[DEBATE] : (Fwd) Former IMFer 'fesses up about US crony capitalism

Thu Apr 2 05:14:12 BST 2009

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.

The Quiet Coup

by Simon Johnson 
The Atlantic
May 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.

Click the chart above for a larger view

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 $10million 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 $1.5trillion (or 10percent 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 100years 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. 

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