Update: the Senate needs to hold a new hearing for Ben Bernanke--here’s the full proposal.

Ben Bernanke’s reconfirmation as chair of the Federal Reserve is in disarray. With President Obama having launched, on Thursday morning, a major new initiative to rein in the power of--and danger posed by--our leading banks, key Senators rightly begin to wonder: Where does Ben Bernanke stand on the central issue of the day?

There are three specific questions that Bernanke must answer, in some convincing detail, if he is to shore up his weakening cause in the Senate.

(1) Does he support the President’s proposed emphasis on limiting the scope and scale of big banks?

(2) With regard to the key detail, is it his view that the size of big banks can be capped “as is” or--more reasonably--should we require these banks to contract or divest so as to return to the profile of system risk that prevailed say 15 or 20 years ago?

(3) If Congress cannot act in the short-term, because of opposition from Republicans and some Democrats, does he see the Fed’s role as taking the initiative in this arena--or will he wait passively for the legislature to act?

As running hard against the “too big to fail” banks is now a major theme of 2010 and beyond for the Democrats, how can any Democratic Senators feel comfortable voting for Ben Bernanke unless they know exactly what his position is on all of these points?

And given what we know about Bernanke’s record and positions relative to these questions, absent new information it is not a surprise to see his support dwindling.

[Cross-posted at the Baseline Scenario.]

The White House background briefing is that their proposals would freeze biggest bank size “as is”--this makes no sense at all.

Twenty years of reckless expansion, a massive crisis, and the most generous bailout in human history are not a recipe for “right” sized banks. There is a lot of work the administration hasn’t done on the details--this is a classic policy scramble, in which ducks have not been lined up. But we should treat this as the public comment phase for potentially sensible principles--and an opportunity to propose workable details. The banks are already hard at work, pushing in the other direction.

It’s a big potential policy change, and my litmus test is simple--does it, at the end of the day, imply breaking Goldman Sachs up into 4 or 5 independent pieces?

[Cross-posted at The Baseline Scenario.]

Paul Volcker, legendary central banker turned radical reformer of our financial system, has won an important round. The WSJ is now reporting:

President Barack Obama on Thursday is expected to propose new limits on the size and risk taken by the country’s biggest banks, marking the administration’s latest assault on Wall Street in what could mark a return--at least in spirit--to some of the curbs on finance put in place during the Great Depression.

This is an important change of course that, while still far from complete, represents a major victory for Volcker--who has been pushing firmly for exactly this.

At this stage in the electoral cycle, Democrats should be running hard against big banks and their consequences. Some roots of our current economic difficulties lie in the Clinton 1990s, but the real origins can be traced to the financial deregulation at the heart of the Reagan Revolution--and all the underlying problems became much worse in eight years of George W. Bush’s unique brand of excess and neglect.

The mismanagement of mammoth financial institutions over the past decade produced a crisis in September 2008 that required a substantial fiscal stimulus--among other bold government measures--simply to prevent the outbreak of a Second Great Depression. That sensible fiscal response, plus the “automatic stabilizers” that worsen any budget (and help limit job losses) as the economy slows, will end up adding around 40 percentage points to our net national debt as a percent of GDP. If you want to accuse the Obama administration of wantonly increasing the national debt--then let’s talk about the circumstances that required this fiscal policy.

The theme for the November midterms should be: Which part of the 8 million jobs lost [since December 2007] do you not understand? The big banks must be reined in and forced to break themselves up, or we’ll head directly for another such crisis.

Instead, the Democrats have fallen into a legislative and electoral trap that--amazingly--they built for themselves.

On the first day of the Financial Crisis Inquiry Commission, Phil Angelides demonstrated a gift for powerful and memorable metaphor: accusing Goldman Sachs of essentially selling defective cars and then taking out insurance on the buyers. Lloyd Blankfein and the other CEOs looked mildly uncomfortable, and this image reinforces the case for a tax on big banks--details to be provided by the president later today.

But the question is: How to keep up the pressure and move the debate forward? If we stop with a few verbal slaps on the wrist and a relatively minor new levy, then we have achieved basically nothing. We need people more broadly to grasp the dangerous financial “risk system” we have created and to agree that it needs to be dismantled completely.

One way to do this would be for the Commission to call key people from Citigroup to testify.

This would not be as part of a large panel with other firms. This would be a drill down into the history, structure, and attitudes involved in building what became the country’s largest bank--and then in driving it into the ground. My full proposal is on the Daily Beast today, but in summary I would question Vikram Pandit and Chuck Prince at length and then pull in Sandy Weil and Robert Rubin.

This is not about the individuals; it’s about the system. But the only way that broader mainstream opinion will change is if it sees and hears from the people who thought they had everything under control. And--let’s face it--Citi has been at the center of all major international financial crises over the past 30 years; its alumni have top positions in our administration; and no one thinks it is a well-run organization.

It’s the human dimension of big bank hubris that will grip the popular imagination. That, and the great fortunes they accumulated at your expense.

[Cross-posted at The Baseline Scenario.]

The Obama administration tipped its hand today--they are planning a new tax of some form on the banking sector. But the details are deliberately left vague--perhaps “not completely decided” would be a better description.

The NYT’s Room for Debate is running some reactions and suggestions. The administration is finally getting a small part of its act together--unfortunately too late to make a difference for the current round of bonuses. 

We know there is a G20 process underway looking at ways to measure “excess bank profits” and, with American leadership, this could lead towards a more reasonable tax system for finance. In the meantime, my point is that taxing bonuses--under today’s circumstances--is not as bad as many people argue, particularly as it lets you target the biggest banks. 

[Cross-posted from The Baseline Scenario.]

The big banks are pre-testing their main messages for bonus season, which starts in earnest next week. Their payouts relative to profits will be “record lows,” their people won’t make as much as in 2007 (except for Goldman), and they will pay a higher proportion of the bonus in stock than usual.  Behind the scenes, leading executives are still arguing out the details of the optics.

As they justify their pay packages, the bankers open up a broader relevant question: How much bonus do they deserve in this situation? After all, bonus time is when you decide who made what kind of relative contribution to your bottom line--and you are able to recognize unusually strong achievement. 

Seen in these terms, the answer is easy: People working at our largest banks--say over $100 billion in total assets--should get zero bonus for 2009.

Sources say that Goldman Sachs’s bonuses will be announced on Monday, January 18, and actually paid sometime between February 4 and February 7. In previous years, the bonuses were paid in early January--but the financial year shifted when Goldman became a bank holding company.

For critics of the company and its fellow travelers, the timing could not be better.

Anxiety levels about the financial sector are on the increase, even on Capitol Hill. The tension between high profits in banking and stress in the rest of the economy becomes increasingly a topic of discussion across the nation.

And you are hard pressed to find any government official who has not by now woken up--in private--to the dangerous hubris of big banks. To add insult to injury (and many other insults), the Bank for International Settlements is holding a meeting to discuss excessive risk-taking in the financial sector; according to CNBC Thursday morning, Lloyd Blankfein of Goldman and Jamie Dimon of JPMorgan Chase were invited but did not show up (they really are very busy).

The smart strategy for Goldman in this context would be to pay no bonus for 2009 (in cash, stock or any other form), but this is not possible for three reasons.

Senator David Vitter submitted one of my questions to Federal Reserve Chairman Ben Bernanke, as part of his reconfirmation hearings, and received the following reply in writing (as already published in the WSJ online):

Q. Simon Johnson, Massachusetts Institute of Technology and blogger: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?

A. The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. ... In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.

This answer misses the central issue. Haldane’s argument (and our point) includes “time inconsistency”--i.e., you promise no bailouts today but, when faced by an awful crash, you provide a massive set of bailouts. There is nothing in Mr. Bernanke’s statements, here or elsewhere, that addresses this concern.

The fundamental divide in opinion regarding our financial system is: Are the people running "large integrated financial groups" hapless fools, buffeted by forces beyond their comprehension and control; or do they know exactly how to ensure they get the upside and the awful, sickening downside is borne by society--including through high unemployment?

Some light was shed on this issue by Monday’s meeting at the White House or, more specifically, by who didn’t turn up and why. Of the dozen bank CEOs invited, Vikram Pandit was supposedly busy trying to extricate Citi from TARP and asked Dick Parsons to attend instead--a wimpy but smart move, as Parsons is close to the President.

However, three executives--Lloyd Blankfein, John Mack, and Dick Parsons himself--did not show up in person and had to join by conference call. Their excuse was bad weather (fog) in DC meant that they were unable to fly in; Mack was quoted as saying, regarding their absence, "It’s certainly not for a lack of effort." 

But really there are three possible interpretations:

(1) Pure bad luck. This happens to us all; even the best laid plans are for nought sometimes.

(2) Bad management by the executives and their logistic teams--who are ordinarily the best of the best.

(3) Wilful defiance of the government which, while not premeditated in this instance, means that the executives grabbed an opportunity to show disrespect and relative power.

We don’t know all the facts of how these executives planned to travel or exactly their routes on Monday morning--and I would be happy to be corrected on any details--but here’s what we can readily construct from the public record. (We do know they didn’t try to come down Sunday evening, because that would have worked.)

The latest round of fretting in global debt markets is focused on Greece (WSJ; Greece). This is misplaced.

To be sure, there will be a great deal of shouting before the matter is formally resolved, but the Abu Dhabi–Dubai affair shows you just where Greece is heading. The global funding environment (thanks to Mr. Bernanke, Time’s Person of the Year) will remain easy for the foreseeable future. This makes it very easy and appealing for a deep pocketed friend and ally (Abu Dhabi; the eurozone) to provide a financial lifeline as appropriate (a loan; continued access to the “repo window” at the European Central Bank, ECB).

Of course, there will be some conditions--and in this regard the Europeans have a big advantage: the Germans.

The guiding myth underpinning the reconstruction of our dangerous banking system is: Financial innovation as we know it is valuable and must be preserved. Anyone opposed to this approach is a populist, with or without a pitchfork.

Single-handedly, Paul Volcker has exploded this myth. Responding to a Wall Street insiders' Future of Finance “report,“ he was quoted in the WSJ yesterday as saying: “Wake up gentlemen. I can only say that your response is inadequate.”

Volcker has three  main points, with which we whole-heartedly agree:

(1) “[Financial engineering] moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”

(2) “I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy.”

and most important:

(3) “I am probably going to win in the end.”