No subject

y there flowed, in just the past decade, a river of deregulatory policies t=
hat is, in hindsight, astonishing:=20



=E2=80=A2 insistence on free movement of capital across borders;=20



=E2=80=A2 the repeal of Depression-era regulations separating commercial an=
d investment banking;=20



=E2=80=A2 a congressional ban on the regulation of credit-default swaps;=20



=E2=80=A2 major increases in the amount of leverage allowed to investment b=
anks;=20



=E2=80=A2 a light (dare I say invisible ?) hand at the Securities and Excha=
nge Commission in its regulatory enforcement;=20



=E2=80=A2 an international agreement to allow banks to measure their own ri=
skiness;=20



=E2=80=A2 and an intentional failure to update regulations so as to keep up=
 with the tremendous pace of financial innovation.=20



The mood that accompanied these measures in Washington seemed to swing betw=
een nonchalance and outright celebration: finance unleashed, it was thought=
, would continue to propel the economy to greater heights.=20



America=E2=80=99s Oligarchs and the Financial Crisis=20



The oligarchy and the government policies that aided it did not alone cause=
 the financial crisis that exploded last year. Many other factors contribut=
ed, including excessive borrowing by households and lax lending standards o=
ut on the fringes of the financial world. But major commercial and investme=
nt banks=E2=80=94and the hedge funds that ran alongside them=E2=80=94were t=
he big beneficiaries of the twin housing and equity-market bubbles of this =
decade, their profits fed by an ever-increasing volume of transactions foun=
ded on a relatively small base of actual physical assets. Each time a loan =
was sold, packaged, securitized, and resold, banks took their transaction f=
ees, and the hedge funds buying those securities reaped ever-larger fees as=
 their holdings grew.=20



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 Washin=
gton 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 an=
d credit-default swaps was evidence of a healthy economy where risk was dis=
tributed safely.=20



In the summer of 2007, signs of strain started appearing. The boom had prod=
uced so much debt that even a small economic stumble could cause major prob=
lems, and rising delinquencies in subprime mortgages proved the stumbling b=
lock. Ever since, the financial sector and the federal government have been=
 behaving exactly the way one would expect them to, in light of past emergi=
ng-market crises.=20



By now, the princes of the financial world have of course been stripped nak=
ed as leaders and strategists=E2=80=94at least in the eyes of most American=
s. But as the months have rolled by, financial elites have continued to ass=
ume that their position as the economy=E2=80=99s favored children is safe, =
despite the wreckage they have caused.=20



Stanley O=E2=80=99Neal, the CEO of Merrill Lynch, pushed his firm heavily i=
nto the mortgage-backed-securities market at its peak in 2005 and 2006; in =
October 2007, he acknowledged, =E2=80=9CThe bottom line is, we=E2=80=94I=E2=
=80=94got it wrong by being overexposed to subprime, and we suffered as a r=
esult of impaired liquidity in that market. No one is more disappointed tha=
n I am in that result.=E2=80=9D O=E2=80=99Neal took home a $14 million bonu=
s in 2006; in 2007, he walked away from Merrill with a severance package wo=
rth $162 million, although it is presumably worth much less today.=20



In October, John Thain, Merrill Lynch=E2=80=99s final CEO, reportedly lobbi=
ed his board of directors for a bonus of $30 million or more, eventually re=
ducing his demand to $10million in December; he withdrew the request, under=
 a firestorm of protest, only after it was leaked to The Wall Street Journa=
l . 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 beg=
inning on January 1. Wall Street paid out $18 billion in year-end bonuses l=
ast year to its New York City employees, after the government disbursed $24=
3 billion in emergency assistance to the financial sector.=20



In a financial panic, the government must respond with both speed and overw=
helming force. The root problem is uncertainty=E2=80=94in our case, uncerta=
inty about whether the major banks have sufficient assets to cover their li=
abilities. Half measures combined with wishful thinking and a wait-and-see =
attitude cannot overcome this uncertainty. And the longer the response take=
s, the longer the uncertainty will stymie the flow of credit, sap consumer =
confidence, and cripple the economy=E2=80=94ultimately making the problem m=
uch harder to solve. Yet the principal characteristics of the government=E2=
=80=99s response to the financial crisis have been delay, lack of transpare=
ncy, and an unwillingness to upset the financial sector.=20



The response so far is perhaps best described as =E2=80=9Cpolicy by deal=E2=
=80=9D: 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=E2=80=99s CEO, sits on the board of directors of the=
 Federal Reserve Bank of New York, which, along with the Treasury Departmen=
t, brokered the deal.) In September, we saw the sale of Merrill Lynch to Ba=
nk of America, the first bailout of AIG, and the takeover and immediate sal=
e of Washington Mutual to JP Morgan=E2=80=94all of which were brokered by t=
he government. In October, nine large banks were recapitalized on the same =
day behind closed doors in Washington. This, in turn, was followed by addit=
ional bailouts for Citigroup, AIG, Bank of America, Citigroup (again), and =
AIG (again).=20



Some of these deals may have been reasonable responses to the immediate sit=
uation. But it was never clear (and still isn=E2=80=99t) what combination o=
f interests was being served, and how. Treasury and the Fed did not act acc=
ording to any publicly articulated principles, but just worked out a transa=
ction and claimed it was the best that could be done under the circumstance=
s. This was late-night, backroom dealing, pure and simple.=20



Throughout the crisis, the government has taken extreme care not to upset t=
he interests of the financial institutions, or to question the basic outlin=
es of the system that got us here. In September 2008, Henry Paulson asked C=
ongress for $700 billion to buy toxic assets from banks, with no strings at=
tached and no judicial review of his purchase decisions. Many observers sus=
pected that the purpose was to overpay for those assets and thereby take th=
e problem off the banks=E2=80=99 hands=E2=80=94indeed, 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 pla=
n was shelved.=20



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 h=
as deepened and financial institutions have needed more help, the governmen=
t has gotten more and more creative in figuring out ways to provide banks w=
ith subsidies that are too complex for the general public to understand. Th=
e first AIG bailout, which was on relatively good terms for the taxpayer, w=
as supplemented by three further bailouts whose terms were more AIG-friendl=
y. The second Citigroup bailout and the Bank of America bailout included co=
mplex asset guarantees that provided the banks with insurance at below-mark=
et rates. The third Citigroup bailout, in late February, converted governme=
nt-owned preferred stock to common stock at a price significantly higher th=
an the market price=E2=80=94a subsidy that probably even most Wall Street J=
ournal readers would miss on first reading. And the convertible preferred s=
hares that the Treasury will buy under the new Financial Stability Plan giv=
e the conversion option (and thus the upside) to the banks, not the governm=
ent.=20



This latest plan=E2=80=94which is likely to provide cheap loans to hedge fu=
nds and others so that they can buy distressed bank assets at relatively hi=
gh prices=E2=80=94has been heavily influenced by the financial sector, and =
Treasury has made no secret of that. As Neel Kashkari, a senior Treasury of=
ficial under both Henry Paulson and Tim Geithner (and a Goldman alum) told =
Congress in March, =E2=80=9CWe had received inbound unsolicited proposals f=
rom people in the private sector saying, =E2=80=98We have capital on the si=
delines; we want to go after [distressed bank] assets.=E2=80=99=E2=80=9D An=
d the plan lets them do just that: =E2=80=9CBy marrying government capital=
=E2=80=94taxpayer capital=E2=80=94with 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.=E2=80=9D Kashkari didn=E2=80=99t mention anything about wha=
t makes sense for the third group involved: the taxpayers.=20



Even leaving aside fairness to taxpayers, the government=E2=80=99s velvet-g=
love approach with the banks is deeply troubling, for one simple reason: it=
 is inadequate to change the behavior of a financial sector accustomed to d=
oing business on its own terms, at a time when that behavior must change. A=
s an unnamed senior bank official said to The New York Times last fall, =E2=
=80=9CIt doesn=E2=80=99t matter how much Hank Paulson gives us, no one is g=
oing to lend a nickel until the economy turns.=E2=80=9D But there=E2=80=99s=
 the rub: the economy can=E2=80=99t recover until the banks are healthy and=
 willing to lend.=20



The Way Out=20



Looking just at the financial crisis (and leaving aside some problems of th=
e larger economy), we face at least two major, interrelated problems. The f=
irst is a desperately ill banking sector that threatens to choke off any in=
cipient recovery that the fiscal stimulus might generate. The second is a p=
olitical balance of power that gives the financial sector a veto over publi=
c policy, even as that sector loses popular support.=20



Big banks, it seems, have only gained political strength since the crisis b=
egan. And this is not surprising. With the financial system so fragile, the=
 damage that a major bank failure could cause=E2=80=94Lehman was small rela=
tive to Citigroup or Bank of America=E2=80=94is 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 secon=
d bailout package (in January) after warning the government that it might n=
ot be able to go through with the acquisition of Merrill Lynch, a prospect =
that Treasury did not want to consider.=20



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 nu=
mbers, there is no doubt what old IMF hands would say: nationalize troubled=
 banks and break them up as necessary.=20



In some ways, of course, the government has already taken control of the ba=
nking system. It has essentially guaranteed the liabilities of the biggest =
banks, and it is their only plausible source of capital today. Meanwhile, t=
he Federal Reserve has taken on a major role in providing credit to the eco=
nomy=E2=80=94the function that the private banking sector is supposed to be=
 performing, but isn=E2=80=99t. Yet there are limits to what the Fed can do=
 on its own; consumers and businesses are still dependent on banks that lac=
k 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 w=
hat they do.=20



At the root of the banks=E2=80=99 problems are the large losses they have u=
ndoubtedly taken on their securities and loan portfolios. But they don=E2=
=80=99t want to recognize the full extent of their losses, because that wou=
ld likely expose them as insolvent. So they talk down the problem, and ask =
for handouts that aren=E2=80=99t enough to make them healthy (again, they c=
an=E2=80=99t reveal the size of the handouts that would be necessary for th=
at), but are enough to keep them upright a little longer. This behavior is =
corrosive: unhealthy banks either don=E2=80=99t lend (hoarding money to sho=
re up reserves) or they make desperate gambles on high-risk loans and inves=
tments that could pay off big, but probably won=E2=80=99t pay off at all. I=
n either case, the economy suffers further, and as it does, bank assets the=
mselves continue to deteriorate=E2=80=94creating a highly destructive vicio=
us cycle.=20



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. governmen=
t itself has insisted to multiple emerging-market countries in the past), t=
he most direct way to do this is nationalization. Instead, Treasury is tryi=
ng to negotiate bailouts bank by bank, and behaving as if the banks hold al=
l the cards=E2=80=94contorting the terms of each deal to minimize governmen=
t ownership while forswearing government influence over bank strategy or op=
erations. Under these conditions, cleaning up bank balance sheets is imposs=
ible.=20



Nationalization would not imply permanent state ownership. The IMF=E2=80=99=
s advice would be, essentially: scale up the standard Federal Deposit Insur=
ance Corporation process. An FDIC =E2=80=9Cintervention=E2=80=9D is basical=
ly 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 b=
e solved before it grows worse.=20



The government needs to inspect the balance sheets and identify the banks t=
hat cannot survive a severe recession. These banks should face a choice: wr=
ite down your assets to their true value and raise private capital within 3=
0 days, or be taken over by the government. The government would write down=
 the toxic assets of banks taken into receivership=E2=80=94recognizing real=
ity=E2=80=94and transfer those assets to a separate government entity, whic=
h 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=E2=80=94cleansed and able to lend safely, and he=
nce trusted again by other lenders and investors=E2=80=94could then be sold=
 off.=20



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 $1.5trillion (or 10percent of our GDP) =
in the long term. But only decisive government action=E2=80=94exposing the =
full extent of the financial rot and restoring some set of banks to publicl=
y verifiable health=E2=80=94can cure the financial sector as a whole.=20



This may seem like strong medicine. But in fact, while necessary, it is ins=
ufficient. The second problem the U.S. faces=E2=80=94the power of the oliga=
rchy=E2=80=94is just as important as the immediate crisis of lending. And t=
he advice from the IMF on this front would again be simple: break the oliga=
rchy.=20



Oversize institutions disproportionately influence public policy; the major=
 banks we have today draw much of their power from being too big to fail. N=
ationalization and re-privatization would not change that; while the replac=
ement 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.=20



Ideally, big banks should be sold in medium-size pieces, divided regionally=
 or by type of business. Where this proves impractical=E2=80=94since we=E2=
=80=99ll want to sell the banks quickly=E2=80=94they could be sold whole, b=
ut with the requirement of being broken up within a short time. Banks that =
remain in private hands should also be subject to size limitations.=20



This may seem like a crude and arbitrary step, but it is the best way to li=
mit the power of individual institutions in a sector that is essential to t=
he economy as a whole. Of course, some people will complain about the =E2=
=80=9Cefficiency costs=E2=80=9D of a more fragmented banking system, and th=
ese costs are real. But so are the costs when a bank that is too big to fai=
l=E2=80=94a financial weapon of mass self-destruction=E2=80=94explodes. Any=
thing that is too big to fail is too big to exist.=20



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 100years ago to combat industrial monopolies w=
ere not designed to address the problem we now face. The problem in the fin=
ancial 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=E2=
=80=99s fiscal stimulus evokes FDR, but what we need to imitate here is Ted=
dy Roosevelt=E2=80=99s trust-busting.=20



Caps on executive compensation, while redolent of populism, might help rest=
ore the political balance of power and deter the emergence of a new oligarc=
hy. Wall Street=E2=80=99s main attraction=E2=80=94to the people who work th=
ere and to the government officials who were only too happy to bask in its =
reflected glory=E2=80=94has been the astounding amount of money that could =
be made. Limiting that money would reduce the allure of the financial secto=
r and make it more like any other industry.=20



Still, outright pay caps are clumsy, especially in the long run. And most m=
oney is now made in largely unregulated private hedge funds and private-equ=
ity firms, so lowering pay would be complicated. Regulation and taxation sh=
ould be part of the solution. Over time, though, the largest part may invol=
ve 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.=20



Two Paths=20



To paraphrase Joseph Schumpeter, the early-20th-century economist, everyone=
 has elites; the important thing is to change them from time to time. If th=
e U.S. were just another country, coming to the IMF with hat in hand, I mig=
ht be fairly optimistic about its future. Most of the emerging-market crise=
s that I=E2=80=99ve mentioned ended relatively quickly, and gave way, for t=
he most part, to relatively strong recoveries. But this, alas, brings us to=
 the limit of the analogy between the U.S. and emerging markets.=20



Emerging-market countries have only a precarious hold on wealth, and are we=
aklings globally. When they get into trouble, they quite literally run out =
of money=E2=80=94or at least out of foreign currency, without which they ca=
nnot survive. They must make difficult decisions; ultimately, aggressive ac=
tion is baked into the cake. But the U.S., of course, is the world=E2=80=99=
s most powerful nation, rich beyond measure, and blessed with the exorbitan=
t privilege of paying its foreign debts in its own currency, which it can p=
rint. As a result, it could very well stumble along for years=E2=80=94as Ja=
pan did during its lost decade=E2=80=94never summoning the courage to do wh=
at it needs to do, and never really recovering. A clean break with the past=
=E2=80=94involving the takeover and cleanup of major banks=E2=80=94hardly l=
ooks like a sure thing right now. Certainly no one at the IMF can force it.=
=20



In my view, the U.S. faces two plausible scenarios. The first involves comp=
licated bank-by-bank deals and a continual drumbeat of (repeated) bailouts,=
 like the ones we saw in February with Citigroup and AIG. The administratio=
n will try to muddle through, and confusion will reign.=20



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 t=
he interests of the powerful=E2=80=94letting 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 byzanti=
ne government arrangements and backroom deals, how do you know that you are=
n=E2=80=99t being fleeced?=20



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=E2=80=99t seem to get into gea=
r.=20



The second scenario begins more bleakly, and might end that way too. But it=
 does provide at least some hope that we=E2=80=99ll be shaken out of our to=
rpor. It goes like this: the global economy continues to deteriorate, the b=
anking system in east-central Europe collapses, and=E2=80=94because eastern=
 Europe=E2=80=99s banks are mostly owned by western European banks=E2=80=94=
justifiable fears of government insolvency spread throughout the Continent.=
 Creditors take further hits and confidence falls further. The Asian econom=
ies that export manufactured goods are devastated, and the commodity produc=
ers in Latin America and Africa are not much better off. A dramatic worseni=
ng of the global environment forces the U.S. economy, already staggering, d=
own onto both knees. The baseline growth rates used in the administration=
=E2=80=99s current budget are increasingly seen as unrealistic, and the ros=
y =E2=80=9Cstress scenario=E2=80=9D that the U.S. Treasury is currently usi=
ng to evaluate banks=E2=80=99 balance sheets becomes a source of great emba=
rrassment.=20



Under this kind of pressure, and faced with the prospect of a national and =
global collapse, minds may become more concentrated.=20



The conventional wisdom among the elite is still that the current slump =E2=
=80=9Ccannot be as bad as the Great Depression.=E2=80=9D This view is wrong=
. What we face now could, in fact, be worse than the Great Depression=E2=80=
=94because the world is now so much more interconnected and because the ban=
king sector is now so big. We face a synchronized downturn in almost all co=
untries, a weakening of confidence among individuals and firms, and major p=
roblems for government finances. If our leadership wakes up to the potentia=
l 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.=20



Simon Johnson, a professor at MIT=E2=80=99s Sloan School of Management, was=
 the chief economist at the International Monetary Fund during 2007 and 200=
8. He blogs about the financial crisis at baselinescenario.com, along with =
James Kwak, who also contributed to this essay.=20