The financial doomsday

Simon Johnson (MIT) and Peter Boone (London School of Economics) claim that the economy is close to burst  its last economic bubble: a profound depression will paralyze the world, they claim, because interest rate are close to zero all over the world and there is nothing else to do.

The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.
Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create. …
Each time the system runs into problems, the Federal Reserve quickly lowers interest rates to revive it. These crises appear to be getting worse and worse – and their impact is increasingly global. Not only are interest rates near zero around the world, but many countries are on fiscal trajectories that require major changes to avoid eventual financial collapse.

The real danger is that as this cycle continues, the scale of the problem is getting bigger. If each cycle requires greater and greater public intervention, we will surely eventually collapse….
In our view, the long-term failure of regulation to check financial collapses reflects deep political difficulties in creating regulation. The banks have the money, they have the best lawyers and they have the funds to finance the political system. Politicians rarely want strong regulators – except after a major collapse. So politics rarely favours regulation.
There are also big operational problems. … It requires a strong leap of faith to believe that our regulatory system will never again be captured or corrupted. The fact that it has spectacularly failed to limit costly risk should be no surprise. In our view, the new regulations discussed in Basel 3 will fail, just as Basel 1 and Basel 2 have failed.

Yet for all its drawbacks, at least the Volcker Plan was the start of a conversation about whether taxpayers should be forced to subsidize the risk-taking activities of Wall Street. … Wall Street heavyweights from Dimon to people like Larry Fink, the head of money-management powerhouse BlackRock—Obama supporters all—made their opposition to the plan well-known to the administration.
The message was clear: Wall Street, which helped elect Barack Obama with an unprecedented support for a Democratic presidential candidate (Goldman Sachs was the second largest contributor to the president’s campaign), was ready to start backing the opposition of the so-called Volcker Rule. … And with that, Volcker, one of the nation’s great economists, was thrown under the bus.

Forget Greece; the euro’s real enemy is Spain, reports the Wall Street Journal. Greece’s huge debts have caused concern among the 16-nation euro zone, but Spain has a larger economy and issues to match. Spain’s shrinking gross domestic product, down 3.6 percent in 2009, has put the country into its “deepest and longest recession in half a century.” Other problems, including “an unemployment rate of 19%, a deflating housing bubble, big debts and a gaping budget deficit,” threaten the continent and the euro, which launched in 1999. Since Spain is part of the euro zone, it cannot use certain measures. For instance, “Spain can’t devalue its currency,” “slash interest rates or print money.” The European Central Bank has control over those decisions. With a budget deficit of 11.4 percent of GDP, Spain also can’t pass tax cuts or spending increases. So, even if Greece pulls its act together, Spain might still drag the euro zone countries down.

Simon Johnson (MIT) and Peter Boone (London School of Economics)