On the financial sector: For 150 years - during the creation of the greatest economy the world had ever seen - finance was not a critical sector. After the Great Depression, banking was quite tightly regulated in the United States and served entrepreneurs and business very well. From the 1970's it changed dramatically. The banks became bigger, were able to take on more risk, and then were able to blow themselves up.
On what changed after the 1970's: The big difference is the ability for banks to take on risk - and ultimately to be able to put the real downside risk onto others.
On Regulatory Capture: Prof. Johnson says he is a follower of George Stigler, who made the point that when you regulate industry, industry will attempt to capture the regulators. Bankers are able to capture the regulation and get themselves huge commissions to take on risk. We witnessed one of the most sophisticated episodes of regulatory capture in the history of humankind.
On who benefitted: The benefit of this kind of rent-seeking accrues to executives in the bank - and not to shareholders.
On how we are addressing the problem: Basel is part of the problem. They are taking the position that someone knows what is risk-free. It doesn't matter if it's a banker, a regulator or an academic. No one can tell you what is risk free. There is no such thing as safe debt.
On the problem created by scale: Think about John Corzine vs. Chuck Prince. John Corzine bet MF Global on sovereign debt - and lost, but he was running a $40bn balance sheet. Who cares? Chuck Prince, bet massively on mortgage-backed securities, and lost. That was a $2.5t balance sheet. Taxpayers ended up taking that one on the chin. Why would anyone want one guy to be in control of a $2.5t balance sheet? We do not want a few guys in a position to be able to bring down the US economy.
On "deregulation": The end of Glass-Steagall is a symbol, but by the time Glass Steagall was repealed, a lot of the restrictions on large-scale risk-taking by big bank holding companies had already gone away. The failure to have a proper regulatory framework for derivatives is a big issue. But the decision by the SEC during the Bush Administration to allow investment banks to massively increase their leverage will go down as one of the great mistakes in financial history.
On moral hazard: In a fiat money system with a central bank, if market participants believe they will be backstopped, you will get bad decision-making. In Greece the damage was done by government gone wild. In Ireland the damage was done by bankers gone wild. But it all derives from the same issue - belief that a central bank will backstop losses.
On what should have happened: Creditors must face losses. Not catastrophic losses necessarily - but they have to face the results of their actions. Management of all bailout recipients should have been removed. The person who brings the money to the deal gets to decide who management will be moving forward - as in CEO's and others should have been shown the door as a condition for making bailout money available.
On who got bailed out: People who socialized with Tim Geithner.
On Alan Greenspan: Hypocrite. A self-proclaimed free-market ideologue, known for the Greenspan Put - which was his tendency to use Fed powers to attempt to micro-manage markets.
On bank size: There should be a hard size-cap on the size of banks relative to the economy. For example, bank total assets cannot be more than of 4% of GDP. For banks that engage in more risky activity - for example investment banks - the cap would be 2%. This has been done in other industries in the past. For example, after Standard Oil was broken up, most of the parts went on to be very successful. The goal is no more bailouts under any circumstances.
On Dodd-Frank: What if we have a problem with Goldman Sachs, with a $900bn balance sheet? Will regulators let them go? Of coursel not. JP Morgan is bigger. Citi is bigger. Dodd-Frank does not adequately address "too big to fail".
On transparency: If banks are allowed to maintain secret information shared only with the regulator and the regulator is captured, we have the opposite of transparency. None of the stress tests are worth anything. Ultimately, a central problem is the lack of transparency in the Fed itself. We need central banking with transparency and accountability. We do not have either right now.
Link to the full interview at EconTalk