Simon Johnson: Wall Street's Stranglehold on Our Democracy Must Be Broken
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If some hedge fund, for example, makes a lot of money and pays its guys a lot of money, I don't really have a problem with that, so long as they aren't creating systemic risk. I'm an entrepreneurship professor at M.I.T, I like people who take risks. What I don't like is people who play with house money, which in this case is the taxpayers' money.
ZC: Your background is with the IMF. Drawing on that experience—do financial crises of the size and scope of what we've just experienced take place without widespread fraud?
SJ: It's a good question. You never know how much fraud there is unless big banks actually collapse. You can see this around Lehman. We knew Lehman was a sharp operator, we knew Lehman was really skating along the edge in many ways, but we didn't know they were engaged in outright fraud. And in fact, even after the revelations about their Repo 105 plan to hide assets from investors, we still don't know if that behavior can be proved fraudulent in a court of law.
They certainly bent the rules massively. They certainly misrepresented things to their investors and to the market. Whether they can be held accountable for that is another question, unfortunately.
But you never really find out about fraud until the company collapses, because after that, nobody wants to do business with them anymore, and nobody wants to cover for them. Nobody thinks, "If I get tough on Lehman, they won't give me any more good trades," because Lehman is gone.
This is what protects the big guys right now, the J.P. Morgans, even Citigroup, which most people on Wall Street really dislike and regard as very poorly run. Even Citi is immune from some level of criticism because there are hedge fund people and people on Wall Street who are very knowledgeable and want to do business with those companies going forward. As long as a company stays in business, the public will never know what was fraudulent and what was not.
ZC: So what's the difference between an Enron-style scandal where people go to jail and what we just lived through?
SJ: I think there are a lot of parallels. With Enron, we never found out about anything until the firm collapsed. After that, there were prosecutions. So we should wait and see how things play out. But the rules that apply to the financial sector are very loosey-goosey, and much more open to interpretation and exploitation than the rules that apply to other companies. Enron was sort of a weird hybrid that committed many financial infractions, but they weren't a bank, and they didn't have the kind of protection that you get from being a bank and being regarded as central to the credit system.
ZC: But they were involved in the derivatives market, and they did engage in accounting hijinks.
SJ: Right, although by today's standards, of course, they were small-scale and primitive.
ZC: But shouldn't that scandal have sounded an alarm somewhere? Shouldn't there have been some broader federal response after Enron?
SJ: Well, the big alarm bell was the failure of the Long-Term Capital Management hedge fund in 1998. And the extraordinary thing, which we point out in 13 Bankers , is that Brooksley Born actually rang the alarm bell before the Long-Term Capital Management crisis, and she was ignored, marginalized and attacked for it.
I think Enron was actually misconstrued, because people dismissed it, saying it was just fraud, they just failed to disclose important things to shareholders. And we did get the Sarbanes-Oxley Act out of it, and I don't think that was a bad idea. But the response did not cut to what now appears to be the heart of the problem.