At one level, all financial crises are the same. A relatively small group of people, typically bankers, find the opportunity to take very big risks. For a while, financiers show high profits, justifying rising stock prices for their companies and large bonuses for their top executives. But these profits are never properly adjusted for what will actually materialize over five to 10 years, meaning that they understate risk and overstate true earnings.
Greater short-term returns are often available if you take more risk; just look at the Icelandic banking system after 2003. Three banks were allowed to develop very large offshore businesses, building up a combined balance sheet that was 10 times the size of Iceland’s gross domestic product, mostly based on short-term funding. Iceland’s political leaders thought they had found a new road to prosperity. In October 2008 they discovered a perennial truth: Giant profits involve giant risks. Iceland’s banks collapsed, plunging the economy into a deep recession.
The Icelandic attempt to run a country like a hedge fund may make you laugh or cry. But the unfortunate truth is that the U.S. and many European Union countries did something similar by allowing or encouraging parts of the financial sector to take on too much risk. This manifested itself in excessive lending to some combination of governments, real-estate developers and households.
We may disagree on the precise causes of any crisis. Some people blame the latest boom-bust-bailout cycle in Europe and the U.S. on bankers for capturing the hearts and minds of government officials; others stress the culpability of those officials. Irrespective of your view, we should agree on one thing: Someone has to pay for the mess.
There are three potential payees.
First, it is natural to point a finger at the people who were at the epicenter of the disaster -- the ones who built the large financial institutions and mismanaged the risks.
The problem is that, even if you could claw back the earnings of this group, they simply did not walk away with enough cash to make a difference. Finance professors Sanjai Bhagat of the University of Colorado at Boulder, and Brian J. Bolton of Portland State University, last year calculated that the chief executives of the U.S.’s top 14 financial companies received about $2.5 billion in cash (salary, bonus and stock options exercised) from 2000 to 2008.
That’s a substantial payday, but a drop in the bucket considering the damages to the nation’s broader social balance sheet. According to the Congressional Budget Office, the U.S.’s medium-term debt-to-GDP increased about 50 percent, or roughly $7 trillion, due to the crisis. (Disclosure: I’m on a panel of economic advisers to the CBO but I’m not involved in producing those estimates, which are based on comparing the January 2008 forecast for debt in 2018 and the revision published in January 2010.)
The true economic damages are, of course, much larger when lower economic growth, loss of jobs and disruption to people’s lives are counted. And part of the higher debt will be shoved onto future generations, hoping that they will be richer, or perhaps just luckier, than we are.
But debt-to-GDP levels in many industrialized countries were already high and the debt surge -- mostly caused by lost tax revenue due to the recession -- has pushed us into the red zone. We need to bring down our deficits and put debt onto a more sustainable path.
The unfortunate truth is that those “responsible” for the crisis never have enough money to make the rest of us whole.
Second, you could tax poor people. This may sound like a shocking suggestion, but typically people at the lower end of the income and wealth distribution are squeezed after major financial crises. They are often not well organized and lack political clout. Their benefits are cut by reducing access to health care, for example, or by laying off teachers, which hurts the quality of public education.
The only politician I’ve heard address this point directly is Iceland’s finance minister, Steingrimur Sigfusson. In a fiery speech at an International Monetary Fund conference in Reykjavik on Oct. 27, Sigfusson made it clear that he will do everything possible to protect Iceland’s lower-income population. The IMF Web site provides comprehensive coverage of the conference; the papers there also give more detail on what has happened in Iceland, including changes in distribution of income.
Finance Minister Sigfusson is a geologist, a former truck driver and a tough politician. His party is not implicated in the financial fiasco and he may get his way in terms of policy priorities. Most other finance ministers lack his clarity of thought on this issue.
But even if you are willing to squeeze the poor to some degree, the butcher’s bill is still too large. Greece cannot put its budget onto a sustainable footing just by cutting subsidies to poor people, which is why you see public-sector trade unions and relatively well-to-do people in the streets.
The third group, of course, is the rest of us. The middle class in the U. S. and Europe is large and, by any historical standard, affluent. People could pay more tax or receive lower benefits from the government. There are plenty of subsidies lurking throughout our system of fiscal transfers.
It’s not hard to balance the budget. Not extending the Bush-era tax cuts, which are due to expire at year’s end, would be a major step in the U.S. It’s also politically imaginable -- extending the cuts would require both chambers of Congress and the president to agree.
But what is the legitimacy for this or that cut in benefits or an increase in anyone’s taxes? None of us caused the crisis. And many of us didn’t even overspend during the boom.
Let’s be honest. We are all now fighting to maintain our subsidies and our tax benefits. Iceland has no choice but to cut; the size of its disaster was overwhelming. Greece is heading in the same direction. Countries such as Italy and France may soon follow.
Allowing the financial markets to beat austerity into you is not smart. It’s a very costly and inefficient way to make fiscal adjustments. But sometimes it’s the only way to break political deadlock and to force difficult decisions, as Iceland and Greece can attest.
(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)
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