Break the Financial Oligarchy

By Simon Johnson
The Atlantic, May 2009

Edited by Andy Ross

The International Monetary Fund specializes in telling its clients what they don't want to hear. The real problem is almost invariably the politics of countries in crisis. Typically, these countries are in crisis because their powerful elites overreached in good times and took too many risks.

The US economic and financial crisis is reminiscent of recent crises 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.

Financiers played a central role in creating the current crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. They are now using their influence to prevent the reforms that are needed. For the past 25 years or so, the financial industry has boomed, becoming ever more powerful.

In a primitive political system, power is transmitted through violence. In a less primitive system, power is transmitted via money. The US financial industry gained political power by feeding the belief that what was good for Wall Street was good for the country.

One channel of influence was the flow of individuals between Wall Street and Washington. 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. A whole generation of policy makers has been mesmerized by Wall Street.

From the confluence of campaign finance, personal connections, and ideology there flowed an astonishing river of deregulatory policies. The mood that accompanied these measures in Washington seemed to be that finance unleashed would continue to propel the economy to greater heights.

Many other factors contributed to the financial crisis that exploded last year, including excessive borrowing by households and lax lending standards out on the fringes of the financial world. But 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.

In the summer of 2007, the boom had produced so much debt that rising delinquencies in subprime mortgages caused a stumble. Ever since, the financial sector and the federal government have been behaving as one would expect. But financial elites have continued to assume that their favored position is safe.

In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty. The longer the response takes, the longer the uncertainty will cripple the economy. 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.

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. This approach is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms.

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, the IMF would say: nationalize troubled banks and break them up as necessary.

The IMF would advise scaling up the standard Federal Deposit Insurance Corporation process. An FDIC intervention 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. According to IMF numbers, the cleanup of the banking system would probably cost close to $1.5 trillion (or 10 percent of GDP) in the long term.

The IMF would also advise the government to break the power of the financial oligarchy. Big banks should be sold in medium-size pieces. The efficiency costs of a more fragmented banking system are real. But so are the costs when a bank that is "too big to fail" fails.

The United States could stumble along for years without doing what it needs to do. No one at the IMF can force it to make a clean break with the past.

Simon Johnson was Economic Counselor and Director of the Research Department at the IMF in 2007 and 2008, on leave from the Sloan School of Management at MIT.

AR  I agree — a clean break is needed but is not yet assured.