By Simon Johnson: link to NPR radio interview (and book excerpt) on how 13 Bankers got their hands on so much political and economic power - and why this spells serious danger for the rest of us.

Against all the odds, a glimmer of hope for real financial reform begins to shine through.  It’s not that anything definite has happened – in fact most of the recent Senate details are not encouraging - but rather that the broader political calculus has shifted in the right direction.

Instead of seeing the big banks as inviolable, top people in Obama administration are beginning to see the advantage of taking them on – at least on the issue of consumer protection.  Even Tim Geithner derided the banks recently as,

“those who told us all they were the masters of noble financial innovation and sophisticated risk management.”

In part this is window dressing.  But in part it recognizes political opportunity – the big banks are unpopular because they remain completely unreformed and unrepentant.  And in part it responds to a very real danger – Senator Dodd’s bill is so obviously weak on “too big to fail” issues that it will be hard to paint its opponents as friends of big banks.

Senator Richard Shelby knows this and is taking the offensive.  The administration can convert an easy win into an own goal if it fails to toughen substantially Senator Dodd’s bill.

Fortunately, there is an easy way to address this issue.

Recall the political history of financial reform during the Obama administration.  The economic team (Tim Geithner and Larry Summers) felt that no substantive change in the structure and incentives for deeply troubled parts of the financial system was necessary or even possible during the height of crisis.  Consequently, they provided unlimited financial support to the country’s largest banks – communicated by the “stress tests” – with no conditions, and they also proposed an initial set of legislative changes that was slight.

Quite quickly, however, this strategy ran into trouble – because the largest banks immediately and demonstrably went back to their uncontrolled risk-taking ways, now based on obvious government guarantees.  The lack of careful management within these banks is not an accident – it’s very much part of the design, which enables large bonuses to be paid at all levels; the point is not that individuals intentionally engender crisis every year, but the system runs through a loop that implies regular (and, in our view, increasing) government support over time.  Too Big To Fail pays well; for the banks it is someone else’s problem to fix, and for policymakers the temptation is to kick all available cans down the road.

From summer 2009, leading banks also exuded arrogance – insulting the president and generally carrying on in a high and mighty fashion.  The abuse of power by our ever more powerful bankers became increasingly obvious – as did their lobbying (Neal Wolin, Deputy Treasury Secretary, said this week that “big banks and Wall Street financial firms” spend $1.4 million per day on “lobbying and campaign contributions”; and “there are four financial lobbyists for every member of Congress”; good speech).

With perfect timing during the fall, in stepped Paul Volcker.  Not someone ever accused of being a populist – let alone carrying a pitchfork – he pointed out, simply and forcefully (and publicly), that our biggest banks were out of control and must be reined in.   With the political side of the White House increasingly anxious about the electoral effects of pandering to an apparent financial oligarchy, Volcker was able to persuade the president to adopt the Volcker Rules: a limit on the risk-taking by big banks and an effective cap on their size.

Unfortunately, the specifics of the Volcker Rules were not well thought through by Treasury and their cause was hardly championed with force.  The Capitol Hill lobbying machine took over and mush duly appeared from Senator Dodd’s committee on the issue of systemic risk.

But Paul Volcker is not finished, not by a long way.  Someone just needs to convince President Obama to call Senator Dodd (or meet again with Dodd and Barney Frank), to ask – politely but firmly – that the Volcker size cap on big banks be legislated, and actually tightened relative to the January proposal.  The House already has the Kanjorski amendment, which is a step in the right direction.

On Tuesday, Volcker will go public again. But that’s not the most important conversation.  His public appearance is just a way to communicate more directly with the political side of the White House.

Volcker’s point is simple.  Without the Volcker Rules, the administration would be in much more difficulty than it is now; these proposals really helped to diffuse pressure.  Now it’s time to make the Rules real – and this requires significantly reducing the size of our largest banks.  Phase the rules in, as proposed in January, and there is no reason to think this will constrain our recovery. 

Chris Dodd can start this ball rolling and Barney Frank would back him up.  The consensus is ready to move.  This is such an easy and obvious political win.  Treasury and the White House economic team can be brought onside by being allowed to claim this was their idea all along – or they can say something along the lines of “the facts changed, so we changed our opinions”.

But if Paul Volcker doesn’t tell the president, who will?

The Baseline Scenario