Will Increased Capital Requirements Kill a Recovery? Morgan Stanley Wants You to Think So (Simon Johnson):
size:85%;">The bottom line, translated: Let us adjust our balance sheets (downwards to some degree) and continue with our existing business models (including unconstrained bonuses), and we will bring you back to growth eventually. If you mess with us, unemployment will stay high for a long time. And any future crises that may befall us are just a cost of doing business, and making us whole is just what you have to do.
size:85%;">But this is all wrong. The essential premise of the Morgan Stanley reasoning (heard much more widely on Wall Street) is that the size of our biggest banks cannot be constrained–because it would raise the cost of equity for these smaller units. This misses three points:
size:85%;">1) If you are sufficiently small, you can take more risk without jeopardizing the system. So the expected risk/return combination can attract investors and be fine for society. Most successful venture capital funds, hedge funds, and private equity funds are in the right size range from this perspectives and don’t have trouble attracting capital–except when the big banks blow up. As long as you are small enough to fail, go for it.
size:85%;">2) Morgan Stanley’s pricing of risk model implicitly assumes that big banks still exist as a comparison point and an alternative for investors. But if you put a size cap on the largest banks (e.g., assets cannot exceed 1% of GDP), this defines the asset class available–so investors don’t choose small vs. medium vs. large; they choose small vs. medium. Yes, this removes a choice for investors, but we routinely constrain investors ability to put money into activities that are potentially dangerous for society (e.g., try proposing a “new” high risk/high return approach to nuclear power).
size:85%;">3) There will always be financial shocks, but these do not always need to have such devastating effects. Our financial system worked fine in the post-World War II period, with a great deal of risk-taking and much nonfinancial innovation–our biggest banks were much smaller, in absolute terms and relative to the economy. The notion of “let us take any risks we want and, if it all goes bad, bail us out so we can make it up to you later” is simply preposterous and completely at odds with the historical record of U.S. economic development.
size:85%;">The big banks’ bonuses undermine their legitimacy. Every time these banks CEOs speak or write in public, they just underline their hubris and the danger this poses to financial system stability. And their own research strengthens the case for breaking up the megabanks.
Why I am an Optimist – pdf (John Mauldin – most of the article is on optimism despite the excerpt below):
size:85%;">When anything as relatively small as Dubai spooks the market, it should serve as a warning sign. The world has priced in 5% GDP growth for the US and much of the developed world in the equity and commodity markets. Either we have to get that or the markets are going to have to come back to the reality of what I think is going to be a much lower growth figure.
But in any event, one of the lessons to be learned is that investors should pay attention to where the leverage is. Unsustainable debt trends end in tears. They always do. Spain, Greece, Italy, the UK, and Japan will all have to face major restructuring in the next decade due to leverage. And we in the US will also find that we cannot grow debt at our current levels. Will we pare our debt willingly or be forced to by the market? Either way, it will make for a less than optimal economy over the coming years. Muddle Through, indeed.