John R. Talbott is a former investment banker with Goldman Sachs and the author of "The 86 Biggest Lies on Wall Street," "Contagion," "Obamanomics," and "The Coming Crash in the Housing Market." His books predicted the housing market crash, the financial crisis and the election of Barack Obama when Obama was still a little-known underdog. Talbott is currently engaged in trying to build what he calls "a grass-roots movement of ordinary Americans who want to take back the government from lobbyists and corporate interests." Anyone interested in learning more can e-mail him at johntalbs (at) hotmail (dot) com.
Simon Johnson, the former chief economist of the International Monetary Fund (IMF), is the cofounder of BaselineScenario.com, a Web site tracking the ongoing financial crisis. He is also the Ronald A. Kurtz professor of entrepreneurship at the MIT Sloan School of Management, a member of the Congressional Budget Office's Council of Economic Advisers and a senior fellow at the Peterson Institute for International Economics in Washington, D.C. He is one of the most visible public commentators on the ongoing financial crisis and its causes and on what role the government and regulatory policy will play in moving the economy forward.
From June to July of 2009, Talbott and Johnson held an e-mail conversation on the following topic:
"The economic crisis: Who caused it? Was it preventable? Was criminal activity involved in bringing it about? And is it over?"
The exchange below is the first of three sets of e-mails. The second pair will be published Thursday, and the final pair will appear Friday.
From: John Talbott
To: Simon Johnson
Subject: A Vast Criminal Enterprise
I believe economists are doing a very poor job of explaining to the American people who and what caused the current economic crisis. I think the reasons for this are threefold.
One: Economists and media pundits -- themselves mostly gentlemanly elites anxious to please corporate America -- are slow to make the accusation that what happened here was truly criminal, and so miss the real story. The American people understand that when a group of bankers shuffle some paper unproductively and get away with hundreds of billions of dollars in bonuses, yet cause a loss of $40 trillion in global wealth and cause approximately 100 million people to become unemployed worldwide, there is only one word to describe it: criminal. We don't have to argue about whether their actions were technically illegal or violated existing statutes, as in this conspiracy the crooks were writing their own regulations and legislation through their control of the government through lobbying.
Two: There has been no criminal investigation to date, so evidence supporting criminality has not been uncovered -- no one is looking for it. Liberals hate to think that Obama, led by Geithner and Summers, is part of a grand cover-up scheme, but that is exactly what is going on. How else can you explain the lack of criminal investigations? Why isn't the FBI breaking down the doors of the commercial and investment banks and grabbing computers so as to preserve incendiary e-mails that will most definitely implicate executives? Why are managements that caused this still in their jobs and still receiving bonuses? Are the bonuses paid to the folks at AIG that caused its collapse nothing more than hush money? How can the rating agencies still be in business? Why don't we make one arrest and lean on the bankster to see if he will fold like the cheap suit that he is and name other conspirators? The FBI spends more time investigating $2,000 drug buys than they have to date investigating the biggest heist in the history of the world: $40 trillion, that's trillion with a T, that's 40 million bags each containing $1 million.
The third reason that we have not had an easy-to-understand explanation from economists as to the cause of this mess: I think we're all trying to fit the facts as we know them into one simple story of causation. I believe there are actually three different storylines occurring contemporaneously, and all of them criminal. It is similar to what Winston Churchill said about trying to forecast Russia's next moves in 1939: "It is a riddle, wrapped in a mystery, inside an enigma."
So what are these three criminal storylines? The first, and the smallest (if you can believe it) at approximately $10 trillion, is the housing crash and the mortgage meltdown. Totally criminal, as its primary cause was banksters stuffing worthless mortgage paper into CDOs [securities known as collateralized debt obligations] and calling them AAA. Criminal at every level, as real estate agents were convincing their buyers to pay more, not less, to "earn" their fees through a winning bid, appraisers were offering non-independent and completely tainted appraisals, mortgage brokers were altering loan documents and changing income data to qualify buyers, bankers were paying rating agencies to call junk paper AAA, and principal investors like pension funds, insurance companies, and sovereign governments failed to perform even the minimum levels of due diligence demanded by their fiduciary duties.
But the second story is even bigger and extends far beyond mortgages to the entire banking system. The banks had found a way to avoid the regulation that everyone knew they needed ever since they were given federally backed depositor insurance to prevent bank runs back in the '30s. They became one of the biggest lobbyists and campaign contributors to your Congress and your presidents. Then, amazingly, they just asked that all limitations on their activities be removed -- and they were. If I paid you $2 for your vote, it would be illegal, but somehow these banks could pay hundreds of millions to our congressmen and presidents for their votes and it was all perfectly legal. Completely nuts!
So what did banks do that was criminal? Well, first they paid your government to eliminate bank restrictions, then they overleveraged, knowing they could not honor contracts with such leverage, then they lied to their shareholders about the risks and magnitudes of their positions, hid their positions illegally off balance sheet, and through the use of derivatives managed to violate minimum capital requirements on an almost daily basis. They took bank debt leverage from 8:1 to over 30:1, thus assuring that the banking system could not survive even a modest credit tightening or recession. They made crazy bets in the credit default swap market that they could never honor in a downturn. They loaned money to anyone who could fog a knife because they knew they were going to stuff it to others through securitization and CDOs. If we had a criminal investigation, we would have access to the incriminating phone calls and e-mails in which the banksters disclosed what they really thought of the assets they were pawning off on others. To see how traders incriminate themselves, watch "The Smartest Guys in the Room," about Enron's collapse.
The final storyline of criminality is the biggest of all. It is bigger than the current financial crisis. It is corporate America's complete control of our nation's elected officials, especially our Congress, through lobbying and campaign donations. Yes, the banks played this game, but the game was much bigger than just the financial industry. Coal-fired utilities have so watered down impending legislation concerning global warming that they have now come out in favor of it in the House vote. TARP money went to banking friends of Hank Paulson, although 97 percent of congressional correspondence from the American people was against it. The credit card industry took a minor slap on the wrist, but faces no limitation on the egregious interest rates it can charge its customers. Pharmaceutical and hospital corporations are fighting hard to keep Americans from having a public alternative to their healthcare, and right now are winning that fight. The transportation industry is at the government trough trying to pass a $500 billion windfall. The AARP prevents any meaningful reform of Social Security; the teachers' union does the same for education reform. Is it crazy to think that defense companies like Dick Cheney's Halliburton (which saw its stock price increase 700 percent during the Iraq war, thanks to no-bid contracts) may be promoting U.S. aggression around the world?
The American people understand that their government is corrupt; that is why they don't want to rely solely on more government regulation to solve this crisis. No, if we are to ever to see positive growth again in this country, we need to make the fundamental reforms that are necessary without relying on regulation which is so often co-opted or captured by those we are trying to regulate. This suggests we need to find a way to get corporations out of our government and ensure they never become either too big to fail or so big that they improperly influence markets and our government.
From: Simon Johnson
To: John Talbott
Subject: Re: A Vast Criminal Conspiracy
You make many good points, but I think the situation may actually be worse.
You stress that criminal acts must have been committed, and I'm sure this is right at the level of individual lenders or investment banks that packaged and resold dubious mortgages, for example. As you point out, when and if prosecutors get their hands on the right e-mails, we'll see evidence for a great deal of intentional deception (of consumers, investors, regulators and everyone else).
Given that we have a relatively decentralized criminal justice system, within which prosecutors have an incentive to build a tough reputation, and given that it takes time to build these kinds of cases, I suspect we will see more such prosecutions in the near future. Also, civil cases now under way may well uncover evidence of criminal wrongdoing -- and this will presumably be referred to prosecutors.
The bigger problem, however, is that much of what has severely damaged our economy and still jeopardizes our future is completely legal. Take, for example, campaign contributions. You rightly rail against these and the power that they confer on big donors -- primarily lobbies of various kinds. And we're all against direct favor buying that is presumably illegal. But much of what was done -- for example, in terms of financial market deregulation since the early 1990s -- was surely completely legal, but a very bad idea.
Bad ideas in public policy, of course, are always with us. What worries me most about our situation at this moment is that while our current leadership on economic strategy issues now talks about the mistakes of their (and our) past, their policies are pointing us back in the same direction. The latest evidence in this regard is the regulatory plan released by the Treasury this June.
This plan is a long list of technocratic tweaks. But when you dig through all the details, it is hard to find anything that will really make a difference to the functioning of our financial system. Most importantly, we will still have banks that are perceived as "too big to fail," and these institutions will have access to government bailouts under vague and completely open-ended terms. In what way will this encourage responsible lending in the future?
The administration does propose to add an agency protecting consumers against financial products -- and this is an implicit recognition that you are right, that the finance industry has long been ripping off consumers in various ways. But beyond that, there is nothing currently on the table that would make our banking system and -- by implication -- the world's financial system better run.
What happened? The finance industry has captured, intellectually, both public policy and a wide range of public intellectuals. People really believe that we need something like today's financial sector in order to resume reasonable growth in this country. This is despite the fact that financial innovation has added little to productivity in the past two decades, and it flies in the face of the obvious damage done recently by overborrowing at various levels.
You point out specifically that economists have not done a good job in terms of explaining the deeper causes of the crisis, and I would agree with that. But again I think this is due to the wrong mental model more than anything else. Most economists think that if we're talking about Indonesia or Korea or Russia, considerations of political economy -- i.e., who has power, what they are trying to do, etc. -- are first order. But as soon as we start to talk about the United States, many reasonable people think that the same special interest politics are second order and that the real action comes from more technical considerations, such as the "business cycle" (whatever that really means).
Implicitly, many economists see the U.S. as quite different from those middle-income countries often called "emerging markets." If these economists allow politics into their view of the world, they consider how altruistic policymakers try to balance conflicting objectives. The U.S., supposedly, is not about the competition for power and influence between strong interest groups.
My own view is that we should be dubious whenever someone says or assumes that "the U.S. is different." Most countries have powerful groups -- almost always including the financial sector, and big banks in particular -- and they are always trying to slant things their way. The U.S. may in fact have a worse problem, as our financial sector made a great deal of money in the early deregulation years of the 1980s and plowed that back into further financial influence.
Big finance, of course, was helped by two major waves of innovation: lower communication costs meant that global investing became cheaper, and lower computing costs meant that more complicated trading strategies (i.e., involving derivatives) became more profitable. Of course, to really take advantage of these changes the finance industry needed new rules: lower barriers to capital flows across borders and no regulation for derivatives trading. When they got both, by the mid-1990s, it was off to the races -- the unsustainable rise of the financial sector since that time is what has really pulled us into our current predicament.
And the way in which the Obama administration is attempting to extricate us from the crisis -- with unconditional support for big banks, regardless of costs -- is not addressing the fundamental imbalance of power that favors the financial sector. If anything, the big banks that survive in this sector have now become more powerful -- the political market share of JP Morgan Chase or Goldman Sachs has increased because Lehman and Bear Stearns are out of business.
Private equity and hedge funds, which could have been brought on board with a more reformist agenda (as they have no great love for supersized big banks), instead are lining up with everyone else for government subsidies of various kinds (e.g., through the toxic asset purchase programs organized by the Treasury). And small banks -- who have considerable potential clout through their access to the Senate -- devote most of their time to shooting down sensible changes to more general financial rules (e.g., about whether mortgages can be modified in personal bankruptcy), rather than helping to rein in big banks.
In some sense, the administration's political strategy in this area is not going at all well. But in another more profound sense, the political strategy of Big Finance is proving incredibly effective. They survived the crisis essentially intact, they will keep the rules that have served them (but not us) well, and their day-to-day influence in the corridors of Washington power has never been higher.
There will be a continuing struggle for reform -- after all, we've seen overbearing financial power reined in before in this country (e.g., by FDR and Congress, following the Pecora Hearings in the early 1930s). But it's going to be a long struggle. There is nothing on the immediate horizon that will address our fundamental problems; in fact, the economic recovery will further strengthen the hand of the largest banks, as they will argue that we should now "move on."
But as long as people like you keep writing about the deeper issues at stake, and -- by all means -- pushing everyone to look for and expose criminal wrongdoing, we will eventually move in the right direction. The battle to control finance is really an argument about ideas. What is the right way to organize the economy? How should big banks be effectively brought under control? How do we prevent anyone from exercising disproportionate influence in our open political system?
Keep at it.