Simon Johnson is a senior fellow at the
Peterson Institute for International Economics since September 2008.
Previously he was the International Monetary Fund's Economic Counselor and Director of the Research Department (2007–08). At
the IMF, Professor Johnson led the global economic outlook team,
helped formulate innovative responses to worldwide financial turmoil,
and was among the first to propose new forms of engagement for
sovereign wealth funds. He was also the first IMF chief economist to
have a blog.
Professor Johnson is the Ronald A.
Kurtz Professor of Entrepreneurship at MIT's Sloan School of
Management, a position he has held since 2004. His previous
appointments include Assistant Director in the IMF's Research
Department (2004–06) and visiting fellow at the Institute
(2006–07).
The Quiet Coup
Atlantic Magazine -
The crash has laid bare many
unpleasant truths about the United States. One of the most alarming,
says a former chief economist of the International Monetary Fund, is
that the finance industry has effectively captured our government—a
state of affairs that more typically describes emerging markets, and
is at the center of many emerging-market crises. 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.
Simon Johnson MAY 1 2009
ONE THING YOU learn rather quickly
when working at the International Monetary Fund is that no one is
ever very happy to see you. Typically, your “clients” come in
only after private capital has abandoned them, after regional
trading-bloc partners have been unable to throw a strong enough
lifeline, after last-ditch attempts to borrow from powerful friends
like China or the European Union have fallen through. You’re never
at the top of anyone’s dance card.
The reason, of course, is that the IMF
specializes in telling its clients what they don’t want to hear. I
should know; I pressed painful changes on many foreign officials
during my time there as chief economist in 2007 and 2008. And I felt
the effects of IMF pressure, at least indirectly, when I worked with
governments in Eastern Europe as they struggled after 1989, and with
the private sector in Asia and Latin America during the crises of the
late 1990s and early 2000s. Over that time, from every vantage point,
I saw firsthand the steady flow of officials—from Ukraine, Russia,
Thailand, Indonesia, South Korea, and elsewhere—trudging to the
fund when circumstances were dire and all else had failed.
Every crisis is different, of course.
Ukraine faced hyperinflation in 1994; Russia desperately needed help
when its short-term-debt rollover scheme exploded in the summer of
1998; the Indonesian rupiah plunged in 1997, nearly leveling the
corporate economy; that same year, South Korea’s 30-year economic
miracle ground to a halt when foreign banks suddenly refused to
extend new credit.
But I must tell you, to IMF officials,
all of these crises looked depressingly similar. Each country, of
course, needed a loan, but more than that, each needed to make big
changes so that the loan could really work. Almost always, countries
in crisis need to learn to live within their means after a period of
excess—exports must be increased, and imports cut—and the goal is
to do this without the most horrible of recessions. Naturally, the
fund’s economists spend time figuring out the policies—budget,
money supply, and the like—that make sense in this context. Yet the
economic solution is seldom very hard to work out.
No, the real concern of the fund’s
senior staff, and the biggest obstacle to recovery, is almost
invariably the politics of countries in crisis.
Typically, these countries are in a
desperate economic situation for one simple reason—the powerful
elites within them overreached in good times and took too many risks.
Emerging-market governments and their private-sector allies commonly
form a tight-knit—and, most of the time, genteel—oligarchy,
running the country rather like a profit-seeking company in which
they are the controlling shareholders. When a country like Indonesia
or South Korea or Russia grows, so do the ambitions of its captains
of industry. As masters of their mini-universe, these people make
some investments that clearly benefit the broader economy, but they
also start making bigger and riskier bets. They reckon—correctly,
in most cases—that their political connections will allow them to
push onto the government any substantial problems that arise.
In Russia, for instance, the private
sector is now in serious trouble because, over the past five years or
so, it borrowed at least $490 billion from global banks and investors
on the assumption that the country’s energy sector could support a
permanent increase in consumption throughout the economy. As Russia’s
oligarchs spent this capital, acquiring other companies and embarking
on ambitious investment plans that generated jobs, their importance
to the political elite increased. Growing political support meant
better access to lucrative contracts, tax breaks, and subsidies. And
foreign investors could not have been more pleased; all other things
being equal, they prefer to lend money to people who have the
implicit backing of their national governments, even if that backing
gives off the faint whiff of corruption.
But inevitably, emerging-market
oligarchs get carried away; they waste money and build massive
business empires on a mountain of debt. Local banks, sometimes
pressured by the government, become too willing to extend credit to
the elite and to those who depend on them. Overborrowing always ends
badly, whether for an individual, a company, or a country. Sooner or
later, credit conditions become tighter and no one will lend you
money on anything close to affordable terms.
The downward spiral that follows is
remarkably steep. Enormous companies teeter on the brink of default,
and the local banks that have lent to them collapse. Yesterday’s
“public-private partnerships” are relabeled “crony capitalism.”
With credit unavailable, economic paralysis ensues, and conditions
just get worse and worse. The government is forced to draw down its
foreign-currency reserves to pay for imports, service debt, and cover
private losses. But these reserves will eventually run out. If the
country cannot right itself before that happens, it will default on
its sovereign debt and become an economic pariah. The government, in
its race to stop the bleeding, will typically need to wipe out some
of the national champions—now hemorrhaging cash—and usually
restructure a banking system that’s gone badly out of balance. It
will, in other words, need to squeeze at least some of its oligarchs.
Squeezing the oligarchs, though, is
seldom the strategy of choice among emerging-market governments.
Quite the contrary: at the outset of the crisis, the oligarchs are
usually among the first to get extra help from the government, such
as preferential access to foreign currency, or maybe a nice tax
break, or—here’s a classic Kremlin bailout technique—the
assumption of private debt obligations by the government. Under
duress, generosity toward old friends takes many innovative forms.
Meanwhile, needing to squeeze someone, most
emerging-market governments look first to ordinary working folk—at
least until the riots grow too large.
Eventually, as the oligarchs in Putin’s
Russia now realize, some within the elite have to lose out before
recovery can begin. It’s a game of musical chairs: there just
aren’t enough currency reserves to take care of everyone, and the
government cannot afford to take over private-sector debt completely.
So the IMF staff looks into the eyes of
the minister of finance and decides whether the government is serious
yet. The fund will give even a country like Russia a loan eventually,
but first it wants to make sure Prime Minister Putin is ready,
willing, and able to be tough on some of his friends. If he is not
ready to throw former pals to the wolves, the fund can wait. And when
he is ready, the fund is happy to make helpful
suggestions—particularly with regard to wresting control of the
banking system from the hands of the most incompetent and avaricious
“entrepreneurs.”
Of course, Putin’s ex-friends will
fight back. They’ll mobilize allies, work the system, and put
pressure on other parts of the government to get additional
subsidies. In extreme cases, they’ll even try subversion—including
calling up their contacts in the American foreign-policy
establishment, as the Ukrainians did with some success in the late
1990s.
Many IMF programs “go off track” (a
euphemism) precisely because the government can’t stay tough on
erstwhile cronies, and the consequences are massive inflation or
other disasters. A program “goes back on track” once the
government prevails or powerful oligarchs sort out among themselves
who will govern—and thus win or lose—under the IMF-supported
plan. The real fight in Thailand and Indonesia in 1997 was about
which powerful families would lose their banks. In Thailand, it was
handled relatively smoothly. In Indonesia, it led to the fall of
President Suharto and economic chaos.
From long years of experience, the IMF
staff knows its program will succeed—stabilizing the economy and
enabling growth—only if at least some of the powerful oligarchs who
did so much to create the underlying problems take a hit. This is the
problem of all emerging markets.
Becoming a Banana Republic
In its depth and suddenness, 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 alarming, they are
now using their influence to prevent precisely the sorts of reforms
that are needed, and fast, to pull the economy out of its nosedive.
The government seems helpless, or unwilling, to act against them.
Top investment bankers and government
officials like to lay the blame for the current crisis on the
lowering of U.S. interest rates after the dotcom bust or, even
better—in a “buck stops somewhere else” sort of way—on the
flow of savings out of China. Some on the right like to complain
about Fannie Mae or Freddie Mac, or even about longer-standing
efforts to promote broader homeownership. And, of course, it is
axiomatic to everyone that the regulators responsible for “safety
and soundness” were fast asleep at the wheel.
But these various
policies—lightweight regulation, cheap money, the unwritten
Chinese-American economic alliance, the promotion of
homeownership—had something in common. Even though some are
traditionally associated with Democrats and some with Republicans,
they all benefited the financial sector. Policy
changes that might have forestalled the crisis but would have limited
the financial sector’s profits—such as Brooksley Born’s
now-famous attempts to regulate credit-default swaps at the Commodity
Futures Trading Commission, in 1998—were ignored or swept aside.
The financial industry has not always
enjoyed such favored treatment. But for the past 25 years or so,
finance has boomed, becoming ever more powerful. The boom began with
the Reagan years, and it only gained strength with the deregulatory
policies of the Clinton and George W. Bush administrations. Several
other factors helped fuel the financial industry’s ascent. Paul
Volcker’s monetary policy in the 1980s, and the increased
volatility in interest rates that accompanied it, made bond trading
much more lucrative. The invention of securitization, interest-rate
swaps, and credit-default swaps greatly increased the volume of
transactions that bankers could make money on. And an aging and
increasingly wealthy population invested more and more money in
securities, helped by the invention of the IRA and the 401(k) plan.
Together, these developments vastly increased the profit
opportunities in financial services.
Not surprisingly, Wall Street ran with
these opportunities. From 1973 to 1985, the financial sector never
earned more than 16 percent of domestic corporate profits. In 1986,
that figure reached 19 percent. In the 1990s, it oscillated between
21 percent and 30 percent, higher than it had ever been in the
postwar period. This decade, it reached 41 percent. Pay rose just as
dramatically. From 1948 to 1982, average compensation in the
financial sector ranged between 99 percent and 108 percent of the
average for all domestic private industries. From 1983, it shot
upward, reaching 181 percent in 2007.
The great wealth that the financial
sector created and concentrated gave bankers enormous political
weight—a weight not seen in the U.S. since the era of J.P. Morgan
(the man). In that period, the banking panic of 1907 could be stopped
only by coordination among private-sector bankers: no government
entity was able to offer an effective response. But that first age of
banking oligarchs came to an end with the passage of significant
banking regulation in response to the Great Depression; the
reemergence of an American financial oligarchy is quite recent.
The Wall Street–Washington
Corridor
Of course, the U.S. is unique. And 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. Although lobbying and campaign
contributions certainly play major roles in the American political
system, old-fashioned corruption—envelopes stuffed with $100
bills—is probably a sideshow today, Jack Abramoff notwithstanding.
Instead, the American financial
industry gained political power by amassing a kind of cultural
capital—a belief system. Once, perhaps, what was good for General
Motors was good for the country. Over the past decade, the attitude
took hold that what was good for Wall Street was good for the
country. The banking-and-securities industry has become one of the
top contributors to political campaigns, but at the peak of its
influence, it did not have to buy favors the way, for example, the
tobacco companies or military contractors might have to. Instead, it
benefited from the fact that Washington insiders already believed
that large financial institutions and free-flowing capital markets
were crucial to America’s position in the world.
One channel of influence was, of
course, the flow of individuals between Wall Street and Washington.
Robert Rubin, once the co-chairman of Goldman Sachs, served in
Washington as Treasury secretary under Clinton, and later became
chairman of Citigroup’s executive committee. Henry Paulson, CEO of
Goldman Sachs during the long boom, became Treasury secretary under
George W.Bush. John Snow, Paulson’s predecessor, left to become
chairman of Cerberus Capital Management, a large private-equity firm
that also counts Dan Quayle among its executives. Alan Greenspan,
after leaving the Federal Reserve, became a consultant to Pimco,
perhaps the biggest player in international bond markets.
These personal connections were
multiplied many times over at the lower levels of the past three
presidential administrations, strengthening the ties between
Washington and Wall Street. It has become something of a tradition
for Goldman Sachs employees to go into public service after they
leave the firm. The flow of Goldman alumni—including Jon Corzine,
now the governor of New Jersey, along with Rubin and Paulson—not
only placed people with Wall Street’s worldview in the halls of
power; it also helped create an image of Goldman (inside the Beltway,
at least) as an institution that was itself almost a form of public
service.
Wall Street is a very seductive place,
imbued with an air of power. Its executives truly believe that they
control the levers that make the world go round. A civil servant from
Washington invited into their conference rooms, even if just for a
meeting, could be forgiven for falling under their sway. Throughout
my time at the IMF, I was struck by the easy access of leading
financiers to the highest U.S. government officials, and the
interweaving of the two career tracks. I vividly remember a meeting
in early 2008—attended by top policy makers from a handful of rich
countries—at which the chair casually proclaimed, to the room’s
general approval, that the best preparation for becoming a
central-bank governor was to work first as an investment banker.
A
whole generation of policy makers has been mesmerized by Wall Street,
always and utterly convinced that whatever the banks said was true.
Alan Greenspan’s pronouncements in favor of unregulated financial
markets are well known. Yet Greenspan was hardly alone. This is what
Ben Bernanke, the man who succeeded him, said
in 2006:
“The management of market risk and credit risk has become
increasingly sophisticated. … Banking organizations of all sizes
have made substantial strides over the past two decades in their
ability to measure and manage risks.”
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. AIG’s Financial
Products division, for instance, made $2.5 billion in pretax profits
in 2005, largely by selling underpriced insurance on complex, poorly
understood securities. Often described as “picking up nickels in
front of a steamroller,” this strategy is profitable in ordinary
years, and catastrophic in bad ones. As of last fall, AIG had
outstanding insurance on more than $400 billion in securities. To
date, the U.S. government, in an effort to rescue the company, has
committed about $180 billion in investments and loans to cover losses
that AIG’s sophisticated risk modeling had said were virtually
impossible.
Wall
Street’s seductive power extended even (or especially) to finance
and economics professors, historically confined to the cramped
offices of universities and the pursuit of Nobel Prizes. As
mathematical finance became more and more essential to practical
finance, professors increasingly took positions as consultants or
partners at financial institutions. Myron Scholes and Robert Merton,
Nobel laureates both, were perhaps the most famous; they took board
seats at the hedge fund Long-Term Capital Management in 1994, before
the fund famously flamed out at the end of the decade. But many
others beat similar paths. This migration gave the stamp of academic
legitimacy (and the intimidating aura of intellectual rigor) to the
burgeoning world of high finance.
As
more and more of the rich made their money in finance, the cult of
finance seeped into the culture at large. Works like Barbarians
at the Gate, Wall
Street,
and Bonfire
of the Vanities—all
intended as cautionary tales—served only to increase Wall Street’s
mystique. Michael
Lewis noted in Portfolio last
year that when he wrote Liar’s
Poker,
an insider’s account of the financial industry, in 1989, he had
hoped the book might provoke outrage at Wall Street’s hubris and
excess. Instead, he found himself “knee-deep in letters from
students at Ohio State who wanted to know if I had any other secrets
to share. … They’d read my book as a how-to manual.” Even Wall
Street’s criminals, like Michael Milken and Ivan Boesky, became
larger than life. 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:
• insistence
on free movement of capital across borders;
• the
repeal of Depression-era regulations separating commercial and
investment banking;
• a
congressional ban on the regulation of credit-default swaps;
• major
increases in the amount of leverage allowed to investment banks;
• a
light (dare I say invisible?)
hand at the Securities and Exchange Commission in its regulatory
enforcement;
• an
international agreement to allow banks to measure their own
riskiness;
• and
an intentional failure to update regulations so as to keep up with
the tremendous pace of financial innovation.
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
The
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.
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. Instead,
Fed Chairman Greenspan and President Bush insisted metronomically
that the economy was fundamentally sound and that the tremendous
growth in complex securities and credit-default swaps was evidence of
a healthy economy where risk was distributed safely.
In
the summer of 2007, signs of strain started appearing. The boom had
produced so much debt that even a small economic stumble could cause
major problems, and rising delinquencies in subprime mortgages proved
the stumbling block. Ever since, the financial sector and the federal
government have been behaving exactly the way one would expect them
to, in light of past emerging-market crises.
By
now, the princes of the financial world have of course been stripped
naked as leaders and strategists—at least in the eyes of most
Americans. But as the months have rolled by, financial elites have
continued to assume that their position as the economy’s favored
children is safe, despite the wreckage they have caused.
Stanley
O’Neal, the CEO of Merrill Lynch, pushed his firm heavily into the
mortgage-backed-securities market at its peak in 2005 and 2006; in
October 2007, he
acknowledged,
“The bottom line is, we—I—got it wrong by being overexposed to
subprime, and we suffered as a result of impaired liquidity in that
market. No one is more disappointed than I am in that result.”
O’Neal took home a $14 million bonus in 2006; in 2007, he walked
away from Merrill with a severance package worth $162 million,
although it is presumably worth much less today.
In
October, John Thain, Merrill Lynch’s final CEO, reportedly lobbied
his board of directors for a bonus of $30 million or more, eventually
reducing his demand to $10 million in December; he withdrew the
request, under a firestorm of protest, only after it was leaked
to The Wall Street Journal. Merrill Lynch as a whole was
no better: it moved its bonus payments, $4 billion in total, forward
to December, presumably to avoid the possibility that they would be
reduced by Bank of America, which would own Merrill beginning on
January 1. Wall Street paid out $18 billion in year-end bonuses last
year to its New York City employees, after the government disbursed
$243 billion in emergency assistance to the financial sector.
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”:
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. In March
2008, Bear Stearns was sold to JP Morgan Chase in what looked to many
like a gift to JP Morgan. (Jamie Dimon, JP Morgan’s CEO, sits on
the board of directors of the Federal Reserve Bank of New York,
which, along with the Treasury Department, brokered the deal.) In
September, we saw the sale of Merrill Lynch to Bank of America, the
first bailout of AIG, and the takeover and immediate sale of
Washington Mutual to JP Morgan—all of which were brokered by the
government. In October, nine large banks were recapitalized on the
same day behind closed doors in Washington. This, in turn, was
followed by additional bailouts for Citigroup, AIG, Bank of America,
Citigroup (again), and AIG (again).
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. In September 2008, Henry
Paulson asked Congress for $700 billion to buy toxic assets from
banks, with no strings attached and no judicial review of his
purchase decisions. Many observers suspected that the purpose was to
overpay for those assets and thereby take the problem off the banks’
hands—indeed, that is the only way that buying toxic assets would
have helped anything. Perhaps because there was no way to make such a
blatant subsidy politically acceptable, that plan was shelved.
Instead,
the money was used to recapitalize banks, buying shares in them on
terms that were grossly favorable to the banks themselves. As the
crisis has deepened and financial institutions have needed more help,
the government has gotten more and more creative in figuring out ways
to provide banks with subsidies that are too complex for the general
public to understand. The first AIG bailout, which was on
relatively good terms for the taxpayer, was supplemented by three
further bailouts whose terms were more AIG-friendly. The second
Citigroup bailout and the Bank of America bailout included complex
asset guarantees that provided the banks with insurance at
below-market rates. The third Citigroup bailout, in late February,
converted government-owned preferred stock to common stock at a price
significantly higher than the market price—a subsidy that probably
even most Wall Street Journal readers would miss on
first reading. And the convertible preferred shares that the Treasury
will buy under the new Financial Stability Plan give the conversion
option (and thus the upside) to the banks, not the government.
This
latest plan—which is likely to provide cheap loans to hedge funds
and others so that they can buy distressed bank assets at relatively
high prices—has been heavily influenced by the financial sector,
and Treasury has made no secret of that. As Neel Kashkari, a senior
Treasury official under both Henry Paulson and Tim Geithner (and a
Goldman alum) told Congress in March, “We had received inbound
unsolicited proposals from people in the private sector saying, ‘We
have capital on the sidelines; we want to go after [distressed bank]
assets.’” And the plan lets them do just that: “By marrying
government capital—taxpayer capital—with private-sector capital
and providing financing, you can enable those investors to then go
after those assets at a price that makes sense for the investors and
at a price that makes sense for the banks.” Kashkari didn’t
mention anything about what makes sense for the third group involved:
the taxpayers.
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.
Bank of America obtained its second bailout package (in January)
after warning the government that it might not be able to go through
with the acquisition of Merrill Lynch, a prospect that Treasury did
not want to consider.
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.
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.
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.
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. The Obama administration’s fiscal stimulus
evokes FDR, but what we need to imitate here is Teddy Roosevelt’s
trust-busting.
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.
Still,
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.
Regulation and taxation should be part of the solution. Over time,
though, 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
Paths
To
paraphrase Joseph Schumpeter, the early-20th-century economist,
everyone has elites; the important thing is to change them from time
to time. If the U.S. were just another country, coming to the IMF
with hat in hand, I might be fairly optimistic about its future. Most
of the emerging-market crises that I’ve mentioned ended relatively
quickly, and gave way, for the most part, to relatively strong
recoveries. But this, alas, brings us to the limit of the analogy
between the U.S. and emerging markets.
Emerging-market
countries have only a precarious hold on wealth, and are weaklings
globally. When they get into trouble, they quite literally run out of
money—or at least out of foreign currency, without which they
cannot survive. They must make difficult decisions;
ultimately, aggressive action is baked into the cake. But the U.S.,
of course, is the world’s most powerful nation, rich beyond
measure, and blessed with the exorbitant privilege of paying its
foreign debts in its own currency, which it can print. As a result,
it could very well stumble along for years—as Japan did during its
lost decade—never summoning the courage to do what it needs to do,
and never really recovering. A clean break with the past—involving
the takeover and cleanup of major banks—hardly looks like a sure
thing right now. Certainly no one at the IMF can force it.
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.
Boris
Fyodorov, the late finance minister of Russia, struggled for much of
the past 20 years against oligarchs, corruption, and abuse of
authority in all its forms. He liked to say that confusion and chaos
were very much in the interests of the powerful—letting them take
things, legally and illegally, with impunity. When inflation is high,
who can say what a piece of property is really worth? 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: the global economy continues to
deteriorate, 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. Creditors take further hits and confidence
falls further. The Asian economies that export manufactured goods are
devastated, and the commodity producers in Latin America and Africa
are not much better off. 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.
Under
this kind of pressure, and faced with the prospect of a national and
global collapse, minds may 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.
Simon
Johnson, a professor at MIT’s Sloan School of Management, was the
chief economist at the International Monetary Fund during 2007 and
2008. He blogs about the financial crisis at baselinescenario.com,
along with James Kwak, who also contributed to this essay.
