Fed Governor Hoenig: Let Failing Banks Die

05/22/2009 05:12 am ET | Updated May 25, 2011

Wall Street may have thought the third man to testify before the congressional Joint Economic Committee Tuesday morning would be on their side, but Kansas City Federal Reserve Bank President Thomas Hoenig bluntly rejected the argument that any troubled banks are "too big to fail."

"I believe that failure is an option," Hoenig said in his prepared remarks. "I think it is the best solution for getting our financial system and economy on the road to recovery."

Hoenig declined to specify which banks he was referring to. "I won't say who of the four are insolvent/should be taken in, but I will say if any of the four have insufficient capital to manage their circumstance," he said, "then the government should take a supervisory position."

With the Obama economic team preparing legislation that would expand the government's power over financial institutions in crisis, the Joint Economic Committee sought advice from top economists who have been critical of the moves made by both the Bush and Obama administrations since the banking sector cratered last fall. Nearly all of their recommendations were more ambitious and less generous toward Wall Street than any the Treasury Department has put forward so far, but the testimony of Hoenig, a key central banker, may have been the most shocking.

Hoenig, who is a nonvoting member of the Federal Open Market Committee, which sets interest rates, joined Joseph Stiglitz, a Nobel winner and preeminent progressive economist who was notably excluded from the broad Obama economic advisory panels during the transition period, and Simon Johnson, the former chief economist of the International Monetary Fund. Johnson's recent essay in The Atlantic Monthly compared the United States to a banana republic in terms of the government's domination by narrow financial interests at the expense of the broader population.

All three men proposed breakups of some financial institutions and conservatorship of others -- though none would name individual firms deserving of either action -- in tandem with varying degrees of new regulation and oversight authorities. All three also criticized the federal government's response to date as both inefficient and further corruptive of the financial markets.

"With the bailout of AIG, we have officially announced that any institution which is systemically significant will be bailed out," Stiglitz said. "The decisions of both the Obama and Bush Administrations to extend unnecessarily the corporate safety net have meant not only that incentives are more distorted but also that our national debt will be massively larger than it otherwise would have been. Going forward, I think it is imperative that Congress narrow the breadth of this new corporate welfare state. It is people that we should be protecting, not corporations."

Drawing on the substance of his Atlantic essay, Johnson focused on the explicit links between government and the financial industry that he believes have limited the effectiveness of the federal response, calling for invocation of federal antitrust laws to break up banks as a complement to Stiglitz's public-utility model. In prefacing his prepared remarks, Johnson said new calculations indicate that current policy would ultimately increase government debt to 80 percent of GDP, double what the Congressional Budget Office has estimated.

The relatively few assembled members of the Joint Economic Committee seemed to have come into the hearing largely in agreement with the experts they had assembled, and used the question and answer period following the economists' prepared remarks mainly to recapitulate certain elements of their testimony.

In her opening remarks, Rep. Carolyn Maloney (D-N.Y.), the committee chair, cited the September collapse of Lehman Brothers as evidence that further bank failures would have brought the U.S. economy lower than its current ebb, but expressed the committee's skepticism that Troubled Asset Relief Program recipients can be trusted not to abuse government aid.

"Implicit guarantees give firms incentives to take bigger risks," Maloney said, foreshadowing later testimony by Hoenig, Stiglitz and Johnson. "Allowing firms to escape the consequences of bad business decisions could prompt even riskier behavior."

Maloney later asked the panel whether the protection of large banks over small ones constitutes a double standard, a contention that all three men affirmed. They also agreed, in response to prompting from ranking committee member Sen. Sam Brownback (R-Ks.), that large banks should be treated the same as smaller ones in order to speed economic recovery, and that this could be done without interruption in consumer bank account or credit card use.

The assembled economists also cited the "revolving door" between financial institutions and government jobs as both damaging to public confidence and to the breadth of solutions conceived of in Washington.

In response to Rep. Elijah Cummings (D-Md.), who complained about the continued dearth of loans from banks receiving TARP money, Stiglitz said, "You're absolutely right that what is good for Wall Street may not be good for the rest of the country."

Arriving near the end of the question-and-answer session, Sen. Amy Klobuchar (D-Minn.) prefaced her questions about future regulation with an apology. "Sorry I missed your testimony," she said. "I've been pretty busy lately. I've got this 'only senator from Minnesota' thing going."

Meanwhile, Stiglitz's discussion of new regulatory agencies leaned on common-sense judgments.

"You can't sell it in your markets if you can't explain it," he offered, not far off from the kind of policies comedian Lewis Black has described. "If you have a company and it can't explain in one sentence what it does, it's illegal," said Black.

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