by Simon Johnson
One thing you learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you. The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear.
Almost always, countries in crisis need to learn to live within their means after a period of excess. 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.
Over borrowing 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. 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 haemorrhaging 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. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government. Meanwhile, needing to squeeze someone, most governments look first to ordinary working folk - at least until the riots grow too large.
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). Elite business interests - financiers, in the case of the U.S. - played a central role in creating the crisis. 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.
The financial industry has not always enjoyed such favoured 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.
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 post war 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.
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.
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.
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 favour of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him.
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 pre tax 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 modelling had said were virtually impossible.
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.
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.
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 favoured children is safe, despite the wreckage they have caused.
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).
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 favourable 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.
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 favourable 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.
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 behaviour 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.
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.
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.
Almost always, countries in crisis need to learn to live within their means after a period of excess. 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.
Over borrowing 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. 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 haemorrhaging 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. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government. Meanwhile, needing to squeeze someone, most governments look first to ordinary working folk - at least until the riots grow too large.
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). Elite business interests - financiers, in the case of the U.S. - played a central role in creating the crisis. 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.
The financial industry has not always enjoyed such favoured 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.
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 post war 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.
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.
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.
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 favour of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him.
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 pre tax 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 modelling had said were virtually impossible.
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.
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.
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 favoured children is safe, despite the wreckage they have caused.
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).
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 favourable 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.
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 favourable 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.
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 behaviour 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.
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.
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.
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