[Corp. Watch] IMF to U.S. banana republic: We must break financial oligarchy

[Corporation Watch]

The Quiet Coup

  The finance industry has effectively captured the govern-
  ment -- and recovery will fail unless we break the financial
  oligarchy that is blocking essential reform

by Simon Johnson

(The Atlantic, May 9) -- One thing you learn rather quickly when  
working at the International Monetary Fund (IMF) is that no one is  
ever very happy to see you. You're never at the top of anyone's dance  
card.

	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.

	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; 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; Russia desperately needed help when its short-term-debt  
rollover scheme exploded in the summer of 1998.

	But 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.

	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 assume -- correctly, in most cases -- that their political  
connections will allow them to push onto the government any  
substantial problems that arise.

	In Russia, 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 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.

	Over-borrowing 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 re-labeled "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 [government] debt and become an economic  
pariah.

	In its race to stop the bleeding, the government will typically need  
to wipe out some of the private companies 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.

	This usually takes the form of preferential access to foreign  
currency, a nice tax break, or -- a classic Kremlin bail-out 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, some within the elite have to lose out before recovery  
can begin, an it becomes a game of financial 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 the prime minister is willing to be tough on some of his friends.

	If he's not ready to throw his former pals to the wolves, the Fund  
can wait. When he is ready, the Fund will 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, those 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" 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) such as South Korea (1997),  
Malaysia (1998), and 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, the fear becomes self- 
fulfilling, as banks that can't roll over their debt 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 dot.com 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 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 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: 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 did not always enjoy such favored treatment.  
But for the past 25 years or so, finance has boomed, becoming ever  
more powerful. This began in the Reagan years, and gained strength  
with the deregulatory policies of the Clinton and 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  
total 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 post-war 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

	And just as the U.S. has 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 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 with Dan Quayle among its executives.

	And, after leaving the Federal Reserve, Alan Greenspan 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, the governor of  
New Jersey, along with Rubin and Paulson -- not only put people with  
Wall Street's worldview in power, it helped create an image of Goldman  
itself as an institution that was 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 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  
policymakers 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 be an  
investment banker.

	A whole generation of policymakers 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.

	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  
pre-tax 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 hedgefund 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 magazine 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 ... 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 making money, it is easy to infer that  
the interests of the financial sector are the same as the interests of  
the country -- and that the winners in the financial sector knew  
better what is good for America than career civil servants in  
Washington do.

	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 flowed, in just the past decade, a river of deregulatory  
policies that is, in hindsight, astonishing:

• Insistence on free movement of capital across borders

• 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 [borrowing] 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

• 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 hedgefunds that  
ran alongside them, were the big beneficiaries of the twin bubbles  
(stocks and housing) of the last decade, profiting from an ever- 
increasing volume of transactions based on relatively few physical  
assets.

	Each time a loan was sold, packaged, securitized, and re-sold, banks  
took their transaction fees, and the hedgefunds 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 sub-prime 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 been stripped naked  
as leaders and strategists, at least in the eyes of most Americans.  
But the financial elite continue to believe that their position as the  
economy's favored children is safe, despite the wreckage they have  
caused.

	Merrill Lynch CEO Stanley O'Neal 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 sub-prime [loans], 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, Merrill Lynch CEO John Thain 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 corporation was no better: It moved a total of $4  
billion in bonus payments from January to December, presumably to  
avoid the possibility that they would be reduced by Bank of America,  
whose purchase of Merrill was effective on January 1.

	Wall Street paid out $18 billion in year-end bonuses to its employees  
last year -- drawn from $243 billion in emergency assistance the  
government disbursed to the financial sector.

	In a financial panic, the government must respond with both speed and  
overwhelming force. The root problem is uncertainty -- in the current  
case, uncertainty about whether the major banks have sufficient assets  
to cover their liabilities.

	Half measures, wishful thinking, and a wait-and-see attitude cannot  
overcome this uncertainty. The longer the response takes, the longer  
uncertainty stymies the flow of credit, saps consumer confidence, and  
cripples 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 bail-out 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 bail-out 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 bail-outs 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, thereby taking 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 has been shelved for now. 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 bail-out, which was on relatively good terms for the  
taxpayer, was supplemented by three further bail-outs whose terms were  
more AIG-friendly.

	The second Citigroup bail-out and the Bank of America bail-out  
included complex asset guarantees that provided the banks with  
insurance at below-market rates.

	The third Citigroup bail-out, in late February, converted government- 
owned preferred stock to common stock at a price significantly higher  
than the market price -- a subsidy that even most Wall Street Journal  
readers would probably 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 Goldman alum Neel Kashkari, a senior Treasury official under both  
Henry Paulson and Tim Geithner told Congress in March, "We received  
unsolicited proposals from people in the private sector saying, 'We  
have capital on the sidelines; we want to go after [distressed bank]  
assets'."

	The plan lets them do just that: "By marrying government capital --  
taxpayer capital -- with private-sector capital and providing  
financing," Kashkari explained, "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."

	He didn't mention anything about what makes sense for the third group  
involved: the taxpayers.

	Leaving aside fairness to taxpayers, the government's velvet-glove  
approach to the banks is deeply troubling, for one simple reason: it  
won't 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 have only gained political strength since the crisis began.  
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 bail-out  
(in January) after warning that it might not be able to go through  
with its acquisition of Merrill Lynch, and leave Treasury holding its  
debt.

	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 still depend 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 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 being insolvent.

	So they talk down the problem, and ask for hand-outs that aren't  
enough to make them healthy (again, they can't reveal the size of the  
hand-outs that would be necessary to do 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 bail-outs 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. The IMF's advice would be, essentially: scale up the  
standard Federal Deposit Insurance Corporation (FDIC) process. An FDIC  
"intervention" is basically a government-managed bankruptcy procedure.

	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 transfer the toxic assets of banks taken into  
receivership 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).

	Nationalization would not imply permanent state ownership. 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 clean-up 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 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 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, swapping one set of powerful  
managers for another would change only the names of the oligarchs.

	Ideally, big banks should be broken into medium-size pieces, based on  
region or type of business, or 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 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 collapses.  
Anything that is too big to fail is too big to exist. Thus, while the  
Obama administration's fiscal stimulus evokes FDR, what we actually  
need to imitate is Teddy Roosevelt's trust-busting instead.

	To ensure systemic change, and prevent the eventual re-emergence of  
dangerous behemoths, we need to overhaul our anti-trust 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 the  
failure of one firm, or a small set of interconnected firms, can bring  
down the economy.

	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.

	Caps on executive compensation, while redolent of populism, might  
help restore the political balance of power and deter the emergence of  
a new oligarchy. 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 hedgefunds and  
private-equity firms, where lowering pay would be complicated.

	Regulation and taxation should be part of the solution. Over time,  
though, the larger 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 safely say  
OK.

Two Paths

	To paraphrase early 20th-century economist Joseph Schumpeter, every  
country has elites; the important thing is to change them from time to  
time.

	If the U.S. were an emerging-market country, I'd be fairly optimistic  
about its future. Most of the crises I've mentioned ended relatively  
quickly and led, for the most part, to relatively strong recoveries.  
But there are limits to the analogy between the U.S. and emerging  
markets.

	Emerging-market countries have a precarious hold on wealth, and are  
weak globally. When they get into trouble, they literally run out of  
money -- or at least foreign currency, without which they cannot  
survive. They must take difficult decisions and, ultimately,  
aggressive action.

	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 stumble along for years -- as Japan did during  
its so-called "lost decade" -- without summoning the courage to do  
what is needed to really recover. A clean break with the past,  
involving the take-over and clean-up of major banks, hardly looks  
likely right now.

	The U.S. faces two plausible scenarios. The first involves  
complicated, bank-by-bank deals and a continual drumbeat of (repeated)  
bail-outs, 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 provides 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 east  
European 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.  
It could become worse than the Depression, because the world is now so  
much more interconnected, and the banking sector is now bigger.

	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.