Some Rare Honesty

Harvard economist Kenneth Rogoff made the headlines today with an interview of unusual clarity. Before we look at what he said, keep in mind that Rogoff is not some kind of crackpot. Prior to joining the Harvard faculty, he was Chief Economist for the International Monetary Fund and before that spent many years on the Federal Reserve Board staff. People with this sort of background are not typically prone to overstatement. If anything, they say little until they are certain of the facts. So it was odd to read this today:

“The worst is yet to come in the U.S.,” Rogoff, a Harvard University professor of economics, said in an interview in Singapore today. “The financial sector needs to shrink; I don’t think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job.”

“Like any shrinking industries, we are going to see the exit of some major players,” Rogoff told Bloomberg, declining to name the banks he expects to fail. “We’re really going to see a consolidation even among the major investment banks.”

“The only way to put discipline into the system is to allow some companies to go bust,” Rogoff said. “You can’t just have an industry where they make giant profits or they get bailed out.”
The worst is yet to come? So far the biggest victims in the financial sector have been Bear Stearns and IndyMac Bancorp. Rogoff expects a few more such failures. He also thinks the government should take over Fannie Mae (FNM) and Freddie Mac (FRE) rather than try to preserve them as quasi-private corporations.

On one point, Rogoff was undeniably correct: the system will not work unless companies, including banks, are allowed to feel the pain of their mistakes. “Heads we win, tails the taxpayers lose” is not free enterprise. It is corporate statism. If anything resembling free markets are to survive, the bailouts need to stop. Now is not too soon.