WASHINGTON Insolvent financial firms must be allowed to fail regardless of size, a top Federal Reserve official said on Tuesday, as two prominent economists urged Congress to break up the biggest U.S. banks.
In blunt criticism of the government Federal Reserve Bank of Kansas City President Thomas Hoenig told Congress' Joint Economic Committee that the design of a $700 billion bank bailout last year sowed uncertainty and slowed recovery.
Citing the costs of the economic crisis, Nobel economic laureate Joseph Stiglitz and former IMF chief economist Simon Johnson also told the panel that it was in the interest of taxpayers to dissolve the largest U.S. financial institutions.
"The United States currently faces economic turmoil related directly to a loss of confidence in our largest financial institutions because policymakers accepted the idea that some firms are just 'too big to fail.' I do not," Hoenig said.
"Yes, these institutions are systemically important, but we all know that in a market system, insolvent firms must be allowed to fail regardless of their size, market position or the complexity of operations," said Hoenig, who will be a voter on the Fed's policy-setting committee next year.
U.S. anti-trust rules should be used to break up the biggest banks to safeguard the economy, said Johnson, a professor at the Massachusetts Institute of Technology. He added the costs of the financial crisis already dwarf the damage done by industrial monopolies in the last century.
"The use of anti-trust (laws) to break up the largest banks will be essential," he said. "This is a very serious, imminent danger that needs to be addressed."
Stiglitz made a similar point, arguing that the American people had not received anything like sufficient benefits from allowing such large financial firms to grow, versus with the costs of the crisis.
"They should be broken up unless a compelling case can be made not to that," Stiglitz, a Columbia University professor, told the committee.
The biggest 19 U.S. banks are being subjected to a battery of so-called stress tests to restore confidence in their soundness, with guidelines on the process due on Friday and the results on May 4.
Stocks fell sharply on Monday amid fear that some of them still face massive losses, as the severe U.S. recession forces loan default rates to continue rising.
U.S. Treasury Secretary Timothy Geithner has signaled that no firms will 'fail' the stress tests, but Hoenig said this would be a mistake.
"Actions that strive to protect our largest institutions from failure risk prolonging the crisis and increasing its cost," Hoenig said.
"Of particular concern to me is the fact that the financial support provided to firms considered "too big to fail" provides them a competitive advantage over other firms and subsidizes their growth and profit with taxpayer funds," he said.
Nodding to anger among ordinary Americans over multi-billion dollar bailouts for rich bankers, Hoenig said some of these firms were simply too complicated, and too well-connected in Washington, for the good of the country.
"These "too big to fail" institutions are not only too big, they are too complex and too politically influential to supervise on a sustained basis without a clear set of rules constraining their actions. When the recession ends, old habits will reemerge," he said.
Hoenig also criticized the government's Troubled Asset Relief Program, or TARP, which was also separately chided on Tuesday by the Treasury's watchdog.
"In the rush to find stability, no clear process was used to allocate TARP funds among the largest firms. This created further uncertainty and is impeding recovery," Hoenig said.
(Reporting by Alister Bull; Editing by Walker Simon)