Thanks to bailouts, all banks want to become too big to fail

Informed opinion is sharply divided about how the next 12 months will play out for the global economy. Those focused on emerging markets are emphasizing accelerating growth, with some forecasts projecting a five percent increase in world output. Others, concerned about problems in Europe and the United States, remain more pessimistic, with growth projections closer to four percent—and some are even inclined to see a possible “double dip” recession.

This is an interesting debate, but it misses the bigger picture. In response to the crisis of 2007-2009, governments in most industrialized countries put in place some of the most generous bailouts ever seen for large financial institutions. Of course, it is not politically correct to call them bailouts—the preferred language of policymakers is “liquidity support” or “systemic protection.” But it amounts to essentially the same thing: When the chips were down, the most powerful governments in the world (on paper, at least) deferred again and again to the needs and wishes of people who had lent money to big banks.

In each instance, the logic was impeccable. For example, if the US hadn’t provided essentially unconditional support to Citigroup in 2008 (under President George W. Bush) and again in 2009 (under President Barack Obama), the resulting financial collapse would have deepened the global recession and worsened job losses around the world. Similarly, if the eurozone had not stepped in—with the help of the International Monetary Fund—to protect Greece and its creditors in recent months, we would have faced further financial distress in Europe and perhaps more broadly.

In effect, there were repeated games of “chicken” between governments and major financial institutions in the US and Western Europe. The governments said: “No more bailouts.” The banks said: “If you don’t bail us out, there will most likely be a second Great Depression.” The governments thought briefly about that prospect and then, without exception, blinked.

Creditors were protected and financial sectors’ losses were transferred to the domestic government (as in Ireland) or to the European Central Bank (as in Greece). Elsewhere (the US), the losses were covered up with a great deal of regulatory “forbearance” (i.e., agreeing to look the other way while banks rebuild their capital by trading securities).

And it worked—in the sense that we are now experiencing an economic recovery, albeit one with a disappointingly slow employment rebound in the US and some European countries. So what is the problem with the policies of 2007-2009, and why can’t we just plan on doing something similar in the future if we ever face a crisis of this nature again?

The problem is incentives—what bailouts imply for attitudes and behavior within the financial sector. The protection that was extended to banks and other financial institutions since summer 2007, and more comprehensively since the failure of Lehman Brothers and AIG in September 2008, sends a simple signal. If you are “big” relative to the system, you are more likely to get generous government support when there is system-wide vulnerability.

How big is “big enough” remains an open and interesting question. Major hedge funds are presumably looking for ways to become bigger and take on “systemic importance.” Ideally—from their point of view—they will bulk up without attracting regulatory scrutiny, i.e., no ex ante limits on their risk-taking activities will be imposed. If all goes well, these hedge funds—and of course the banks that are already undoubtedly Too Big to Fail (TBTF)—get a great deal of upside.

Of course, if anything goes wrong, everyone who is TBTF—and who has lent to TBTF firms—expects to receive government protection. This expectation lowers the cost of credit for megabanks today (relative to their competitors, which are small enough that they are more likely to be allowed to fail). As a result, all financial institutions gain a powerful incentive to bulk up (and borrow more) in hope of also becoming bigger and therefore “safer” (from creditors’ point of view, not from a social perspective.)

Top US policymakers acknowledge that this structure of incentives is a problem—interestingly, many of their European counterparts are not yet willing even to discuss these issues openly. But the rhetoric from the White House and the Treasury Department is “we have ended TBTF” with financial reform legislation currently before Congress and likely to be signed by Obama within a month.

Unfortunately, this is simply not the case. On the critical dimension of excessive bank size and what it implies for systemic risk, there was a concerted effort by Senators Ted Kaufman and Sherrod Brown to impose a size cap on the largest banks—very much in accordance with the spirit of the original “Volcker Rule” proposed in January 2010 by Obama himself.

In an almost unbelievable volte face, for reasons that remain somewhat mysterious, Obama’s administration itself shot down this approach. “If enacted, Brown-Kaufman would have broken up the six biggest banks in America,” a senior Treasury official said. “If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.”

Whether the world economy grows now at four percent or five percent matters, but it does not much affect our medium-term prospects. The US financial sector received an unconditional bailout—and is not now facing any kind of meaningful re-regulation. We are setting ourselves up, without question, for another boom based on excessive and reckless risk-taking at the heart of the world’s financial system. This can end only one way: badly.

Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, BaselineScenario.com, a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics.