"The crash has laid bare many unpleasant truths about the United States. One of the most alarming is that the finance industry has effectively captured our government", says Simon Johnson, a chief economist with the International Monetary Fund in 2007 and 2008. In an article entitled "The Quiet Coup" in the May, 2009 issue of the Atlantic magazine he (with James Kwak) goes on to say that "if the IMF's staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform and if we are to prevent a true depression, we're running out of time".
America is in financial crisis but instead of the financial oligarchy being broken up to permit essential reform they are continuing to use their influence to prevent precisely the sorts of reforms that are needed immediately to pull the economy out of its nosedive. Unfortunately, our legislators seem unwilling to act against these powerful financiers opting instead to succumb to their power and influence and continue to give them what they deem to be in their best interest instead of that of the taxpayers'. All this is happening because of the false belief by all concerned that large financial institutions and free-flowing capital markets are crucial to America's position in the world and that whatever the banks say is true and what they want is necessary. The government's velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. There is no better time to take such action than now but it is evident that reform is but a pipe dream. America's financial oligarchy is still in control and, as such, the long-term consequences will be dire!
Johnson's article is so frank, so insightful and so alarming it deserves the widest readership possible during these traumatic times and, as such, I have taken the liberty to edit and paraphrase in places his intriguing interpretation of what ails America's economic state and what needs to be done to alleviate the crisis.
The Powerful Elites have Over-reached
Johnson says that "typically countries in crisis are in a desperate economic situation for one simple reason -- the powerful elites within them overreached in good times and took too many risks and that certainly is the case in America. Indeed, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.
But there's a deeper and more disturbing similarity: elite business interests -- financiers, in the case of the U.S. -- played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarmingly, they are now using their influence to prevent precisely the sorts of reforms that are needed immediately to pull the economy out of its nosedive. Unfortunately, the government seems helpless, or unwilling, to act against these powerful financiers.
Financial Industry has Gained Political Power
Of course, the U.S. is unique in that, just as we have the world's most advanced economy, military, and technology, we also have its most advanced oligarchy.
In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts.
Instead, the American financial industry gained political power by amassing a kind of cultural capital, a belief system ... in which Washington insiders believe that large financial institutions and free-flowing capital markets are crucial to America's position in the world ... and always and utterly convinced that whatever the banks said was true.
Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn't.
As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large....In a society that celebrates the idea of making money, it was easy to infer that the interests of the financial sector were the same as the interests of the country -- and that the winners in the financial sector knew better what was good for America than did the career civil servants in Washington. Faith in free financial markets grew into conventional wisdom -- trumpeted on the editorial pages of The Wall Street Journal and on the floor of Congress.
From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing.
The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.
America's Oligarchs and the Financial Crisis
America's oligarchy and the government policies that aided it did not alone cause the financial crisis that exploded last year. Many other factors contributed, including excessive borrowing by households and lax lending standards out on the fringes of the financial world. But major commercial and investment banks -- and the hedge funds that ran alongside them -- were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew. (See the article I wrote entitled "Our Worst Nightmare: The Puncture of the U.S Housing Bubble" back in early 2006 for a detailed expose on just how such loans were handled.)
Because everyone was getting richer, and the health of the national economy depended so heavily on growth in real estate and finance, no one in Washington had any incentive to question what was going on.
In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty -- in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy -- ultimately making the problem much harder to solve. Yet the principal characteristics of the government's response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector.
The response so far is perhaps best described as "policy by deal" in that when a major financial institution gets into trouble, the Treasury Department and the Federal Reserve engineer a bailout over the weekend and announce on Monday that everything is fine.
Some of these deals may have been reasonable responses to the immediate situation but it was never clear (and still isn't) what combination of interests was being served, and how. Treasury and the Fed did not act according to any publicly articulated principles, but just worked out a transaction and claimed it was the best that could be done under the circumstances. This was late-night, backroom dealing, pure and simple.
Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here.
Even leaving aside fairness to taxpayers, the government's velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, "It doesn't matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns." But there's the rub: the economy can't recover until the banks are healthy and willing to lend.
The Way Out
Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.
Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause -- Lehman was small relative to Citigroup or Bank of America -- is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington.
The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.
Nationalize the Banks
In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy -- the function that the private banking sector is supposed to be performing, but isn't. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do.
At the root of the banks' problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don't want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren't enough to make them healthy (again, they can't reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don't lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won't pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate -- creating a highly destructive vicious cycle.
To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards -- contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible.
Nationalization would not imply permanent state ownership. The IMF's advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC "intervention" is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector. The main advantage is immediate recognition of the problem so that it can be solved before it grows worse.
The government needs to inspect the balance sheets and identify the banks that cannot survive a severe recession. These banks should face a choice: write down your assets to their true value and raise private capital within 30 days, or be taken over by the government. The government would write down the toxic assets of banks taken into receivership -- recognizing reality -- and transfer those assets to a separate government entity, which would attempt to salvage whatever value is possible for the taxpayer (as the Resolution Trust Corporation did after the savings-and-loan debacle of the 1980s). The rump banks -- cleansed and able to lend safely, and hence trusted again by other lenders and investors -- could then be sold off.
Cleaning up the megabanks will be complex. And it will be expensive for the taxpayer; according to the latest IMF numbers, the cleanup of the banking system would probably cost close to $1.5 trillion (or 10 percent of our GDP) in the long term. But only decisive government action -- exposing the full extent of the financial rot and restoring some set of banks to publicly verifiable health -- can cure the financial sector as a whole.
This may seem like strong medicine. But in fact, while necessary, it is insufficient. The second problem the U.S. faces -- the power of the oligarchy -- is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy.
Limit Bank Size
Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.
Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical -- since we'll want to sell the banks quickly -- they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.
This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the "efficiency costs" of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail -- a financial weapon of mass self-destruction -- explodes. Anything that is too big to fail is too big to exist.
Overhaul Antitrust Legislation
To ensure systematic bank breakup, and to prevent the eventual reemergence of dangerous behemoths, we also need to overhaul our antitrust legislation. Laws put in place more than 100 years ago to combat industrial monopolies were not designed to address the problem we now face. The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy.
Cap Executive Compensation
Caps on executive compensation, while redolent of populism, might help restore the political balance of power and deter the emergence of a new oligarchy. Wall Street's main attraction -- to the people who work there and to the government officials who were only too happy to bask in its reflected glory -- has been the astounding amount of money that could be made. Limiting that money would reduce the allure of the financial sector and make it more like any other industry.
Increase Regulation and Taxation
Outright pay caps are clumsy, especially in the long run and most money is now made in largely unregulated private hedge funds and private-equity firms, so lowering pay would be complicated. Therefore, regulation and taxation should be part of the solution.
More Transparency and Competition
Over time the largest part may involve more transparency and competition, which would bring financial-industry fees down. To those who say this would drive financial activities to other countries, we can now safely say: fine.
Two Plausible Scenarios
In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign. Moreover, when the credit system is supported by byzantine government arrangements and backroom deals, how do you know that you aren't being fleeced?
Our future could be one in which continued tumult feeds the looting of the financial system, and we talk more and more about exactly how our oligarchs became bandits and how the economy just can't seem to get into gear.
The second scenario begins more bleakly, and might end that way too. But it does provide at least some hope that we'll be shaken out of our torpor. It goes like this: a) the global economy continues to deteriorate,
b) the banking system in east-central Europe collapses, and -- because eastern Europe's banks are mostly owned by western European banks -- justifiable fears of government insolvency spread throughout the Continent,
c) creditors take further hits and confidence falls further,
d) Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off,
e) a dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration's current budget are increasingly seen as unrealistic, and the rosy "stress scenario" that the U.S. Treasury is currently using to evaluate banks' balance sheets becomes a source of great embarrassment,
f) under this kind of pressure, and faced with the prospect of a national and global collapse, minds become more concentrated.
The conventional wisdom among the elite is still that the current slump cannot be as bad as the Great Depression. This view is wrong. What we face now could, in fact, be worse than the Great Depression -- because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances.
If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late."
The Financial Oligarchy's Control Continues
Please Note: Such wishful thinking is not about to happen any time soon as evidenced by a change just this past Thursday on April 2nd, 2009 to three accounting rules by the Financial Accounting Standards Board (FASB) that now gives banks more discretion in reporting the value of mortgage securities. The new rules, referred to as mark-to-market, will enable all financial institutions with such securities to report higher profits by assuming that the securities are worth more than anyone now is prepared to pay for them.
FASB, at first, resisted making the changes because they would enable financial institutions to avoid recognizing losses from bad loans that they had made but they buckled under heavy political pressure brought to bear, on behalf of the financial oligarchy, by legislators from both parties.
As a result of having their way the financial institutions affected are now free to apply the new rules to their financial statements for the quarter that ended on March 31st. How convenient! Edward Yingling, president of the oligarchy's lobby group, the American Bankers Association, was naturally very pleased with their successful efforts and praised the FASB quickly putting a spin on the changes saying that 'Today's decision should improve information for investors by providing more accurate estimates of market values.'
Not everyone was so elated, however. Two of the rule changes passed unanimously including one that will permit financial institutions to write down assets to market value only if they conclude that the decline is 'other than temporary.' The one that will allow banks to keep part of such declines off their income statements but still show said declines on the institutions' balance sheets, however, had one of the FASB dissenters in the vote, Thomas J. Linsmeier, arguing that accounting rules already on the books allowed 'the fiction that all banks are well capitalized', adding that such changes 'would make them seem better capitalized' than they actually were. Linsmeier was not alone. The vote drew condemnation from an organization called the Investors Working Group, and the two former S.E.C. chairmen who lead it - William H. Donaldson and Arthur Levitt Jr. but even they were no match for the power and influence of the financial oligarchy.
The country is in financial crisis and instead of the financial oligarchy being broken up to permit essential reform they are continuing to use their influence to prevent precisely the sorts of reforms that are needed immediately to pull the economy out of its nosedive. Unfortunately, our legislators seem unwilling to act against these powerful financiers opting instead to succumb to their power and influence and continue to give them what they deem to be in their best interest instead of that of the taxpayers'. All this is happening because of the false belief that large financial institutions and free-flowing capital markets are crucial to America's position in the world ... and always and utterly convinced that whatever the banks say is true and what they want is necessary. The government's velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. There is no better time to take such action than now but it is evident that reform is but a pipe dream. America's financial oligarchy is still in control and, as such, the long-term consequences will be dire!
Simon Johnson is a former chief economist with the International Monetary Fund and is currently a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. He, along with James Kwak, a former McKinsey consultant, is a co-founder of The Baseline Scenario (www.baselinescenario.com) which is a blog dedicated to explaining what happened in the global economy and what we can do about it.
