Meryn King, the British counterpart to U.S. Fed Chair Ben Bernanke, had this to say in a speech yesterday:

“The United Kingdom faces two fundamental long-run challenges. First, to rebalance the economy, with more resources allocated to business investment and net exports and fewer to consumption.

“That is consistent with the need – now widely accepted – to eliminate the large structural fiscal deficit and to raise the national saving rate. It is part of a need for a wider rebalancing of domestic demand in the world economy away from those countries that borrowed and ran current account deficits towards those that lent and ran surpluses.”

Everything he has to say about the UK is true in spades for the US. The US. is more dependent on consumption than is the UK and perpetually runs trade (current account) deficits. We need for the US to be consuming less and investing more in productive capacity, and then exporting more than we import.

It is the current account deficit, not the budget deficit, that leads us to be deeply indebted to the Chinese and OPEC. In any sort of rational world, it would be the large, developed, mature economies that would be exporting capital to emerging markets, not the other way around.

“Second, both the structure and regulation of banking in the UK need reform. Banks increased both the size and leverage of their balance sheets to levels that threatened stability of the system as a whole. They remain extraordinarily dependent on the public sector for support. That was necessary in the immediate crisis, but is not sustainable in the medium term.”

Any bank that is “too big to fail” should not be allowed to operate as a casino. Yes, risk-taking activity is vital to the growth and vibrancy of the economy, but it should not be undertaken by banks that are backstopped by the taxpayer.

The reforms that the Obama Administration have put forth are a good first step, but only a first step. Unfortunately, as most of the nation has been focused on the Health Care battle, the lobbyists for the banks have already swooped in and begun to undermine the reforms. Yes, we might get something call financial regulatory reform, but it will not be anywhere near strong enough to prevent a recurrence of last year’s events.

Requiring higher capital standards for the Tier One financial institutions, those that are “too big to fail,” might do the trick, but to offset the much lower cost of capital that comes with that implicit federal guarantee of their debt, the capital requirements will have to be very high — higher than will be politically sustainable.

A far better solution would be to declare that a bank that is “too big to fail” is “too big to exist.” We need to bring back something that looks like Glass-Stiegel, the law that stabilized the banking system and prevented any real problems like these for almost half a century.  

“Why were banks willing to take risks that proved so damaging both to themselves and the rest of the economy? One of the key reasons – mentioned by market participants in conversations before the crisis hit – is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as ‘too important to fail.’

“Such banks could raise funding more cheaply and expand faster than other institutions. They had less incentive than others to guard against tail risk. Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.”

We are setting up the biggest case of moral hazard ever. If a pay-off from a bet is structured so that if things go right, you make a fortune, and if things go wrong you just break even, people will start to take crazy risks. That cannot be allowed to happen again with taxpayers being the ones who cover the bets if things go the wrong way.

Just a year after the world stood on the brink of disaster, the Street is back to handing out record bonuses. At Goldman Sachs (GS) alone, a firm with 25,000 employees world wide, the bonus pool is reportedly $23 billion.

That is equivalent to 0.16% of GDP…for the bonus pool of one firm! A firm that has benefited greatly from Federal largess over the last year.

Yes, Goldman has had a very profitable year, mostly due to their prop desk. In other words, they have done well by their risk-taking with the capital of the firm. That is all well and good, but it is not an activity that should be backstopped by the government.

Unfortunately, in the heat of the crisis, and because there was, in many cases nowhere else to turn, we moved in exactly the wrong direction, with the “too big to fail” banks becoming substantially larger – J.P. Morgan (JPM) gobbled up Bear Stearns and WaMu, Wells Fargo (WFC) ate Wachovia, and Bank of America (BAC) swallowed Merrill Lynch.
Read the full analyst report on “GS”
Read the full analyst report on “JPM”
Read the full analyst report on “WFC”
Read the full analyst report on “BAC”
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