totally true) and government policies were so laissez-faire (perposterously untrue) that the global financial system almost collapsed under the weight of the housing collapse and mortgage meltdown we suffered through. Johnson is not content to blame lax regulatory standards in a few areas, over a few years, but rather asserts a generational collapse of regulation brought about by Ronald Reagan’s cozy relationship with the banking industry. (At one point, he actually suggests that the 1970′s elimination of fixed commissions in the stock brokerage business was indicative of Wall Street always getting their way – a demonstrably false and absurd claim if there ever was one). Johnson claims that “Reaganism meant breaking down the rules that constrained the activities of financial institutions”. He predictably jumps on the bandwagon of demonizing Michael Milken and junk bond innovation (all empirical evidence which contradicts his claims notwithstanding). He blasts the Garn-St. Germain Act for “allowing S&L’s to expand into new businesses” (horror of horrors). This lengthy set-up of the book’s major thesis contains no arguments whatsoever, unless an argument now amounts to nothing more than a rhetorically-charged assertion. He assumes that readers will look at the fruit and automatically assume that the tree was bad, rather than some other possible cause (i.e. are we really to believe that the S&L crisis was caused by the government allowing banks to diversify their sources of income??). At one point he complains that financial sector profits from 1980-2005 grew by 800% (adjusted for inflation), where nonfinancial sector profits grew by only 250%. Did it occur to this MIT economist that the profit growth in the financial sector might have set the stage for the profit growth in the nonfinancial sector? Was any consideration given to the higher return potential embedded in the higher risk structures of the financial sector? A consistent theme in the book is to ignore any path that could possibly venture off the pre-determined script, and that pre-determined script is the quintessential rallying cry of modern liberalism: the minions need a big government to save them from the profit-seekers.
As he proceeds into the 1990′s he lists dozens of employees of major Wall Street firms who either started at government jobs or ended up at government jobs, the inference being that there is such an incestuous relationship between Wall Street and Washington D.C. that something must be awry. The fact that for every position he cites there exists dozens of positions where such a relationship was not present escapes him. The idea that there could be any number of causes to this effect is ignored, including ones far more plausible than his Oliver Stone-conspiracy world. He lambasts the Efficient Markets Hypothesis, and somehow links adherence to the notion that markets are (in some form) efficient to the belief that financial markets require “no regulation whatsoever.” As an economist, Johnson is abundantly qualified to critique the Efficient Markets Hypothesis on a number of different levels, but he is being disingenuous at best to suggest that any proponent of the hypothesis actually believes that there is ” no need for any regulation whatsoever”. It is a classic straw man fallacy. Johnson states that “basic microeconomic models assume that the world is made up of rational actors who make accurate decisions, based on perfect information, to maximize their expected utility (benefits to themselves). Given these assumptions, regulation is unnecessary because parties will only engage in transactions that are good for them.” And yes, put that way, it sure sounds silly, doesn’t it? But here is the rub – no one, anywhere, really believes that. What many people do believe, though, this reviewer included, is that parties to a transaction are free to reap the consequences of that transaction, even when it proves to be negative. The issue is not that markets work perfectly, and therefore no regulation is needed; rather, the issue is why in the world we should be expected to believe that totally disinterested parties in a given transaction are more qualified to speak to its merits and virtues than the parties who are a part of it? This is a philosophical problem that Johnson does not attempt to deal with – he just accepts at face value that there exists a solution to the woes of the marketplace, and it can be found in the halls of Congress.
Regulation is a pretty heavy theme in his book, though one can not help but notice that Johnson seems to be missing the point in his own over-stated data. Johnson dedicates dozens of pages to the failures of regulators to avoid the financial crisis of 2008. He thoroughly documents the inefficiency of government agencies (dozens and dozens of them) in regulating the capital markets. He never seems to notice the contradiction in claiming on one page that the crisis was caused by a complete lack of regulation in the financial markets, and then stating on the very next page that there were a plethora of government bureaus who were incapable of regulating the conditions that led to the crisis. Johnson picks one element where the government was not allowed to properly regulate (the issuance of credit derivatives), and ignores the far more eggregious consequences of their inept regulating in an area where they had ample authority (the subprime mortgage market). He is beyond generous in the hall pass he gives Fannie and Freddie, which explains how he can possible say with a straight face that the solution to the future dilemma of modern finance is to give control of the nation’s largest financial firms to the same entity that created and enabled Fannie and Freddie – the entities from which the taxpayers will lose more money than every single other company involved in the financial mess, combined.
Johnson’s section on the folly of the home ownership religion is quite good, though it is disappointing that he does not bother to parlay it into more of a point about the real cause of the crisis. If Johnson were to go down that path it would contradict his theme that Main Street was victimized by Wall Street during the crisis, and not vice versa. The role of populist crusader is an odd one for such a pedigreed economist to take, as he actually ends up condoning such practices as mortgage “cramdowns”, despite the disastrous unintended consequences that economists universally acknowledge such a practice creates. His treatment of the subprime crisis is perhaps the most cartoonish fantasy of the book, wherein (by his version) millions of low-income borrowers were tricked into taking a loan they did not want or did not need for a house they did not want by a predatory and dishonest lender who never explained to the subprime borrower that he probably could not afford a $700,000 house on $50,000 of income. Johnson praises the silly idea of a “Consumer Financial Protection Agency” and says that this consumer agency would “deter the abusive practices that resulted in families losing their homes”. So the Feds demand that banks give a higher percentage of loans to low-income families, Fannie/Freddie securitize everything on the street (with a legal order that they dedicate 56% of their funds to low-income families), and then a slew of American people decide to indebt themselves up to their eyeballs and consciously lie about their incomes in doing so all so they can move into a house that they never had a prayer of affording, and Johnson’s conclusion is that “Wall Street practices caused them to lose their house” (you know, the one that they never, ever, ever, had any business affording to begin with). I am more distressed that so many people accept this idiocy than I am that an MIT economist is actually saying it.
Johnson has no desire to embrace the truth about bailout-ism in this book. Wall Street-bashing is his chosen sacramental practice as it fits into the script and enjoys extremely convenient use of rhetoric and emotion. When he says that “never before has so much taxpayer money been dedicated to save an industry from the consequences of its own mistakes”, one assumes that he has never studied the government’s relationship with the farming industry, or the airline industry, or the railroad industry, or (I don’t know), the automobile industry , etc. My desire is for an entire financial system that is totally devoid of reliance upon the government, and I oppose “too big to fail” in every way, shape, and form. But when an MIT economist writes an entire book saying that only Wall Street has ever milked the taxpayers, and only Wall Street needs to be taken over and broken up by the anointed folks in federal government, we ought to be very suspicious of his worldview.
I would be content to simply disagree with the dangerous conclusions of the book and leave it alone if Johnson did not resort to such dishonesty in making his arguments. I am surprised any serious academics are taking the book seriously at all given its treatment of Alan Greenspan. He is not portrayed as a reckless central banker who accelerated the housing bubble with absurd easy monetary policy and rank central bank manipulation. Rather, Greenspan is condemned as a free market extremist who just couldn’t help but want to turn the entire marketplace over to natural forces. Greenspan should be eulogized for what he did in the build-up to this crisis, but not for inadequate control, but rather excessive and dangerous control!! He contends that it was the “the taxpayer who would pay to rescue the financial sector without getting much in return”. Simon Johnson’s entire point in writing this book is to demand that all of the largest firms on Wall Street be forced to break up into smaller pieces, and then become heavily run by the government. However, it is only these financial institutions that have actually paid back the taxpayers, and done so at a significant double digit return. Johnson’s version of the meeting that took place when the TARP funds were distriubted is unbecoming of a scholar. He blasts Paulson and the government for giving such a sweetheart deal to the banks, implying that they were basically getting free money. However, every one of those nine instituions have paid back in full at a rate of return between 15% and 25% (once the value of the exercised warrants is factored in). Does Johnson want to suggest that a 21% return is paltry in this environment? What is the rate of return the taxpayers have made on the farmers, the autoworker unions, Amtrak, and the airline companies? Come to think of it, how are we doing on that $1 trillion that Fannie and Freddie owe us? I am not suggesting that Wall Street firms ought to have their hands on the Federal treasury bank, and I believe that a system must be created which allows companies to blow themselves up. But what Johnson is suggesting is that we can make this problem all better if the benevolent and omniscient hand of Congress is given the power to put out of business the companies they want, before they get themselves into trouble. Statism is too nice of a word.
I mentioned earlier the web of contradictions embedded in this book. Johnson has built his book around the idea of a forced break-up of the largest financial institutions. Yet he is the first to say that “the acute phase of the recent crisis was triggered not by mammoth commercial or savings banks … but by modestly smaller, risk-seeking investment banks.” He admits that “it was the collapse of thousands of small banks that helped bring on the Great Depression.” He devoted pages to documenting the problems created during the savings and loan crisis (again, a massive crisis that featured thousands of tiny financial organizations). How could one be so cognizant of these inconvenient facts, and still carry on with the statist conclusion that only a government takeover of large firms will keep the world safe?
Johnson claims that the “economic policy elite of the Democratic Party was fully won over to the idea that finance was good.” I would say that most people with brains have been won over to this idea. The prehistoric nostalgia guiding Dr. Johnson would result in the complete replacement of the American financial system with a foreign financial system that will not impede itself with such ludicrous self-defeating limitations. Johnson is right to fear the perpertual bailout, but he never once addresses the greatest solution for bailouts (going forward) ever presented: Quit giving them. If creditors, trading partners, depositors, hedge funds, shareholders, and all participants in the global financial system truly believe in their hearts that no bailout will be coming if Wall Street blows itself up, there is absolutely no doubt that behavior would change. The moral hazard Wall Street has exploited was a moral hazard created by the government. There is a tremendous opportunity to change the landscape of global finance and to put an end to “too big to fail”. Johnson’s prescription is the worst possible medicine. None of us want to even comprehend a society where a small political elite are given the arbitrary power to set size limits on companies. The government has no set of data sufficient to qualify them for this task, and has proven beyond any shadow of any doubt that they lack the technical skill to even take a stab at such an undertaking. I share Dr. Johnson’s contempt for participants of private enterpise who would privatize profits yet socialize losses. But the solution is to force companies to behave responsibly through the greatest punitive threats that the world has ever seen: market failure. Drexel Burnham, Salomon Brothers, and Kidder Peabody are all gone. You and I are still here, and the earth is still rotating.
This book paints a picture of Wall Street run amok, with a government too helplessly influenced by Wall Street to do anything about it. Surely a better solution exists than giving Wall Street over to the helpless. He concludes his book by saying that “Thomas Jefferson’s suspicion of concentrated power remains an essential thread in the fabric of American democracy … It is to help reinvigorate that spirit of Jefferson that we have written this book.” I would suggest to my readers that it is now possible to get a Ph.D in economics from MIT and to write a New York Times best-selling book without ever having done an even cursory study of Thomas Jefferson, if Simon Johnson really believes this. The financial crisis of 2008 has given ideologues a mandate to respond with solutions that protect freedom and seek to maximize opportunity for a better society in the future. Johnson’s prescription kills the American system. Thomas Jefferson would have none if it. Either should we.
Next book reviews on the financial crisis of 2008:
The End of Wall Street by Roger Lowenstein
The Crisis of Capitalist Democracy by Richard Posner
The Death of Capital by Michael Lewitt
Bailout Nation by Barry Ritholtz
The Quants by Scott Patterson
The Return of Depression Era Economics and the Crisis of 2008 by Paul Krugman