From the G-20 to AIG: The Unfinished Turmoil in Global Banking and Finance

Editor’s Note: From the rage over Wall Street to global summits, the world of finance and banking is in a state of unrest over how to solve the fallout from the financial crisis. In an interview with NPR’s On Point, scholars Eswar Prasad and Kenneth Rogoff discuss these issues and the importance of global leadership as the G-20 Summit approaches.

Tom Ashbrook: Do you see an entire style of finance, maybe even of capitalism, going out the window, here? Between global upset and Europe really unhappy about it, and everybody saying there wasn’t enough regulation – are we into a phase change here?

Kenneth Rogoff: We’re certainly into a sea change. The question is what’s happening and when. I think Chris rightly said that the change in the financial regulation, the new financial regulations, is complicated. It’s going to take time. But I’m disappointed that they’re not moving on it faster. Because we have a big mess, we have to sort it out. But how can we do it if we don’t know where we’re going, if we don’t know where we want to be in four or five years? As long as they’re fighting about that, it’s very hard to get a work out of the financial crisis, which is really what’s dragging down the economy right now.

Ashbrook: And by implication you are saying there that can only today, these days, accomplished by this group, not simply by Washington or London? No one power can say, well here’s where we’re headed?

Rogoff: Absolutely we need some kind of global coordination. There’s a question of how far. But the fact is capital flows freely across borders, and if the United States and Britain have a lot lighter standards and we’re the easy place to go, with no regulation, that’s where all the money goes – I think the Europeans are right to be furious about it. We were making tons of money putting the whole world at risk and now the whole world’s paying the price.

Ashbrook: So if the goal hasn’t been set, if it hasn’t been articulated, put down on paper, is that a failure of the G-20 meeting in Horsham this weekend?

Rogoff: Well, I mean it depends on your expectations. I’ve sat in on the deputy meetings for these, and they’re pretty huge and unwieldy. And I think if you happen to greed something in advance it’s a little much to expect it. But I think it’s a broader failure of the leadership in the world at the moment. I mean we’re just swimming in this thing.

Ashbrook: I wonder if it’s not just the bonuses, but the whole business that AIG was in here. We’re talking Goldman Sachs and Barclays. These are very sophisticated outfits. They had investments insured through these credit default swaps. Were they in effect gambling, themselves, that if AIG had problems, that the American tax payer would have to bail them out? That does sound like legalized robbery.

Eswar Prasad: Tom, that implicit bailout that was always there in the background certainly did not help. But ultimately what we are seeing is that the financial system was built on a house of cards. And this house of cards was sustained by two or three factors. Of course one was the incentives that investment managers had to take on very large risks, without being exposed themselves to the down side risk that they faced. The second, of course, was that there were some problems with the regulatory system which we are beginning to learn about now. There were parts of the financial system that were not well regulated, and we thought this wouldn’t infect those parts of the regulatory system, of the financial system, that were in fact, we thought, recently well regulated, like the banks. And what we’re learning, of course, is that those are connected. And the third part is that there is an international dimension to it because one of the factors that led to this just not being the bubble in the United States that popped, but, as Professor Rogoff pointed out, ended up in a cataclysm that has engulfed economies around the globe, is that there were a macroeconomic imbalances around the world. And Professor Rogoff himself has written extensively about these here that have conditions for excessive consumption in the United States. It was fueled by excessive savings in China, so ultimately this is where the G-20 process becomes very important because we cannot fix the financial system problems and hope that these financial crises will not happen again in the future unless we solve the macroeconomic part as well.

Ashbrook: Could this have been deliberately played or was this beyond everybody’s comprehension, how this would unfold?

Prasad: At a time when the going was good, Tom, it was very difficult for some of these people to stay on the side lines and see their competitors make large sums of money. So it was the natural temptation. But the temptation was fueled by very weak regulation and ultimately that is where part of the solution has to come from, because it is good to have relatively unfettered financial innovation, so long as there is a frame work making sure that things don’t get out of hand. And in this case, the sort of bets that were taken by many of these financial firms, including AIG, were based on assumptions that came from relatively good times. And as Ken pointed out, AIG did not seem to have a good handle on what exactly it was insuring. The complexity of these financial products is another issue. There is this notion that people on Wall Street are very, very smart, have all this figured out and therefore they are protecting themselves. I am a little less sure, because these products had become extremely complex and it was very difficult for even one firm like Goldman Sachs to see all the assets and liabilities on its balance sheet and get a good sense of how much risk it was facing. Plus all the interconnections among these different big players created further problems because as we saw from the case from Lehman’s collapse, when one big firm went under, the sort of risks that were in the system suddenly became much, much greater because there was this notion of counter party risk, where if one firm fails, essentially the risks on your books become that much greater. So I don’t think this was all that well thought out, either by the banks themselves or by the regulatory system. And when the going was good, the executives had good incentives to continue playing the game, and to make large sums of money. So in terms of the compensation schemes for the executives, and in terms of the regulatory system, I think a great deal needs to be re-thought and re-worked to make sure this doesn’t happen again.
 
Listen to the entire interivew » (Rogoff’s section begins at 7:30 minutes and Prasad’s at 11:55 minutes)