The Quiet Coup

The not so quiet takeover

ECONOMY MAY 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.

by Simon Johnson

The Quiet Coup

IMAGE CREDIT: JIM BOURG/REUTERS/CORBIS

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.

<http://www.theatlantic.com/images/issues/200905/johnson-chart.gif>
http://www.theatlantic.com/images/issues/200905/johnson-chart-small.gif

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,
<http://www.federalreserve.gov/newsevents/speech/Bernanke20060612a.htm> 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,
<http://www.imdb.com/title/tt0094291/> Wall Street, and
<http://www.imdb.com/title/tt0099165/> Bonfire of the Vanities-all intended
as cautionary tales-served only to increase Wall Street's mystique.
<http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/Th
e-End-of-Wall-Streets-Boom> Michael Lewis noted in Portfolio last year that
when he wrote
<http://www.amazon.com/Liars-Poker-Rising-Through-Wreckage/dp/0140143459>
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, <http://www.reuters.com/article/ousiv/idUSWNAS778320071024> he
acknowledged, "The bottom line is, we-I-got it wrong by being overexposed to
subprime, and we suffered as a result of impaired liquidity in that market.
No one is more disappointed than I am in that result." O'Neal took home a
$14 million bonus in 2006; in 2007, he walked away from Merrill with a
severance package worth $162 million, although it is presumably worth much
less today.

In October, John Thain, Merrill Lynch's final CEO, reportedly lobbied his
board of directors for a bonus of $30 million or more, eventually reducing
his demand to $10 million in December; he withdrew the request, under a
firestorm of protest, only after it was leaked to The Wall Street Journal.
Merrill Lynch as a whole was no better: it moved its bonus payments, $4
billion in total, forward to December, presumably to avoid the possibility
that they would be reduced by Bank of America, which would own Merrill
beginning on January 1. Wall Street paid out $18 billion in year-end bonuses
last year to its New York City employees, after the government disbursed
$243 billion in emergency assistance to the financial sector.

In a financial panic, the government must respond with both speed and
overwhelming force. The root problem is uncertainty-in our case, uncertainty
about whether the major banks have sufficient assets to cover their
liabilities. Half measures combined with wishful thinking and a wait-and-see
attitude cannot overcome this uncertainty. And the longer the response
takes, the longer the uncertainty will stymie the flow of credit, sap
consumer confidence, and cripple the economy-ultimately making the problem
much harder to solve. Yet the principal characteristics of the government's
response to the financial crisis have been delay, lack of transparency, and
an unwillingness to upset the financial sector.

The response so far is perhaps best described as "policy by deal": when a
major financial institution gets into trouble, the Treasury Department and
the Federal Reserve engineer a bailout over the weekend and announce on
Monday that everything is fine. In March 2008, Bear Stearns was sold to JP
Morgan Chase in what looked to many like a gift to JP Morgan. (Jamie Dimon,
JP Morgan's CEO, sits on the board of directors of the Federal Reserve Bank
of New York, which, along with the Treasury Department, brokered the deal.)
In September, we saw the sale of Merrill Lynch to Bank of America, the first
bailout of AIG, and the takeover and immediate sale of Washington Mutual to
JP Morgan-all of which were brokered by the government. In October, nine
large banks were recapitalized on the same day behind closed doors in
Washington. This, in turn, was followed by additional bailouts for
Citigroup, AIG, Bank of America, Citigroup (again), and AIG (again).

Some of these deals may have been reasonable responses to the immediate
situation. But it was never clear (and still isn't) what combination of
interests was being served, and how. Treasury and the Fed did not act
according to any publicly articulated principles, but just worked out a
transaction and claimed it was the best that could be done under the
circumstances. This was late-night, backroom dealing, pure and simple.

Throughout the crisis, the government has taken extreme care not to upset
the interests of the financial institutions, or to question the basic
outlines of the system that got us here. In September 2008, Henry Paulson
asked Congress for $700 billion to buy toxic assets from banks, with no
strings attached and no judicial review of his purchase decisions. Many
observers suspected that the purpose was to overpay for those assets and
thereby take the problem off the banks' hands-indeed, that is the only way
that buying toxic assets would have helped anything. Perhaps because there
was no way to make such a blatant subsidy politically acceptable, that plan
was shelved.

Instead, the money was used to recapitalize banks, buying shares in them on
terms that were grossly favorable to the banks themselves. As the crisis has
deepened and financial institutions have needed more help, the government
has gotten more and more creative in figuring out ways to provide banks with
subsidies that are too complex for the general public to understand. The
first AIG bailout, which was on relatively good terms for the taxpayer, was
supplemented by three further bailouts whose terms were more AIG-friendly.
The second Citigroup bailout and the Bank of America bailout included
complex asset guarantees that provided the banks with insurance at
below-market rates. The third Citigroup bailout, in late February, converted
government-owned preferred stock to common stock at a price significantly
higher than the market price-a subsidy that probably even most Wall Street
Journal readers would miss on first reading. And the convertible preferred
shares that the Treasury will buy under the new Financial Stability Plan
give the conversion option (and thus the upside) to the banks, not the
government.

This latest plan-which is likely to provide cheap loans to hedge funds and
others so that they can buy distressed bank assets at relatively high
prices-has been heavily influenced by the financial sector, and Treasury has
made no secret of that. As Neel Kashkari, a senior Treasury official under
both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in
March, "We had received inbound unsolicited proposals from people in the
private sector saying, 'We have capital on the sidelines; we want to go
after [distressed bank] assets.'" And the plan lets them do just that: "By
marrying government capital-taxpayer capital-with private-sector capital and
providing financing, you can enable those investors to then go after those
assets at a price that makes sense for the investors and at a price that
makes sense for the banks." Kashkari didn't mention anything about what
makes sense for the third group involved: the taxpayers.

Even leaving aside fairness to taxpayers, the government's velvet-glove
approach with the banks is deeply troubling, for one simple reason: it is
inadequate to change the behavior of a financial sector accustomed to doing
business on its own terms, at a time when that behavior must change. As an
unnamed senior bank official
<http://dealbook.blogs.nytimes.com/2008/10/21/for-credit-markets-one-day-doe
snt-make-a-trend/> said to The New York Times last fall, "It doesn't matter
how much Hank Paulson gives us, no one is going to lend a nickel until the
economy turns." But there's the rub: the economy can't recover until the
banks are healthy and willing to lend.

The Way Out

Looking just at the financial crisis (and leaving aside some problems of the
larger economy), we face at least two major, interrelated problems. The
first is a desperately ill banking sector that threatens to choke off any
incipient recovery that the fiscal stimulus might generate. The second is a
political balance of power that gives the financial sector a veto over
public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis
began. And this is not surprising. With the financial system so fragile, the
damage that a major bank failure could cause-Lehman was small relative to
Citigroup or Bank of America-is much greater than it would be during
ordinary times. The banks have been exploiting this fear as they wring
favorable deals out of Washington. Bank of America obtained its second
bailout package (in January) after warning the government that it might not
be able to go through with the acquisition of Merrill Lynch, a prospect that
Treasury did not want to consider.

The challenges the United States faces are familiar territory to the people
at the IMF. If you hid the name of the country and just showed them the
numbers, there is no doubt what old IMF hands would say: nationalize
troubled banks and break them up as necessary.

In some ways, of course, the government has already taken control of the
banking system. It has essentially guaranteed the liabilities of the biggest
banks, and it is their only plausible source of capital today. Meanwhile,
the Federal Reserve has taken on a major role in providing credit to the
economy-the function that the private banking sector is supposed to be
performing, but isn't. Yet there are limits to what the Fed can do on its
own; consumers and businesses are still dependent on banks that lack the
balance sheets and the incentives to make the loans the economy needs, and
the government has no real control over who runs the banks, or over what
they do.

At the root of the banks' problems are the large losses they have
undoubtedly taken on their securities and loan portfolios. But they don't
want to recognize the full extent of their losses, because that would likely
expose them as insolvent. So they talk down the problem, and ask for
handouts that aren't enough to make them healthy (again, they can't reveal
the size of the handouts that would be necessary for that), but are enough
to keep them upright a little longer. This behavior is corrosive: unhealthy
banks either don't lend (hoarding money to shore up reserves) or they make
desperate gambles on high-risk loans and investments that could pay off big,
but probably won't pay off at all. In either case, the economy suffers
further, and as it does, bank assets themselves continue to
deteriorate-creating a highly destructive vicious cycle.

To break this cycle, the government must force the banks to acknowledge the
scale of their problems. As the IMF understands (and as the U.S. government
itself has insisted to multiple emerging-market countries in the past), the
most direct way to do this is nationalization. Instead, Treasury is trying
to negotiate bailouts bank by bank, and behaving as if the banks hold all
the cards-contorting the terms of each deal to minimize government ownership
while forswearing government influence over bank strategy or operations.
Under these conditions, cleaning up bank balance sheets is impossible.

Nationalization would not imply permanent state ownership. The IMF's advice
would be, essentially: scale up the standard Federal Deposit Insurance
Corporation process. An FDIC "intervention" is basically a
government-managed bankruptcy procedure for banks. It would allow the
government to wipe out bank shareholders, replace failed management, clean
up the balance sheets, and then sell the banks back to the private sector.
The main advantage is immediate recognition of the problem so that it can be
solved before it grows worse.

The government needs to inspect the balance sheets and identify the banks
that cannot survive a severe recession. These banks should face a choice:
write down your assets to their true value and raise private capital within
30 days, or be taken over by the government. The government would write down
the toxic assets of banks taken into receivership-recognizing reality-and
transfer those assets to a separate government entity, which would attempt
to salvage whatever value is possible for the taxpayer (as the Resolution
Trust Corporation did after the savings-and-loan debacle of the 1980s). The
rump banks-cleansed and able to lend safely, and hence trusted again by
other lenders and investors-could then be sold off.

Cleaning up the megabanks will be complex. And it will be expensive for the
taxpayer; according to the latest IMF numbers, the cleanup of the banking
system would probably cost close to $1.5 trillion (or 10 percent of our GDP)
in the long term. But only decisive government action-exposing the full
extent of the financial rot and restoring some set of banks to publicly
verifiable health-can cure the financial sector as a whole.

This may seem like strong medicine. But in fact, while necessary, it is
insufficient. The second problem the U.S. faces-the power of the
oligarchy-is just as important as the immediate crisis of lending. And the
advice from the IMF on this front would again be simple: break the
oligarchy.

Oversize institutions disproportionately influence public policy; the major
banks we have today draw much of their power from being too big to fail.
Nationalization and re-privatization would not change that; while the
replacement of the bank executives who got us into this crisis would be just
and sensible, ultimately, the swapping-out of one set of powerful managers
for another would change only the names of the oligarchs.

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

This may seem like a crude and arbitrary step, but it is the best way to
limit the power of individual institutions in a sector that is essential to
the economy as a whole. Of course, some people will complain about the
"efficiency costs" of a more fragmented banking system, and these costs are
real. But so are the costs when a bank that is too big to fail-a financial
weapon of mass self-destruction-explodes. Anything that is too big to fail
is too big to exist.

To ensure systematic bank breakup, and to prevent the eventual reemergence
of dangerous behemoths, we also need to overhaul our antitrust legislation.
Laws put in place more than 100 years ago to combat industrial monopolies
were not designed to address the problem we now face. The problem in the
financial sector today is not that a given firm might have enough market
share to influence prices; it is that one firm or a small set of
interconnected firms, by failing, can bring down the economy. The Obama
administration's fiscal stimulus evokes FDR, but what we need to imitate
here is Teddy Roosevelt's trust-busting.

Caps on executive compensation, while redolent of populism, might help
restore the political balance of power and deter the emergence of a new
oligarchy. Wall Street's main attraction-to the people who work there and to
the government officials who were only too happy to bask in its reflected
glory-has been the astounding amount of money that could be made. Limiting
that money would reduce the allure of the financial sector and make it more
like any other industry.

Still, outright pay caps are clumsy, especially in the long run. And most
money is now made in largely unregulated private hedge funds and
private-equity firms, so lowering pay would be complicated. Regulation and
taxation should be part of the solution. Over time, though, the largest part
may involve more transparency and competition, which would bring
financial-industry fees down. To those who say this would drive financial
activities to other countries, we can now safely say: fine.

Two Paths

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

Emerging-market countries have only a precarious hold on wealth, and are
weaklings globally. When they get into trouble, they quite literally run out
of money-or at least out of foreign currency, without which they cannot
survive. They must make difficult decisions; ultimately, aggressive action
is baked into the cake. But the U.S., of course, is the world's most
powerful nation, rich beyond measure, and blessed with the exorbitant
privilege of paying its foreign debts in its own currency, which it can
print. As a result, it could very well stumble along for years-as Japan did
during its lost decade-never summoning the courage to do what it needs to
do, and never really recovering. A clean break with the past-involving the
takeover and cleanup of major banks-hardly looks like a sure thing right
now. Certainly no one at the IMF can force it.

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

Boris Fyodorov, the late finance minister of Russia, struggled for much of
the past 20 years against oligarchs, corruption, and abuse of authority in
all its forms. He liked to say that confusion and chaos were very much in
the interests of the powerful-letting them take things, legally and
illegally, with impunity. When inflation is high, who can say what a piece
of property is really worth? When the credit system is supported by
byzantine government arrangements and backroom deals, how do you know that
you aren't being fleeced?

Our future could be one in which continued tumult feeds the looting of the
financial system, and we talk more and more about exactly how our oligarchs
became bandits and how the economy just can't seem to get into gear.

The second scenario begins more bleakly, and might end that way too. But it
does provide at least some hope that we'll be shaken out of our torpor. It
goes like this: the global economy continues to deteriorate, the banking
system in east-central Europe collapses, and-because eastern Europe's banks
are mostly owned by western European banks-justifiable fears of government
insolvency spread throughout the Continent. Creditors take further hits and
confidence falls further. The Asian economies that export manufactured goods
are devastated, and the commodity producers in Latin America and Africa are
not much better off. A dramatic worsening of the global environment forces
the U.S. economy, already staggering, down onto both knees. The baseline
growth rates used in the administration's current budget are increasingly
seen as unrealistic, and the rosy "stress scenario" that the U.S. Treasury
is currently using to evaluate banks' balance sheets becomes a source of
great embarrassment.

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

The conventional wisdom among the elite is still that the current slump
"cannot be as bad as the Great Depression." This view is wrong. What we face
now could, in fact, be worse than the Great Depression-because the world is
now so much more interconnected and because the banking sector is now so
big. We face a synchronized downturn in almost all countries, a weakening of
confidence among individuals and firms, and major problems for government
finances. If our leadership wakes up to the potential consequences, we may
yet see dramatic action on the banking system and a breaking of the old
elite. Let us hope it is not then too late.

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