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FTR #670 Update on the Meltdown, Part 3: Top Banana Republic

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The pro­gram fea­tures “Qui­et Coup” (The Atlantic; May/2009) by Simon John­son, a for­mer chief econ­o­mist for the Inter­na­tion­al Mon­e­tary Fund. His arti­cle com­pares the func­tion­ing of oli­garchi­cal eco­nom­ic elites in Third World IMF client coun­tries on the one hand, and the Unit­ed States on the oth­er. He feels the sit­u­a­tions of his for­mer IMF clients and that of the US are basi­cal­ly the same–a polit­i­cal­ly-dom­i­nant over­reach­ing, debt-laden oli­garchy has pre­cip­i­tat­ed the prob­lems which they now feel that their cronies in gov­ern­ment will ame­lio­rate.

Ana­lyz­ing how the US became “Top Banana Repub­lic,” John­son attrib­ut­es the phe­nom­e­non to a num­ber of fac­tors. With the orgias­tic dereg­u­la­tion of the Rea­gan admin­is­tra­tions (per­pet­u­at­ed in the Bush I , Clin­ton and Bush II years), the finan­cial sec­tor grew to assume a much larg­er pro­por­tion­al share of U.S. GDP.  Exac­er­bat­ing this is what John­son terms a “revolv­ing door” between gov­ern­ment and the finance sec­tor, epit­o­mized in many ways by Gold­man Sachs, which has placed promi­nent alum­ni in the cor­ri­dors of Wash­ing­ton and White House pow­er.

In addi­tion, John­son iden­ti­fies what might be termed a cul­tur­al hege­mo­ny over Wash­ing­ton pow­er struc­ture in which the pre­vail­ing political/intellectual ide­ol­o­gy is one that iden­ti­fies the needs of the Unit­ed States with those of Wall Street. The iner­tia gen­er­at­ed by this rela­tion­ship has also led to the inclu­sion of key aca­d­e­mics in the Wall Street/Washington ide­o­log­i­cal axis–scholars whose research and intel­lec­tu­al caches sup­ple­ment and are, in turn, derived from, the pre­vail­ing the­o­ret­i­cal par­a­digm.

Social Climber

Social Climber

Fur­ther exac­er­bat­ing the prob­lem, pop­u­lar cul­ture lion­izes the promi­nent play­ers on the land­scape of finance, even crim­i­nals such as Ivan Boesky and Michael Miliken.

Not­ing the Wall Street/Washington axis’s dom­i­nance over polit­i­cal deci­sion-mak­ing in the face of the col­lapse, John­son extends his com­par­i­son of IMF client-states with the Top Banana Repub­lic. As is the case with less pres­ti­gious “crony cap­i­tal­ist” nations, the oli­garchs of finance have turned to their polit­i­cal allies in order to bail them out.

Decry­ing the “deal by deal” bailouts of weak finan­cial giants (pre­sent­ed by first the Bush and now the Oba­ma admin­is­tra­tions) John­son believes that the steps will not only fail but could lead to the onset of an eco­nom­ic cri­sis that would be worse than the Great Depres­sion.

At the very least, fail­ing to make the nec­es­sary changes in the pre­vail­ing polit­i­cal, eco­nom­ic and social order will prob­a­bly lead to a “lost decade,” such as that expe­ri­enced by Japan in the 1990’s.

Per­haps the most trag­ic aspect of this is the fact that John­son feels that an IMF-style admin­is­tra­tion of the U.S. political/economic land­scape could straight­en things out rel­a­tive­ly quick­ly and pain­less­ly. Will, in fact, the Top Banana Repub­lic pull togeth­er in time? Or will John­son’s dire fore­casts come true?

Stay tuned, as they say in broad­cast­ing.

1. Simon John­son begins his arti­cle with a com­par­i­son between the func­tion­ing of oli­garchi­cal eco­nom­ic elites in third world coun­tries that require assis­tance from the IMF and the Unit­ed States. As indi­cat­ed above, he feels the sit­u­a­tions are basi­cal­ly the same–an over­reach­ing, debt-laden oli­garchy has pre­cip­i­tat­ed the prob­lems which they now feel that their cronies in gov­ern­ment will ame­lio­rate.

” . . . 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.”

2. Empha­siz­ing his thesis–expressed above–Johnson com­pares the eco­nom­ic plight of the U.S. with recent crises in Rus­sia, Asia and Latin Amer­i­ca.

“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 home own­er­ship. 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 home own­er­ship-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.”

3. Pro­vid­ing his­tor­i­cal back­ground to the devel­op­ment of the cur­rent eco­nom­ic cri­sis, John­son high­lights the enor­mous growth of the finan­cial sec­tor in the U.S. econ­o­my rel­a­tive to man­u­fac­tur­ing. Ben­e­fit­ing from the dereg­u­la­tion imple­ment­ed by the Rea­gan admin­is­tra­tion and sub­se­quent regimes, the finan­cial sec­tor has, in turn, devel­oped tremen­dous polit­i­cal clout which has accel­er­at­ed the dynam­ic.

“The finan­cial indus­try has not always enjoyed such favored treat­ment. But for the past 25 years or so, finance has boomed, becom­ing ever more pow­er­ful. The boom began with the Rea­gan years, and it only gained strength with the dereg­u­la­to­ry poli­cies of the Clin­ton and George W. Bush admin­is­tra­tions. Sev­er­al oth­er fac­tors helped fuel the finan­cial indus­try’s ascent. Paul Vol­ck­er’s mon­e­tary pol­i­cy in the 1980s, and the increased volatil­i­ty in inter­est rates that accom­pa­nied it, made bond trad­ing much more lucra­tive. The inven­tion of secu­ri­ti­za­tion, inter­est-rate swaps, and cred­it-default swaps great­ly increased the vol­ume of trans­ac­tions that bankers could make mon­ey on. And an aging and increas­ing­ly wealthy pop­u­la­tion invest­ed more and more mon­ey in secu­ri­ties, helped by the inven­tion of the IRA and the 401(k) plan. Togeth­er, these devel­op­ments vast­ly increased the prof­it oppor­tu­ni­ties in finan­cial ser­vices.

Not sur­pris­ing­ly, Wall Street ran with these oppor­tu­ni­ties. From 1973 to 1985, the finan­cial sec­tor nev­er earned more than 16 per­cent of domes­tic cor­po­rate prof­its. In 1986, that fig­ure reached 19 per­cent. In the 1990s, it oscil­lat­ed between 21 per­cent and 30 per­cent, high­er than it had ever been in the post­war peri­od. This decade, it reached 41 per­cent. Pay rose just as dra­mat­i­cal­ly. From 1948 to 1982, aver­age com­pen­sa­tion in the finan­cial sec­tor ranged between 99 per­cent and 108 per­cent of the aver­age for all domes­tic pri­vate indus­tries. From 1983, it shot upward, reach­ing 181 per­cent in 2007.

The great wealth that the finan­cial sec­tor cre­at­ed and con­cen­trat­ed gave bankers enor­mous polit­i­cal weight‑a weight not seen in the U.S. since the era of J.P. Mor­gan (the man). In that peri­od, the bank­ing pan­ic of 1907 could be stopped only by coor­di­na­tion among pri­vate-sec­tor bankers: no gov­ern­ment enti­ty was able to offer an effec­tive response. But that first age of bank­ing oli­garchs came to an end with the pas­sage of sig­nif­i­cant bank­ing reg­u­la­tion in response to the Great Depres­sion; the reemer­gence of an Amer­i­can finan­cial oli­garchy is quite recent.”

4. Accord­ing to John­son, a dis­tin­guish­ing fea­ture of the political/economic hege­mo­ny of the Amer­i­can finan­cial oli­garchy is a belief sys­tem which nour­ish­es and accel­er­ates the con­cen­tra­tion of pow­er and imple­men­ta­tion of dereg­u­la­tion. With the inter­twin­ing and sym­bio­sis of the polit­i­cal and finan­cial elites, we have seen the devel­op­ment of a revolv­ing door between the upper tiers of finance and those of the polit­i­cal estab­lish­ment. The devel­op­ment of this government/finance sec­tor axis has been bipar­ti­san, to a con­sid­er­able extent. Note the pre­em­i­nence of Gold­man Sachs, in par­tic­u­lar in this regard.

“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.”

5. As the government/finance sec­tor axis has devel­oped, its grav­i­tas has drawn a grow­ing num­ber of aca­d­e­mi­cians into its sphere of influ­ence, some of whom have acced­ed to posi­tions of promi­nence. In turn, the gen­er­al cul­ture as a whole has been drawn into this sphere of influ­ence, fur­ther accel­er­at­ing the phe­nom­e­non. John­son then chron­i­cles some of the steps tak­en by the gov­ern­ment on behalf of the finance indus­try that (he believes) set the stage for what since tran­spired.

“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 under priced 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.”

6. Next, John­son chron­i­cles the begin­ning of the great unrav­el­ing, as well as the utter lack of humil­i­ty on the part of some of the exec­u­tives that helped to engen­der the cri­sis. Note the eco­nom­ic pun­dits’ inabil­i­ty to dis­tance them­selves from the pre­vail­ing “non-wis­dom” that led to the melt­down. (For­mer Fed chair­man Alan Greenspan typ­i­fies this inabil­i­ty.)

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

Because every­one was get­ting rich­er, and the health of the nation­al econ­o­my depend­ed so heav­i­ly on growth in real estate and finance, no one in Wash­ing­ton had any incen­tive to ques­tion what was going on. Instead, Fed Chair­man Greenspan and Pres­i­dent Bush insist­ed metro­nom­i­cal­ly that the econ­o­my was fun­da­men­tal­ly sound and that the tremen­dous growth in com­plex secu­ri­ties and cred­it-default swaps was evi­dence of a healthy econ­o­my where risk was dis­trib­uted safe­ly.

In the sum­mer of 2007, signs of strain start­ed appear­ing. The boom had pro­duced so much debt that even a small eco­nom­ic stum­ble could cause major prob­lems, and ris­ing delin­quen­cies in sub­prime mort­gages proved the stum­bling block. Ever since, the finan­cial sec­tor and the fed­er­al gov­ern­ment have been behav­ing exact­ly the way one would expect them to, in light of past emerg­ing-mar­ket crises.

By now, the princes of the finan­cial world have of course been stripped naked as lead­ers and strate­gists-at least in the eyes of most Amer­i­cans. But as the months have rolled by, finan­cial elites have con­tin­ued to assume that their posi­tion as the econ­o­my’s favored chil­dren is safe, despite the wreck­age they have caused.

Stan­ley O’Neal, the CEO of Mer­rill Lynch, pushed his firm heav­i­ly into the mort­gage-backed-secu­ri­ties mar­ket at its peak in 2005 and 2006; in Octo­ber 2007, he acknowl­edged, ‘The bot­tom line is, we-I-got it wrong by being over­ex­posed to sub­prime, and we suf­fered as a result of impaired liq­uid­i­ty in that mar­ket. No one is more dis­ap­point­ed than I am in that result.’ O’Neal took home a $14 mil­lion bonus in 2006; in 2007, he walked away from Mer­rill with a sev­er­ance pack­age worth $162 mil­lion, although it is pre­sum­ably worth much less today.

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

7. Not­ing that fast, deci­sive and unequiv­o­cal action is required to break up the “crony cap­i­tal­ism” that char­ac­ter­izes coun­tries that are under under the super­vi­sion of the IMF, John­son decries the con­tin­u­a­tion of the U.S. finan­cial “bud­dy sys­tem” that brought about the cri­sis in the first place. Note, in par­tic­u­lar, that the banks aren’t going to lend a pen­ny until the cri­sis has passed–and yet only their lend­ing can lead to the ame­lio­ra­tion of the down­turn!!

“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.”

8. John­son empha­sizes that the ail­ing big banks should be nation­al­ized, and that such a step would be reflex­ive­ly sug­gest­ed by the IMF, were the U.S. one of its ail­ing clients. Fol­low­ing nation­al­iza­tion, some of the sick giants must be bro­ken up. As part of the down­siz­ing of the finan­cial giants, the breakup of the oli­garchy is essen­tial, accord­ing to John­son.

“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.”

9. Indeed, John­son notes that the very size and pow­er of the ail­ing finan­cial giants per­pet­u­ates the unten­able sta­tus quo. As he says, a bank that is too big to fail is to big to exist in the first place. Again, break­ing up the oli­garchy is essen­tial in any sce­nario which would per­mit a return to fis­cal health. In addi­tion, he feels that cap­ping exec­u­tive pay is essen­tial. John­son’s rec­om­men­da­tion for Oba­ma is that he sup­ple­ment his echo­ing of FDR’s poli­cies of eco­nom­ic stim­u­lus with a reca­pit­u­la­tion of Ted­dy Roo­sevelt’s Trust Bust­ing.

“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.”

10. Not­ing that the rel­a­tive­ly poor, weak coun­tries that he advised dur­ing his tenure with the IMF had their prob­lems resolved rel­a­tive­ly eas­i­ly, in part because of their weak­ness and the fact that they actu­al­ly ran out of wealth because of that vul­ner­a­bil­i­ty. The dan­ger for the U.S.–the “Top Banana Republic”–is the fact that, because of its size, pow­er and wealth, it may go on for years mud­dling through, “deal by deal” with­out real­ly effect­ing the fun­da­men­tal insti­tu­tion­al reforms and revi­sions that the sit­u­a­tion requires. in this sce­nario, John­son envi­sions the pos­si­bil­i­ty of a “lost decade” like that expe­ri­enced by Japan in the 1990’s.

“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.”

11. John­son envi­sions anoth­er, grim­mer pos­si­bil­i­ty, albeit one with a sil­ver lin­ing. He sees a dra­mat­ic wors­en­ing of the glob­al eco­nom­ic cri­sis, with the inter­con­nect­ed­ness of world finan­cial estab­lish­ments pro­duc­ing a “domi­no effect,” lead­ing to the pre­cip­i­tat­ing of even worse con­di­tions here in the U.S. John­son notes that such a dra­mat­ic devel­op­ment might cause the Amer­i­can intel­li­gentsia to reassess the sta­tus quo and break the pow­er of the oli­garchy strad­dling the gov­ern­ment and the finan­cial sec­tor.

Fail­ing the abil­i­ty to do so, John­son omi­nous­ly sees the pos­si­bil­i­ty of a col­lapse worse than the Great Depres­sion!

“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.”

Discussion

3 comments for “FTR #670 Update on the Meltdown, Part 3: Top Banana Republic”

  1. There is also a relat­ed piece on the Wall Street takeover in Rolling Stone from March ’09.

    Posted by T. Delaney | May 25, 2009, 7:57 am
  2. http://www.independent.co.uk/news/business/analysis-and-features/what-price-the-new-democracy-goldman-sachs-conquers-europe-6264091.html

    What price the new democ­ra­cy? Gold­man Sachs con­quers Europe

    While ordi­nary peo­ple fret about aus­ter­i­ty and jobs, the euro­zone’s cor­ri­dors of pow­er have been under­go­ing a remark­able trans­for­ma­tion

    STEPHEN FOLEY FRIDAY 18 NOVEMBER 2011

    The ascen­sion of Mario Mon­ti to the Ital­ian prime min­is­ter­ship is remark­able for more rea­sons than it is pos­si­ble to count. By replac­ing the scan­dal-surf­ing Sil­vio Berlus­coni, Italy has dis­lodged the undis­lodge­able. By impos­ing rule by unelect­ed tech­nocrats, it has sus­pend­ed the nor­mal rules of democ­ra­cy, and maybe democ­ra­cy itself. And by putting a senior advis­er at Gold­man Sachs in charge of a West­ern nation, it has tak­en to new heights the polit­i­cal pow­er of an invest­ment bank that you might have thought was pro­hib­i­tive­ly polit­i­cal­ly tox­ic.

    This is the most remark­able thing of all: a giant leap for­ward for, or per­haps even the suc­cess­ful cul­mi­na­tion of, the Gold­man Sachs Project.

    It is not just Mr Mon­ti. The Euro­pean Cen­tral Bank, anoth­er cru­cial play­er in the sov­er­eign debt dra­ma, is under ex-Gold­man man­age­ment, and the invest­ment bank’s alum­ni hold sway in the cor­ri­dors of pow­er in almost every Euro­pean nation, as they have done in the US through­out the finan­cial cri­sis. Until Wednes­day, the Inter­na­tion­al Mon­e­tary Fund’s Euro­pean divi­sion was also run by a Gold­man man, Anto­nio Borges, who just resigned for per­son­al rea­sons.

    Even before the upheaval in Italy, there was no sign of Gold­man Sachs liv­ing down its nick­name as “the Vam­pire Squid”, and now that its ten­ta­cles reach to the top of the euro­zone, scep­ti­cal voic­es are rais­ing ques­tions over its influ­ence. The polit­i­cal deci­sions tak­en in the com­ing weeks will deter­mine if the euro­zone can and will pay its debts – and Gold­man’s inter­ests are intri­cate­ly tied up with the answer to that ques­tion.

    Simon John­son, the for­mer Inter­na­tion­al Mon­e­tary Fund econ­o­mist, in his book 13 Bankers, argued that Gold­man Sachs and the oth­er large banks had become so close to gov­ern­ment in the run-up to the finan­cial cri­sis that the US was effec­tive­ly an oli­garchy. At least Euro­pean politi­cians aren’t “bought and paid for” by cor­po­ra­tions, as in the US, he says. “Instead what you have in Europe is a shared world-view among the pol­i­cy elite and the bankers, a shared set of goals and mutu­al rein­force­ment of illu­sions.”

    This is The Gold­man Sachs Project. Put sim­ply, it is to hug gov­ern­ments close. Every busi­ness wants to advance its inter­ests with the reg­u­la­tors that can stymie them and the politi­cians who can give them a tax break, but this is no mere lob­by­ing effort. Gold­man is there to pro­vide advice for gov­ern­ments and to pro­vide financ­ing, to send its peo­ple into pub­lic ser­vice and to dan­gle lucra­tive jobs in front of peo­ple com­ing out of gov­ern­ment. The Project is to cre­ate such a deep exchange of peo­ple and ideas and mon­ey that it is impos­si­ble to tell the dif­fer­ence between the pub­lic inter­est and the Gold­man Sachs inter­est.

    Mr Mon­ti is one of Italy’s most emi­nent econ­o­mists, and he spent most of his career in acad­e­mia and think­tankery, but it was when Mr Berlus­coni appoint­ed him to the Euro­pean Com­mis­sion in 1995 that Gold­man Sachs start­ed to get inter­est­ed in him. First as com­mis­sion­er for the inter­nal mar­ket, and then espe­cial­ly as com­mis­sion­er for com­pe­ti­tion, he has made deci­sions that could make or break the takeover and merg­er deals that Gold­man’s bankers were work­ing on or pro­vid­ing the fund­ing for. Mr Mon­ti also lat­er chaired the Ital­ian Trea­sury’s com­mit­tee on the bank­ing and finan­cial sys­tem, which set the coun­try’s finan­cial poli­cies.

    With these con­nec­tions, it was nat­ur­al for Gold­man to invite him to join its board of inter­na­tion­al advis­ers. The bank’s two dozen-strong inter­na­tion­al advis­ers act as infor­mal lob­by­ists for its inter­ests with the politi­cians that reg­u­late its work. Oth­er advis­ers include Otmar Iss­ing who, as a board mem­ber of the Ger­man Bun­des­bank and then the Euro­pean Cen­tral Bank, was one of the archi­tects of the euro.

    Per­haps the most promi­nent ex-politi­cian inside the bank is Peter Suther­land, Attor­ney Gen­er­al of Ire­land in the 1980s and anoth­er for­mer EU Com­pe­ti­tion Com­mis­sion­er. He is now non-exec­u­tive chair­man of Gold­man’s UK-based bro­ker-deal­er arm, Gold­man Sachs Inter­na­tion­al, and until its col­lapse and nation­al­i­sa­tion he was also a non-exec­u­tive direc­tor of Roy­al Bank of Scot­land. He has been a promi­nent voice with­in Ire­land on its bailout by the EU, argu­ing that the terms of emer­gency loans should be eased, so as not to exac­er­bate the coun­try’s finan­cial woes. The EU agreed to cut Ire­land’s inter­est rate this sum­mer.

    Pick­ing up well-con­nect­ed pol­i­cy­mak­ers on their way out of gov­ern­ment is only one half of the Project, send­ing Gold­man alum­ni into gov­ern­ment is the oth­er half. Like Mr Mon­ti, Mario Draghi, who took over as Pres­i­dent of the ECB on 1 Novem­ber, has been in and out of gov­ern­ment and in and out of Gold­man. He was a mem­ber of the World Bank and man­ag­ing direc­tor of the Ital­ian Trea­sury before spend­ing three years as man­ag­ing direc­tor of Gold­man Sachs Inter­na­tion­al between 2002 and 2005 – only to return to gov­ern­ment as pres­i­dent of the Ital­ian cen­tral bank.

    Mr Draghi has been dogged by con­tro­ver­sy over the account­ing tricks con­duct­ed by Italy and oth­er nations on the euro­zone periph­ery as they tried to squeeze into the sin­gle cur­ren­cy a decade ago. By using com­plex deriv­a­tives, Italy and Greece were able to slim down the appar­ent size of their gov­ern­ment debt, which euro rules man­dat­ed should­n’t be above 60 per cent of the size of the econ­o­my. And the brains behind sev­er­al of those deriv­a­tives were the men and women of Gold­man Sachs.

    The bank’s traders cre­at­ed a num­ber of finan­cial deals that allowed Greece to raise mon­ey to cut its bud­get deficit imme­di­ate­ly, in return for repay­ments over time. In one deal, Gold­man chan­nelled $1bn of fund­ing to the Greek gov­ern­ment in 2002 in a trans­ac­tion called a cross-cur­ren­cy swap. On the oth­er side of the deal, work­ing in the Nation­al Bank of Greece, was Pet­ros Christodoulou, who had begun his career at Gold­man, and who has been pro­mot­ed now to head the office man­ag­ing gov­ern­ment Greek debt. Lucas Papademos, now installed as Prime Min­is­ter in Greece’s uni­ty gov­ern­ment, was a tech­no­crat run­ning the Cen­tral Bank of Greece at the time.

    Gold­man says that the debt reduc­tion achieved by the swaps was neg­li­gi­ble in rela­tion to euro rules, but it expressed some regrets over the deals. Ger­ald Cor­ri­g­an, a Gold­man part­ner who came to the bank after run­ning the New York branch of the US Fed­er­al Reserve, told a UK par­lia­men­tary hear­ing last year: “It is clear with hind­sight that the stan­dards of trans­paren­cy could have been and prob­a­bly should have been high­er.”

    When the issue was raised at con­fir­ma­tion hear­ings in the Euro­pean Par­lia­ment for his job at the ECB, Mr Draghi says he was­n’t involved in the swaps deals either at the Trea­sury or at Gold­man.

    It has proved impos­si­ble to hold the line on Greece, which under the lat­est EU pro­pos­als is effec­tive­ly going to default on its debt by ask­ing cred­i­tors to take a “vol­un­tary” hair­cut of 50 per cent on its bonds, but the cur­rent con­sen­sus in the euro­zone is that the cred­i­tors of big­ger nations like Italy and Spain must be paid in full. These cred­i­tors, of course, are the con­ti­nen­t’s big banks, and it is their health that is the pri­ma­ry con­cern of pol­i­cy­mak­ers. The com­bi­na­tion of aus­ter­i­ty mea­sures imposed by the new tech­no­crat­ic gov­ern­ments in Athens and Rome and the lead­ers of oth­er euro­zone coun­tries, such as Ire­land, and res­cue funds from the IMF and the large­ly Ger­man-backed Euro­pean Finan­cial Sta­bil­i­ty Facil­i­ty, can all be traced to this con­sen­sus.

    “My for­mer col­leagues at the IMF are run­ning around try­ing to jus­ti­fy bailouts of €1.5trn-€4trn, but what does that mean?” says Simon John­son. “It means bail­ing out the cred­i­tors 100 per cent. It is anoth­er bank bailout, like in 2008: The mech­a­nism is dif­fer­ent, in that this is hap­pen­ing at the sov­er­eign lev­el not the bank lev­el, but the ratio­nale is the same.”

    So cer­tain is the finan­cial elite that the banks will be bailed out, that some are plac­ing bet-the-com­pa­ny wagers on just such an out­come. Jon Corzine, a for­mer chief exec­u­tive of Gold­man Sachs, returned to Wall Street last year after almost a decade in pol­i­tics and took con­trol of a his­toric firm called MF Glob­al. He placed a $6bn bet with the fir­m’s mon­ey that Ital­ian gov­ern­ment bonds will not default.

    When the bet was revealed last month, clients and trad­ing part­ners decid­ed it was too risky to do busi­ness with MF Glob­al and the firm col­lapsed with­in days. It was one of the ten biggest bank­rupt­cies in US his­to­ry.

    The grave dan­ger is that, if Italy stops pay­ing its debts, cred­i­tor banks could be made insol­vent. Gold­man Sachs, which has writ­ten over $2trn of insur­ance, includ­ing an undis­closed amount on euro­zone coun­tries’ debt, would not escape unharmed, espe­cial­ly if some of the $2trn of insur­ance it has pur­chased on that insur­ance turns out to be with a bank that has gone under. No bank – and espe­cial­ly not the Vam­pire Squid – can eas­i­ly untan­gle its ten­ta­cles from the ten­ta­cles of its peers. This is the ratio­nale for the bailouts and the aus­ter­i­ty, the rea­son we are get­ting more Gold­man, not less. The alter­na­tive is a sec­ond finan­cial cri­sis, a sec­ond eco­nom­ic col­lapse.

    Shared illu­sions, per­haps? Who would dare test it?

    Posted by R. Wilson | November 19, 2011, 1:30 am
  3. Great, the mag­ic of the mar­ket is now greased with secret high-speed microwave com­mu­ni­ca­tion net­works. It’s always a lit­tle jar­ring when a sec­tor of the econ­o­my drops the pre­tense of legit­i­ma­cy:

    Lasers, microwave deployed in high-speed trad­ing arms race

    By Eric Onstad

    LONDON | Wed May 1, 2013 10:55am EDT

    (Reuters) — Laser beams and microwave dish­es are the lat­est weapons in an arms race to shave mil­lisec­onds off deal­ing times in the shad­owy world of high-speed, com­put­er­ized finan­cial trad­ing.

    Traders, who make mon­ey by exploit­ing tiny, light­ning-fast price changes on exchanges, are now tar­get­ing Europe and Asia after skir­mish­ing in the Unit­ed States.

    The first microwave con­nec­tions between Lon­don and Frank­furt have been launched, cut­ting the time to send a trade by about 40 per­cent com­pared with optic fiber cables.

    Behind the scenes, rivals are also rac­ing to trim thou­sandths of sec­onds from routes to Moscow, Hong Kong and Tokyo, while also scram­bling to find new tech­nolo­gies, includ­ing the use of drones as plat­forms for wire­less links.

    The race to trans­mit at near­ly the speed of light comes as reg­u­la­tors in Europe and the Unit­ed States debate crack­ing down on a sec­tor accused of increas­ing mar­ket volatil­i­ty and mul­ti­ply­ing the risk of a mar­ket melt­down.

    Investors have blamed high-speed traders for exag­ger­at­ing mar­ket move­ments — includ­ing the biggest-ever dai­ly plunge in gold last month — while eth­i­cal issues have been raised at a time when the rep­u­ta­tion of the finan­cial sec­tor as a whole is under scruti­ny as a result of scan­dals such as banks rig­ging the Libor inter­est rate bench­mark.

    But such ques­tions are not damp­en­ing fierce com­pe­ti­tion among traders and their com­mu­ni­ca­tions providers to squeeze out more speed.

    A laser beam tech­nol­o­gy devel­oped for the U.S. mil­i­tary for com­mu­ni­ca­tion between fight­er jets is to be used over the route between Britain and Ger­many in com­ing months.

    ...

    More typ­i­cal was the bat­tle to erect the first microwave link in Europe.

    Perseus Tele­com kept qui­et last Octo­ber when it flipped the switch on its Lon­don to Frank­furt net­work, which trimmed sev­er­al thou­sandths of a sec­ond, or mil­lisec­onds, off the time need­ed to com­plete a trade. The pri­vate­ly held firm based in New York only showed its hand when Euro­pean tele­coms provider Colt Group SA launched a rival ser­vice in Feb­ru­ary.

    “High fre­quen­cy trad­ing is dri­ven by being either the fastest to mar­ket, or equal fastest to mar­ket, and com­ing sec­ond is like los­ing,” said Hugh Cum­ber­land, man­ag­er for finan­cial ser­vices with Colt.

    SERIES OF DISHES

    The move to microwave is just one more step by high fre­quen­cy trad­ing (HFT) com­pa­nies to seek an edge since they emerged on the scene decades ago with com­put­er black box­es that spew out thou­sands of trades a sec­ond.

    HFT has grown to dom­i­nate equi­ties trad­ing, although vol­umes and prof­its have tapered off since the glob­al finan­cial cri­sis.

    In Europe, high speed trad­ing account­ed for 6.7 tril­lion euros of equi­ties trad­ing vol­umes last year, 39 per­cent of the total, ana­lyst Rebec­ca Healey at con­sul­tan­cy Tabb Group said.

    Prof­its in the U.S. HFT sec­tor slid by 56 per­cent last year to $1.8 bil­lion, she added.

    High-speed trad­ing has been blamed for caus­ing vio­lent lurch­es on finan­cial mar­kets, such the U.S. “flash crash” in May 2010 when the stock mar­ket plum­met­ed more than 1,000 points, or near­ly 10 per­cent, in a mat­ter of min­utes.

    The top U.S. deriv­a­tives reg­u­la­tor said on Tues­day the need to look at reg­u­lat­ing auto­mat­ed trad­ing was under­scored by a phoney tweet from the Asso­ci­at­ed Press’ hacked Twit­ter account, which sparked a short-lived pan­ic in the U.S. stock mar­ket last month. Ger­many is expect­ed to bring in tougher rules gov­ern­ing high fre­quen­cy trad­ing lat­er this year.

    ...

    For HFT, send­ing data through the air saves mil­lisec­onds. On the Lon­don to Frank­furt route, Perseus says its microwave sys­tem has slashed a round trip to below 4.6 mil­lisec­onds com­pared to 8.35 mil­lisec­onds for its high-speed fiber optic net­work.

    Speed in HFT is typ­i­cal­ly mea­sured in round trip times to gauge how long it takes to send a trade and get a con­fir­ma­tion.

    Perseus, which was formed in 2010, spent 10–20 mil­lion euros con­struct­ing its net­work of microwave dish­es from Lon­don to Frank­furt, a time-con­sum­ing process involv­ing per­mits for each tow­er from var­i­ous juris­dic­tions.

    “It’s all about being as straight a line as pos­si­ble. Pull the string as tight as you can with­out caus­ing it to break,” said Perseus Chief Exec­u­tive Jock Per­cy.

    Being fastest to trans­act between two trad­ing cen­ters is most impor­tant to one type of HFT strat­e­gy, arbi­trage, where traders seek to be first to exploit price dif­fer­ences in two secu­ri­ties in dif­fer­ent loca­tions.

    For exam­ple, when a share on the Deutsche Bourse is out of sync with its equiv­a­lent futures con­tract in Lon­don or vice ver­sa, HFT com­put­ers will simul­ta­ne­ous­ly buy the cheap­er one and sell it on the more expen­sive mar­ket.

    LASER BEAMS

    Ano­va is bet­ting its laser tech­nol­o­gy will prove to be anoth­er leap for the sec­tor, tar­get­ing the weak­ness­es of microwave dish­es: they are eas­i­ly dis­rupt­ed by weath­er and can car­ry tiny amounts of data com­pared to fiber optic net­works.

    The com­pa­ny formed a joint ven­ture with AOp­tix, found­ed by two Cal­i­for­nia sci­en­tists who devel­oped a high-band­width com­mu­ni­ca­tions net­work for the U.S. Air Force to send large amounts of data between mov­ing air­craft using rotat­ing lasers.

    The new hybrid sys­tem — com­bin­ing lasers and mil­lime­ter wave wire­less dish­es — is due to be first rolled out on short-range U.S. and British net­works over the next two months before the first long-haul route to Ger­many, per­haps next year.

    ...

    AMBUSH

    Per­si­co, who acknowl­edges rivals are also work­ing behind the scenes, must hope that he is not the vic­tim of the type of ambush that hit traders when microwave emerged in the Unit­ed States.

    At the time, when most speed traders were focus­ing on improv­ing fiber optics net­works, pri­vate­ly owned Spread Net­works made a mas­sive invest­ment that Forbes esti­mat­ed at $300 mil­lion.

    It built a new fiber optics net­work between Chica­go and New York to improve speed by three mil­lisec­onds. After it opened in 2010, cus­tomers could­n’t under­stand why they were being beat­en.

    Lat­er they real­ized the first microwave net­work for traders had been built in secret by rivals.

    Asked what might come next, Per­si­co men­tioned the use of drones and barges to cre­ate a transat­lantic wire­less net­work.

    ...

    Posted by Pterrafractyl | May 2, 2013, 7:38 am

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