I date the beginning of out current economic woes three years ago – to the collapse of two of Bear Sterns’ hedge funds although, as you’ll read below, the slide actually started with the infamous terrorist attack on 9 – 11. However, it was investors calling for redemptions of their investments in those two Bear Sterns hedge funds and the inability of the funds to sell their assets at anywhere near book value that alerted the world in March of 2007 that there was going to be a world of hurt in derivatives. Bear Sterns wound down their hedge funds and, although they were not legally obligated to do so, they paid the funds’ investors with Bear’s own money. However, it was too late. The cat was out of the bag. The whole world now knew that these new-fangled derivatives were just so much toxic sludge. I’ve discussed derivatives in great length over the years so I won’t beat them to death again, Suffice to say that that event set in motion the financial and economic melt-down we are still suffering.

     One of the most startling truths to emerge over the last three years is that the American financial industry has captured the U.S. government: its politicians, bureaucrats and regulators as well as the mass media with perhaps the exception of Fox News (that’s debatable.) Simon Johnson, a former chief economist with the International Monetary Fund (IMF) said that this is “a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.”

      Johnson wrote that last May in an article for The Atlantic titled “The Quiet Coup” (for those of you with the time and inclination, I’ve reprinted the article in its entirety in NOTES at the end of my commentary. I strongly urge you to read it as it is very revealing.) His last sentence above is alarming;  “And if we are to prevent a true depression, we’re running out of time.”

     One year later, nothing has changed. Attempts at reform have been a desultory smoke screen and firmly blocked by the financial oligarchs.  Johnson ends his article with these words, “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.

 Wealth Disparities in U.S. Approaching 1920s Levels

The light blue bars are the percentage of U.S. wealth owned by the top 1% of the population and the dark blue is the bottom 90%. America is going backwards 80 years. This is Jim Sinclair’s comment (and he’s a multi-millionaire),

What a time to be an oligarch! All I wanted to do was vomit when I saw this.

Folks, there is no way we can have economic prosperity in this country when the top 1% has all of the money. The middle class is basically being destroyed right in front of our very eyes. Consumption economies die when the consumers have no money to consume!

I see growing signs of desperation and anger as the wealth of this nation continues to get transferred to the elite of this nation.   – Jim Sinclair – JS Mineset, Feb 21, 2010

The End of the 30 Year Prosperity Bubble

     From the research I’ve done over the last several years, two dates stand out and are particularly significant to today’s economic malaise. Those dates are August 15, 1971 and September 11, 2001. In 1971, President Richard Nixon took the U.S. off the gold standard i.e. the U.S. dollar was no longer redeemable in gold. To avoid a run on their gold reserves, other nations followed suit. The other date, of course, is the terrorist attacks known as 9 – 11.

     Although modern fiat currency began with the introduction of the U.S. Federal Reserve in 1913 and other central banks world-wide following thereafter, currency was still partly based on a gold standard and was redeemable in gold. When Nixon dropped the gold standard, countries could then print money to their heart’s content. When you look at various charts below, you can see the wild ride that began in 1971 and the false prosperity and massive debt (and credit bubble) that unrestrained money printing created for three decades. We had an unprecedented debt-fuelled economic expansion for 30 years with very few recessions during that time. That bubble has now burst.

     It all ended in 9 – 11. After watching the Twin Towers collapse on TV, I said, “Things will never be the same.” Little did I know then how prescient that statement would become. Historians in the future will see that date as a turning point for the West and especially for America. Certainly there was an outpouring of sympathy for the victims. After a while it was business as usual but the whole world began to see the U.S. in a different light.

     For one thing, the price of gold began to rise much faster. As I’ve said in previous commentaries, gold retains its value over centuries and millennia, To really understand the value of other assets whether it’s housing, the stock markets or currency, compare it to gold. In other words treat gold as money and see what these other assets look like compared to gold. The Dow, even though it peaked at 14,000 actually began to decline after 2001.

Note: although the DOW has recovered from its low of 2009 it is still well within the down channel.

The U.S. dollar and most other currencies also began their descent in 2001. The graph below shows the U.S. dollar VS gold. Notice how the dollar slide begins after 9 – 11.

     Now the question naturally arises, why was Sept. 11, 2001 a turning point? I haven’t found any commentary to substantiate my own analysis.

     The most obvious answer is because not only did it happen but it happened on U.S. soil. Sure the U.S. had been attacked before but it was the U.S. forces’ barracks in Beirut, Lebanon in 1983, it was “Blackhawk Down” during the Somalia civil war 1992-93, it was the bombing of the US Navy destroyer “Cole” in the Yemeni port of Aden in 2000. All these happened overseas, not on U.S. soil. Granted there was Wako and the Oklahoma City bombing by Timothy McVeigh but these were seen as U.S. citizens run amok and not foreign terrorists. September 11, 2001 was different; it was done by foreign terrorists in the U.S. homeland. Suddenly, the U.S. was seen as vulnerable. As I’ve said before, confidence is very important, more important than most people realize at least consciously.

     Another reason is that it was allowed to happen; perhaps not be design but it was a major failure of U.S. intelligence. Again, this make America’s vaunted intelligence services look like the Keystone Kops. Again, it makes the U.S. look vulnerable which once again destroys confidence in America’s ability to protect itself.

    Still another reason and one that is gaining more credibility is the conspiracy theory; that 9-11 was designed, that the twin towers were deliberately destroyed. There is more information coming to light (far too much to include here) and many respectable people asking hard questions for which there have been no satisfactory answers. Again, this shatters confidence. If the American leadership is so crass as to allow almost 3,000 people to be killed on 9-11 and tens of thousand lives cut short as a result of the toxic rescue and clean-up efforts, then how much credibility does American leadership have? It all boils down to confidence again. 

     All finance relies on confidence. Modern finance, based on fiat currency is a confidence game – a con game. Once confidence is shaken, the con stops working and it takes a very long time to restore lost confidence.

Depressions are Multiple Recessions

     There’s something you need to understand about depressions. They aren’t linear. Many people believe that in a depression the economy and stock markets slow down for a long time before eventually recovering. In fact, depressions are a series of recessions with weak economic recovery between recessions. In short, a depression is a series of recessions happening with great frequency. The last two Great Depressions occurred from 1873 to 1896 and from 1930 to 1947 and consisted of downturns and partial recoveries.

     This is what makes depressions so frustrating to endure; these minor recoveries between recessions lead to ill-conceived decisions by governments, businesses and individuals. Governments back off on their recovery efforts only to be blindsided by the next downturn. Businesses start investing only to see their investments turn sour in the next downturn. Individuals jump back into the stock market only to lose money in the next downturn. Homeowners buy a house or re-new mortgages just before house prices collapse once again.

     And, this is what makes depressions so long. After being burned several times, businesses refuse to invest even after the economy becomes capable of recovery and it’s the same with investors and homeowners. And, governments being none too bright anyway usually do the wrong thing at the wrong time and make matters worse than they should be. Finance and fiat paper money rely on confidence (like a con game) and depressions destroy confidence. It takes a long time to restore lost confidence.

     In a March 17 interview, the legendary Jim Rogers said, of course we’re going to have another recession. We always have recessions every 4 to 6 years. The last one started in 2008 so the next one could be in 2012 or, given the economic downturn, it could be sooner. The next one is going to be worse because we are out of bullets. The American government can’t quintuple its debt again because there aren’t enough trees to print all that money and interest rates can’t go any lower because they’re already effectively at zero.

Demographics and Depressions

     Another important factor overlooked by most commentators and one that I’ve mentioned numerous times is demographics; in particular the influence of the Baby Boomers in the Western countries. They are the largest segment of the Western population. 30 years ago, there were 7 workers for every retiree. With the Boomers starting to retire en mass there will be 2 workers for every retiree. This will have numerous negative effects.

    First, we will lose a large productive capacity of our economies. There simply aren’t enough young people to replace all the Boomers so our western economies will shrink (this includes China with its “one-child policy.”) This couldn’t happen at a worse time – at the beginning of this, the Third Great Depression when we need economies to strengthen, not weaken. This, among other factors, ensures that the depression will be long and painful.

     Second, we have many Boomers who cannot retire having lost much of their 401k, RRSP and other pensions in the recent downturn. By delaying the entry of young people into the work force in their most “instructive” years, it reduces their experience and competence which further weakens our economy and puts us at a competitive disadvantage,

    Third, the largest of all economies, the U.S. does NOT have a funded government pension plan. Yes, social security taxes were collected but they were NOT put into a fund. They were added to general revenue and spent long ago. The U.S. “plan” is nothing but a bunch of I.O.U.s that the government owes itself. In the past, current social security deductions from 7 workers could support one retiree. In the near future, how well do you think every retiree will be supported by only 2 workers? Those 2 workers will be taxed to death. This will reduce the incentive to work and encourage tax evasion. And, retirees’ benefits will be greatly reduced. This will have a detrimental effect on the economy not to mention a reduced standard of living for both working people and retirees.

     Yes, Canada does have a funded Canada Pension Plan but the health of that plan will be determined by the health of our economy. As the global economies continue to deteriorate, Canada’s will follow. The Canada Pension Plan is invested in stocks, bonds and mortgages. Stock markets decline in depressions, bonds depend on healthy governments and mortgages default as housing bubbles burst. Already, the Canadian government is talking about raising the retirement age to 67 and you can bet, as time goes on that will be raised further.

Retirement Trick?

     Some Canadians close to retirement, age 60, are asking employers to stop paying them for a month, filing for early Canada pensions and putting their (reduced) Canada Pension cheques into an RRSP. As they continue working and paying income tax, the RRSP deductions offset the tax on their pension income while their RRSP increases. You want to ensure you’re eligible for enough Canada Pension over 5 years to more than offset the loss of one month of income. Be aware that it’s only a matter of time before they close this loophole. Also, be aware that there is talk about reducing RRSP contributions from a tax deduction to a tax credit; in other words from 100% to whatever your tax rate is.

Missing in Action?

      Whatever happened to Meredith Whitney, the very last American bank analyst who wasn’t afraid to “tell it like it is?” She’s disappeared off the radar. Wanna bet someone hasn’t had a chat with her? I still remember the haunted look on her face when she said that the entire American economy needs to be restructured. In case you missed it, “the entire American economy needs to be restructured.” Can anyone guess how long and painful this will be?

Rating Agencies

Many financial pundits believe the US will lose its triple A financial rating because of its massive debt load. Puhlease! The major rating agencies, Moody’s, Fitch and the S&P are American and they are beholden to the financial oligarchs and are in the government’s pocket. Do you think they’re going to bite the hand that feeds them? District attorneys are kept on a leash so the agencies aren’t charged with the numerous crimes of fraud they committed. It’s Triple AAA all the way until the last doofus stops believing their improbable ratings. After all, if they can cover up for an American company like Enron until a couple of weeks prior to its bankruptcy (see the following chart) they’ll certainly do it for the government. 

Fund Fun or Folly?

     People sometimes ask me for investment advice. I decline to give specific advice because I’m not a financial advisor and I’d have to know a lot about their debts & assets, their objectives, timelines, etc. I will however offer “broad brush” suggestions especially if I ask what they’re invested in and they say a fund. Alarm bells go off when I hear that. What is the fund invested in? Oh, it’s a growth fund or an income fund or whatever. More alarm bells!

     You don’t invest in a fund. You invest “with” a fund but the fund itself is invested in stocks (equities) or bonds or mortgages or currencies or specific assets. If you don’t know what your fund is invested in you should GET THE HELL OUT of it until you know what you’re investing in. Stocks are overbought and waiting for a crash. Bonds are as high as they are going to go because the price of a bond is the opposite of its interest rate i.e. interest rates are going up so bond prices will go down. With mortgages you have to be very selective and currencies are a short term trade i.e. speculative. It doesn’t leave much unless you’re prepared to spend a lot of time in research and then closely monitoring your investment. “Buy and hold” is dead no matter what your broker / advisor tells you. Unless you’re a twenty-something you can’t wait for an asset to regain its value after it crashes. In the current economy, the return OF your investment is more important than the return ON your investment. On the plus side, money can be made from the volatility the markets will be going through but this too is short term trading, not investing. If you aren’t sure you can jump into and out of the markets, keep your money in cash or GICs (Canadian) or CDs (U.S.) and make sure it’s in a solid financial institution (and that takes research and monitoring, too.)

Snippets

– There is much debate whether economies will recover or go into a double dip (i.e. continue the downturn.) Since the only thing that prevented a complete collapse has been massive government stimulus and since that stimulus is coming to an end with no real recovery in sight, there’s a snowball’s chance in hell of continued recovery. Double dip here we come…. and the depression continues.

– History shows when governments lose control in a depression; they almost always go to war.

– Do NOT assume we will always have a free and unfettered internet. There are too many questions being raised on the internet about the oligarchs. Western governments feel threatened by internet-spawned, freedom-oriented groups of ordinary citizens who stop believing the ass media propaganda.

– The melt-down of the last 3 years and governments’ inability to recognize the severity of our problems and their insane attempts to solve the symptoms of the problem rather than their root cause means that it is going to be a long, slow, painful decline.

– Most people believe whatever current conditions are, they will last forever. Nothing lasts forever. Don’t be a sheep; be a contrarian. Do the opposite of what everyone else is doing.

– I’ve said it before and I’ll say it again, 1) you can’t spend your way to prosperity, 2) you can’t borrow your way out of debt, and 3) you can’t pretend your way out of trouble. Our leaders are trying to do all three impossible things. The trouble with impossible things is, well, they’re impossible.

– The Austrian economist von Mises said: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.” The trouble with those Austrian economists is they know what they’re talking about.

– Churchill said America always does the right thing … after trying everything else. This time they won’t even last long enough to do all the wrong things.

– “Never before has a country simply committed economic suicide by moving its plants and equipment and its middle class jobs into other countries and letting them benefit from the production of good and services that that country (the U.S.) consumes.” – Paul Craig Roberts, former Undersecretary of Treasury under Reagan on RT TV (Russia Today)

– Weather has become the excuse du jour in explaining the economic malaise. Snow storms on the Eastern seaboard, in Europe and Russia are being blamed for the poor economic recovery. I guess it’s never snowed there before.

– None of this has any application to the mountain of old OTC derivatives (Gerold comment – OTC is Over The Counter i.e. private, opaque and unregulated) that was valued at one quadrillion, one hundred and forty four trillion before the BIS (Gerold comment – BIS is Bank of International Settlements i.e. the Central Bank of the Central Banks) altered their means of computer valuation to “Value to Maturity,” in order to reduce it to $600 trillion. The article did not even get that right. – Jim Sinclair 3-02-10

– Click on this link for the US unemployment map and then Play it to see how unemployment changed from month to month http://cohort11.americanobserver.net/latoyaegwuekwe/multimediafinal.html

– Survival Emergency Measure – if you have important documents stored on your computer, what will you do if the electricity goes off? Consider what documents you need – medical, recipes, survival, etc. – and print them. You can always read them by candle light. Don’t assume electricity will be restored shortly. In some storm-related power outages, people have waited more than a week before electricity was restored.

 – Financial Emergency Measure – print and store in a safe place copies of financial documents (brokerage, insurance, savings, RRSP, etc.) so you have proof of you assets in the event of power outage, bank closure (euphemistically called a “bank holiday”), financial institution bankruptcy, etc. Do this at least monthly. If you don’t have proof in writing it’s your word against theirs.

– Notable Quote – As far as we can tell, the last successful government program was WWII. And that was only successful because the competitors’ programs were also run by government.   – Bill Bonner, “The Follies of Federal Reserve Chairmen” Daily Reckoning, Apr 9, 2010

– Another nail in the coffin – as I predicted, the U.S. has enacted currency controls. Buried in the fine print of $17.5 billion Hiring Incentives to Restore Employment Act HR 2487 (another futile stimulus bill) requires foreign banks to withhold 30% of all outgoing capital flows and remit them to the U.S. Treasury.

Debt? What Debt?

The following is from Casey Research on U.S. debt. “The chart here, from BusinessInsider.com, shows total U.S. public and private debt. As you can see, the debt bubble that led to this crisis hasn’t been reduced at all.

What has transpired, as our own Bud Conrad has shown several times, is that a turndown in private debt has been more than offset by soaring public debt. In other words, Uncle Sam is perpetuating the debt bubble.

Ultimately, this has to be resolved – with the only politically feasible solution (or at least as the politicians will see it) being to debase the currency that the debts are paid back in.

Meanwhile, a businessman I know told me last week that even though he has never missed a payment on his personal or corporate debt, the banks he has relationships with have cut all of his credit lines back to the minimum and that he couldn’t get a loan from anyone, for anything, at this point. This does not bode well for a quick restart of the engines of the nation’s businesses. At least not for those that don’t rely on government spending for their bread and butter.

– Casey’s Daily Dispatch 2-08-10

BS, Spin & Propaganda

The Reserve Bank of Australia recently tried to pin the blame for their inflation on the mining boom caused by Chinese demand for raw materials rather than admit their inflation is caused by the Reserve Bank’s own actions. Such spin (propaganda) is also evident in our “official” inflation statistics whereby our governments try to convince us we do NOT have inflation and if we do, ok, maybe just a little bit.

     In previous commentary, I forecast that we would get inflation in the things we OWE and deflation in the things we OWN. We would pay more (inflation) for essentials we OWE such as groceries, taxes, utilities, rent, gas, energy, etc. but the things we OWN such as pensions, investments and property (in the U.S. and soon in Canada) are going down in value (deflation.)

     One way that governments fudge the inflation numbers is by adjusting the components in the “consumer basket of goods” they use to calculate inflation. They replace necessities with discretionary items. I recently bought an electric can opener for $4.95. Twenty years ago I paid $25 for an electric can opener which in today’s inflated currency would be $50. Now it’s a tenth the price thanks to cheap Chinese labor. Twenty years ago a PC cost more than $3,000 whereas today a more powerful laptop can be had for less than $800. These discretionary items go down in price whereas essential such as heating and groceries go up in price. I can live without an electric can opener (my 30 year old manual can openers work just fine) and I can live without a computer (I can still type letters on my 1965 Remington manual typewriter) but it’s difficult to live without essentials such as heat and groceries.

     Worse yet, as the things I OWE go up in price, I have less discretionary income left to buy cheap non-essentials such as electric can openers and laptops. Worse still, there’s no end for the inflation of essentials. Governments are broke and will continue to raise taxes whereas there is a limit to how low Chinese labor rates will go. In fact, we seem to have bottomed out. Hard as it is to believe, the Chinese are facing labor shortages and they are having to raise wages not only to attract labor but to accommodate their own inflation.

     This is the economic collapse I have been writing about. This is the slow destruction of our standard of living I have been warning about for 2 ½ years now. This is why I am so righteously pissed at our governments for not biting the bullet, recognizing the severity of the collapse and allowing the marketplace to work by bankrupting insolvent companies so their assets can be acquired by more efficient companies. Instead, failures are bailed out (the Japanese way in 1990 that I mentioned in previous commentaries) instead of allowing their collapse (the Swedish way also in 1990.) Japan is in its 3^rd decade of a depression. Have you heard about Sweden lately? Of course not! We are going into a multi-decade decline of our standard of living. Had we done it the Swedish way we would be 6 months into our recovery. Instead we are at the beginning of a long depression brought on by government meddling and incompetence.

    To make matters worse, we are going to demand more government meddling ostensibly to solve the very problems created by government in the first place. We will demand more regulation and more social safety nets and more union power and more protectionism and more security (less freedom) and more of everything that was done during the last Great Depression to make it worse.   

The Next American Shoe to Drop

    Residential mortgages such as Alt – A, Option – ARM and Unsecuritized ARM (Adjustable Rate Mortgages) as well as commercial real estate are about to hit the wall. Alt – A is a short form for Alternative A-paper and it’s not as risky as sub-prime (remember the sub-prime bomb?) but when even prime mortgages are underwater and foreclosing then Alt – A is going to be toast. ARM start out with low teaser rates then re-set higher. The graph below shows that residential mortgages are as big as sub-prime. Add in Commercial mortgages and this bomb is bigger than sub-prime. The fun starts right now and continues for two and a half years.

The upward sloping line is the cumulative dollar amount of mortgages being re-set (in $billions.) This graph does NOT include commercial  mortgages. These will only add to the problem.

Real statistics VS Government BS

Jim Sinclair asks, “Have you ever wondered why the CPI, GDP and employment numbers run counter to your personal and business experiences? The problem lies in biased and often-manipulated government reporting”. Here are graphic explanations from John Williams “Shadow Government Statistics” website.

The SGS Alternate Unemployment Rate reflects current unemployment reporting methodology adjusted for SGS-estimated long-term discouraged workers, who were defined out of official existence in 1994. That estimate is added to the BLS estimate of U-6 unemployment, which includes short-term discouraged workers.

We offer an exposé of the problems within the reporting system, and an assessment of underlying economic reality. – John Williams’ “Shadow Government Statistics” Jim Sinclair’s JS Mineset 3-18-10

Some recovery!

      First there was talk about “green shoots.” Now the U.S. is in a “technical recovery” or a “jobless recovery.” This is just more bullshit. It’s a technical recovery because the government is cooking the numbers and the Financial Accounting Standards Board (FASB) is allowing financial institutions to report their toxic assets and non-performing loans at whatever value they want. Remember what I said, you can’t pretend your way out of trouble. Second, there can be no recovery until unemployment stops falling, employment starts to INCREASE and the housing market stabilizes. None of these things are happening.

   Here’s Greg Hunter’s  (Apr 9, 2010) take on the U.S. recovery. We have been told non-stop that we are in a “recovery.” We are clearly not. Want proof that we are not in a “recovery?” Just two days ago, Fed Chief Ben Bernanke said, “We are far from being out of the woods.” According to a Bloomberg story, in a recent speech in Dallas, Texas, the Fed Chief was hardly trumpeting a huge turnaround for the economy. Bernanke said, “. . . the U.S. faces hurdles including the lack of a sustained rebound in housing, a “troubled” commercial real estate market and “very weak” hiring. . .” (Click here for the complete Bloomberg story.)  Why is the Fed Chief, all of a sudden, not beating the “recovery” drum? I think someone figured out that if they keep talking up the “recovery” and that does not happen, then the Fed will lose major credibility.  

Sure, the economy looks like it stopped falling, but you have to keep in mind we spent trillions of dollars just to get to where we are now. Taxpayers bailed out everything from car companies to insurance companies. ALL the big banks got taxpayer charity, and the best we can do is bottom bounce?    

If we really are in a “recovery,” then why is the Fed keeping its key rate at nearly 0%?  The Fed has repeatedly said this cheap money “needs” to remain for an “extended period.” If this was a big “recovery,” wouldn’t the Fed raise rates? 

Here are another 138,000 reasons we are not in a recovery.  That’s how many people filed for bankruptcy last month! An astounding 35% increase over February filings. This increase is almost totally ignored by the mainstream media.  

And, this fro The Daily Reckoning’s Joel Bowman, “What is this “road to recovery” nonsense? Don’t these people know the world is in a prolonged deleveraging stage? Don’t they know that we are unwinding from half a century of credit expansion, of living far beyond our means? Don’t they know that western economies are hemorrhaging and that Band-Aid welfare fixes are temporary, at best? Don’t they know that living off demand stolen from the future on a currency beaten into submission is not the kind of recovery on which to build a smile and a brighter tomorrow? Don’t they know that people are cutting back? That beer is the new champagne..”. – Joel Bowman – Daily Reckoning “Detaining Americans in the Name of Economic Recovery” 4-08-10

  Deconstructing Bullshit

     The following headline got a lot of people horny even some of the financial analysts I read. The “Great Recession” is over and jobs in the U.S. are coming back. Yeah, right! Let’s examine the story a little closer with my comments attached.

U.S. economy adds 162,000 jobs in March — biggest one-month pickup in three years
04/02/2010 08:31:19 AM   MarketWatch Bulletin

By Rex Nutting, MarketWatch

WASHINGTON (MarketWatch) — Boosted by hiring for the Census and a rebound from bad weather, the U.S. economy created 162,000 jobs in March, the largest seasonally adjusted increase in nonfarm payrolls in three years, the Labor Department reported Friday. (Gerold comment: “bad weather” will be an excuse as long as they can spin it. Then the excuse will be Easter, then they’ll find something else.)

Nonfarm payrolls rose for just the third time in the past 27 months, aided by the hiring of 48,000 temporary workers to conduct the Census. Excluding the Census workers, payrolls rose by 114,000. Read the full report on the Bureau of Labor Statistics website. (Gerold comment: The U.S. economy needs between 100,000 to 150,000 new jobs a month just to break even in order to accommodate more graduations than retirements, immigration and population increase. Therefore, deducting temporary Census workers, the increase in real jobs at 114,000 is much less than the average of 125,000 needed to break even. Be careful; the American government plans to hire as many as 1.5 million Census workers over the next several months. These are temporary jobs but they’ll include them in the headline job numbers. After the Census when these jobs are terminated, rather than report the truth they’ll cook the numbers as “seasonally adjusted.” PLUS the BLS added 82,000 fictitious jobs from the estimated “birth/death ratio.” From my previous commentaries you may recall that the BLS estimates new small businesses that have started (“birth”) compared to existing small businesses that have gone out of business (“death”). If you’ve driven past some American strip malls lately you can see that the BLS should drop the L. There are very few businesses left in most strip malls.)  

The unemployment rate was steady at 9.7%, with the labor force rising by 398,000. (Comment: Hmm, let’s see. 32,000 new jobs created after deducting government bullshit. There are 398,000 more people eligible to work and yet the unemployment percentage remains the same. Sure, I’m stupid enough to believe that.)

The report was largely in line with expectations. Economists surveyed by MarketWatch were forecasting a 200,000 increase in nonfarm payrolls, with about half of those coming from temporary hires at the Census Bureau. Economists expected the unemployment rate to remain at 9.7%. See our complete economic calendar and consensus forecast. (Comment: no matter how bad things are, don’t worry, “it was expected.” Spin, spin, spin.)

Ahead of the report, economists cautioned against reading too much into it, in light of the temporary hiring by the Census and the likely rebound from two massive snowstorms during the survey week in February. (Comment: after this economic shit-storm, economists here and below are finally being cautious. About time!) 

The March report “doesn’t tell you much about sustainability,” said Steven Ricchiuto, chief economist for Mizuho Securities USA.

The report was mixed, said Tom Porcelli, an economist for RBC Capital Markets. “No need to celebrate at all.” He expects modest job gains in coming months. (Comment: hopefully more than 125,000 a month EXCLUDING Census workers and the fictitious “birth/death ratio”).

A year ago, payrolls were falling by an average of more than 700,000 per month. Since the recession began in December 2007, 8.2 million jobs have been lost. (Comment: Let’s do some more math. Total U.S. labor force before the current depression was 133 million. Shadowtats.com unemployment at 22% means 29 million jobs lost not 8.2 million. Spin, spin, spin! Add in unpaid work i.e. working 5 days getting paid for 4 or “rolling layoffs” i.e. off one week a month and still counted as fulltime and it just gets worse and worse).

Service-producing industries added 121,000, including 39,000 in government. (Comment: 25% government employees – just like dysfunctional Greece.)

The average workweek increased by two-tenths of an hour to 33.3 hours. Total hours worked rose by 0.7%, reversing the storm-related 0.6% decline in February. (Comment: don’t forget the difference between a percentage decrease VS increase. You need a larger increase to make up for a decrease. For instance, using these numbers, a 6% decline is 94% of the original number. A 7% increase .94 X 1.07 = 1.0058 not 1.01. In other words, a 7% increase after a 6% decrease is not a full 1% increase but only a 0.58% increase. Beware how they spin the numbers)

Average hourly earnings fell by 2 cents, or 0.1%, to $18.90. It was the first decline on record, dating to 2006. (This does not bode well. For instance, income as measured by GDI – Gross Domestic Income is a more accurate economic indicator than spending as measured by GDP – Gross Domestic Product. If GDI is lower than GDP it means people are earning less money than they’re spending. This is what got us into trouble in the first place.)

Long-term unemployment worsened in March. Of the 15 million people officially classified as unemployed, a record 6.5 million, or 44.1%, had been out of work longer than six months. (Comment: not good news. Those who are off work more than 6 months have little chance of EVER gaining employment because they probably had jobs that are not coming back, they lose work habits and changes in the workplace leave them behind.)   

The U6 alternative gauge of the unemployment rate, which includes discouraged workers and those forced to work part-time, rose to 16.9% from 16.8%. (Comment: U6 unemployment is a more accurate statistic than the headline numbers although it is still “cooked” by the government. Shadowstats.com calculates real unemployment at about 22%. “Discouraged” workers are those whose unemployment insurance benefits have run out. Such a lovely euphemism! “Discouraged” makes it sound like all they need to do is adopt a positive attitude and jobs will magically appear.) 

Nothing-has-Changed Department

      Derivatives are still opaque and need the visibility of a market exchange. This is especially true of Credit Default Swaps (CDS) which are totally unregulated, naked and highly lucrative. What does this mean? Unregulated means no one can see who owns what so in the future we will again be blindsided when they blow up. Naked means you don’t have to own the underlying asset so anybody can buy this form of insurance. This is like a thousand people buying life insurance on you in the hopes you die. There’s two problems with this. First, because an unlimited amount of CDSs can be sold, the total payout could exceed the assets available to cover the payout i.e. lots more bankruptcies. Second, there’s too much incentive for someone to engineer your death just as there’s too much incentive for the holders of CDSs to engineer the downfall of the entity they are insuring (company, country or whatever) and it’s difficult to prove so no one goes to jail. There are laws against naked short-selling yet the banksters who create these CDSs are still allowed to get away with it. Lucrative means the bankster oligarchs who continue to create and sell these toxic instruments make a shit-load of money in commissions so the bankster oligarchs hire lobbyists to persuade government not to regulate them.

     In other words, the entire financial industry has become more of a gamble than casinos. At least the casinos are regulated. Derivatives have already blown up and killed large financial institutions and they will blow up again. Much of the credit crisis we are still suffering is a result of derivatives melting down. The U.S. Federal Reserve has bought from the banks more than a trillion dollars of toxic mortgage backed securities (another type of derivative) so the banks can then use the cash to buy lucrative guaranteed government bonds (paid for by those generous taxpayers) and gamble in the stock market which is getting set to blow up instead of the banks lending to consumers and businesses which are desperate to access operating capital. After all, if the banks aren’t lending, who is?

     Another thing that has not changed is “too big to fail.” Actually, it has changed insofar the “too big to fail” American financial institutions have gotten even bigger by swallowing up failed banks. This means that the next melt-down will be even bigger and now the taxpayers are out of bullets and are getting angry at all these bailouts and the governments are out of bullets because interest rates are already effectively at zero and can’t get any lower and the Federal Reserve’s balance sheet is already bloated with toxic derivatives. Have we learned from our mistakes? No. What happens next time? We bend over and kiss our asses goodbye because the next time Uncle Sam goes down he’s taking the whole world with him.

China is a Bubble

     I wish there was more time to report on this and so many other things but they’ll have to wait for my next commentary.

Gerald Celente on Disaster Preparedness

     Gerald Celente, founder & director of The Trends Research Institute was in Chile when it was struck by that massive earthquake. He stresses the importance of disaster preparedness whether it be a natural disaster, civil breakdown, terrorism or whatever. He was surprised how quickly the social order broke down. In the time it took him to run down 14 flights of stairs in his hotel, there were already roving gangs of youths attacking people, assaulting and robbing them.

     A social network is very important whether it be a martial arts club or a gardening club. In his case, he contacted some of his subscribers outside the country who phoned and emailed others and quickly found a driver willing to drive him to Argentina that same night. Other hotel guests waited in their hotel rooms for help to arrive. They were still waiting to get out of the country more than a week later. He says he didn’t see any police; don’t look for a leader, be your own leader.

     The following is from his King World News interview and applies to both home and travelling:

Celente stresses the importance of people thinking for themselves in survival mode. He discusses what he’s doing, and what one can do, to prepare for the worst during these difficult times:

• When arriving in a new city, go on a tour first to get an idea of the layout.
• Belong to a network/community of like-minded people and stay in touch; Plan with a group.
• Keep enough cash on hand and out of banks; Don’t count on an ATM.
• Have gold in possession.
• Buy clean, local food (organic when possible).
• Use a water filtration system with reverse osmosis for clean drinking water.
• Keep at least 3 weeks of dried foods and water in storage.
• Exercise Second Amendment rights and have protection on hand.
• Think for yourself, lead yourself, and heal yourself.
• Become more aware of what’s going on; Look for new opportunities and new ways of thinking.

“We are entering the period of high-level terrorist alerts,” says Celente. “The likelihood of one happening in 2010 is very high.” He also forecasts a new black plague, not the swine flu, with immune systems breaking down in high levels

And whither Canada?

For months the investment community… has seen Canada (and/or the loonie) as some sort

of resource-driven wunderkind. But in reality Canada is a tired old country with no gold reserves, an overpriced currency, the first trade deficit in decades, and industry (such as remains) in distress. Now the bloom is off metals and budget deficits (provincial and federal) are collectively at Club Med levels. The strength in the loonie over the past six months has resulted strictly from currency speculation. The denouement will be dramatic because optimism has been so universal.

 G7 Finance ministers recently met in Canada and concluded that they had better keep their collective foot on the gas. They really have no choice. It is absurd to think that Greece, Spain, the UK, Ontario, California, the US or anybody else is going to solve its problems

through austerity. A lot of economists think governments should start to tighten, but under current circumstances that would only lead to civil unrest and African levels of unemployment throughout the Western world. The chickens are coming home to roost; there is only one way out. The G7 has become a colossal Enron.    – Pollitt and Co. Toronto 2-12-10

The following is David Rosenberg’s take on Canadian unemployment, 

As in the U.S.A., wages in Canada actually contracted in March in part because even with the positive job growth numbers of late, slack in the labour market is widening. Just as we saw in the U.S. employment data for March, the broadest measure of unemployment in Canada rose last month to 12.4% from 12.1% in February — the same as it was a year ago and only fractionally off the cycle high of 12.6% last July (this is the R-8 measure which like the U-6 stateside, adds in discouraged workers and involuntary part-timers to the labour force). David Rosenberg – Breakfast with Dave 4-09-10

Canadian Real Estate as per Garth Turner

     Here are some interesting snippets on Canadian housing from Canada’s own Garth Turner

The average US resale home costs $178,000. In Canada, the national average right now is $337,410. So, a house to the south costs 2.64 times income, and here it is 4.4 times income – which is damn close to twice the price. Not only that, but Americans are able to write off 100% of the interest on their mortgages from taxable income, as well as property taxes. They also enjoy the same capital gains-free status on their homes in essence as we do.

Canadians will taste the bitter remedy of negative equity which has been forced down the throat of 23 million Americans. Those who bought most recently, at the highest levels, and with extreme leverage, are at greatest risk. The dangers we face have been well articulated here and will logically result in a 15% decline in the national average house price. In Toronto, maybe less. In Calgary and Kelowna, more. In Vancouver, may God be with us.

why the market will not blow up overnight:

• The federal government is terrified of this happening. They will endure a bubble, even with its destructive long-term consequences, over allowing market forces to be unleashed. This is called ‘politics.’

• In the light of the cabinet shuffle and the looming budget, the feds are signalling that the pain will come in the form of less spending, then higher taxes.

• The latest statements by the Bank of Canada suggest strongly that CHMC’s 5% down disaster will not now be amended to 10%.

• I’m betting the interest rate increase later this summer will be tame to start – maybe a couple of quarter points. The real misery is being held back for 2011 and 2012.

• Looks like we should expect a wave of new listings in the next couple of months, seriously diluting the supply-demand equation, quickly knocking price increases back to 0% and giving Ottawa a way to back off its recent mortgage threat.

Why the market will melt down, instead:

• Interest rates will be returning to their historic norm. That means mortgage renewals in 2014 or 2015 will shock people who borrowed in 2009 and 2010.

• Housing affordability will crash due to rising rates, stagnant incomes and higher income and consumption taxes.

• The Boomers hit the 65 mark starting in 2011, on their way to Freedom 85 – but only if they ditch the big house. Another tidal wave of listings.

• Economic growth will suck for at least half a decade, perhaps much longer. Government stimulus drugs will be cut off, our biggest trading partner is in decline, and China still has all our jobs.

• Rapidly rising energy costs over the next few years along with more taxes will help stoke inflation and rob Canadians of disposable income. This is hardly the climate for bidding wars, or $900,000 un-renovated bungs.

• A housing correction will become self-reinforcing, as recent buyers taste negative equity and the news spreads that real estate is now eating the young.

What this means:

• As I said yesterday, 2010 will be see the start of a correcting market, with a likely decline in average prices nation-wide of 15% by the end of the year.

• This will be the start, not the end.

• Between now and the time a five-year mortgage renews, I can see residential real estate declining another 20% to 40%, depending on the market, GDP growth, rates and taxes.

• This will bring a return to 2007 or 2008 prices and some extraordinary buying opportunities for those with cash.

Real estate is not a tech stock. It won’t crash in value in the space of a few months. This Spring a ton of owners – afraid they missed the peak – will list their homes and, being the greedy people they are, try for top dollar. That happens in March. If they have not sold in 90 days, they might reduce the price by 10%. That takes us to July, just when the BoCanada raises rates for the first time. If no offers materialize, they might drop prices again after another three months, and now it’s October.

At that point – nine months distant – sale prices will drop below list prices as inventory accumulates and buyers melt away.

There’s a reason I’ve not said on this blog real estate will crash. It won’t. Get a grip. But this is the top.  The road ahead belongs to the realistic.

 Below is a very informative graph on Canadian housing compared to American. It’s worth taking the time to study it. It shows how the U.S. bubble has corrected and how Canadian real estate is in a much higher bubble. Remember, bubbles burst.

But it’s often worth having a second set of eyes look at something. Especially experienced ones. So here is the scoop on Canada’s housing market, from some USA analysts:

• For the first time ever, house prices in Canada are double those in America.

• The average Canadian house is now overvalued by $71,000.

• Canadians are paying an average of 27% more for a home than it’s worth.

• Once the bubble bursts, prices will not recover until 2016.

This comes from Freddy Hutter, of the analytical chart-based web site TrendLines, who writes me: “Hi Garth. I  understand that u have been having problems with officaldom taking heed of your housing bubble warnings for almost four years.  I know what it feels like.  I was a voice in the wilderness in 1989!”

The fuzzy but informative graph above gives Hutter’s  vision of the US and Canadian markets, showing the while houses here are $70,000 too frothy, in the States they are now $15,000 too cheap. It certainly supports the argument made here recently for Sell Canada, Buy USA if you are into cross-border real estate arbitrage.

Hutter also echoes what we’ve been saying about CMHC, the government agency that by insuring loans makes our lenders reckless. Average downpayments shouldn’t be 5%, we’re told, but rather 10%, “until the downside risk dissipates.”

“This recommended action may be difficult in an environment where economists for four of Canada’s largest banks have been unequivocal in recent weeks that “there is no real estate bubble in Canada”.  We heard their same rationalizations in 1989 & from their counterparts south of the 49th in 2005!  Both events posed an assault on the Disposable Income of consumers, and wealth effect ramifications resulted in imminent Recessions within twenty-four months.  As elaborated in our Canadian Recession Meter, failure by the Bank of Canada & CMHC to address a winding down of the Housing Bubble could easily turn the expected 2012 economic downturn into a full fledged Recession.”

By the way, the average US home prices has dropped by 22% from its bubble peak. Hutter says we are 27% too expensive.

If you are unaware of what happened in Miami or Vegas, Phoenix or SoCal, now’s the time to find out. Especially if you live in Vancouver or Kelowna, Calgary or Toronto. – Garth Turner – Boffo 7, Bubble 1, March 26, 2010

More Garth Turner Financial Advice

First, avoid taxes. Stuff money into RRSPs and collect the massive deduction that goes along with that. Slide all your investment assets inside the shelter of a TFSA so you avoid paying any more. Make your mortgage tax-deductible by selling assets, paying off the home loan, then re-borrowing to buy the portfolio back. Stop collecting interest and start paying 80% less tax with the same amount of dividend income. Create a tax-free pension using universal life. Use the homebuyer’s plan to leverage up a down payment with tax money. Income split with your kids and recycle capital gains to them with a tax-free savings account. Use leverage to get money out of a RRIF free of tax.

All of those strategies are in my latest book, and if you don’t know how they work, find out.

Second, prepare for a property tax storm and a service drought. The worst may be a few years away, but that makes it no less inevitable. Pay close attention to the taxes on any real estate you consider buying, then ask yourself if you could afford to pay 50% more. Also realize what that might do to property values, especially in cities where homeowners are already nailed.

Gerold Comment – I’m about a third of the way through Turner’s book “Money Road.” I highly recommend it for financial advice. He knows what he’s talking about. You can order it from his website

http://www.greaterfool.ca/

In Closing

     Have you ever wondered how I got to be such a sceptic? It was easy although it took some time. 22 years ago, I threw away my TV. I got tired of yelling at it. Plus it insulted my intelligence. So I threw away the boob tube and got a life and started to read a lot more.

     The trouble with TV is it doesn’t let you think. It’s a constant stream of sights and sounds. It’s active and I’m passive. I just sit there and take it all in. So, Adios TV.

     Now I get most of my information from print – newsletters, newspapers, magazines and tons of stuff online. The good thing about reading is I can stop and think, I can go back and reread, I can read faster or slower or skip sections. I’m more in control of the flow of information but most important I have time to think about what I’m reading. In other words there’s time for my bullshit detector to sound off. Scepticism grows through questioning and doubting and approaching new information with an open mind. All it takes is time. And, no TV.

    By the way, I appreciate the feedback I’ve received the last few years about these commentaries and thanks to those who send me new sources of information. It’s amazing how much gold you find among the garbage.

Stay tuned. It gets more interesting. There’s a very interesting perspective below.

Gerold

The Quiet Coup

http://www.theatlantic.com/doc/200905/imf-advice/4

May 2009 Atlantic

The crash has laid bare many unpleasant truths about the United States. One of the most alarming says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

by Simon Johnson 

One thing you learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you. Typically, your “clients” come in only after private capital has abandoned them, after regional trading-bloc partners have been unable to throw a strong enough lifeline, after last-ditch attempts to borrow from powerful friends like China or the European Union have fallen through. You’re never at the top of anyone’s dance card.

The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear. I should know; I pressed painful changes on many foreign officials during my time there as chief economist in 2007 and 2008. And I felt the effects of IMF pressure, at least indirectly, when I worked with governments in Eastern Europe as they struggled after 1989, and with the private sector in Asia and Latin America during the crises of the late 1990s and early 2000s. Over that time, from every vantage point, I saw firsthand the steady flow of officials—from Ukraine, Russia, Thailand, Indonesia, South Korea, and elsewhere—trudging to the fund when circumstances were dire and all else had failed.

Every crisis is different, of course. Ukraine faced hyperinflation in 1994; Russia desperately needed help when its short-term-debt rollover scheme exploded in the summer of 1998; the Indonesian rupiah plunged in 1997, nearly leveling the corporate economy; that same year, South Korea’s 30-year economic miracle ground to a halt when foreign banks suddenly refused to extend new credit.

But I must tell you, to IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out.

No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis.

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise.

In Russia, for instance, the private sector is now in serious trouble because, over the past five years or so, it borrowed at least $490 billion from global banks and investors on the assumption that the country’s energy sector could support a permanent increase in consumption throughout the economy. As Russia’s oligarchs spent this capital, acquiring other companies and embarking on ambitious investment plans that generated jobs, their importance to the political elite increased. Growing political support meant better access to lucrative contracts, tax breaks, and subsidies. And foreign investors could not have been more pleased; all other things being equal, they prefer to lend money to people who have the implicit backing of their national governments, even if that backing gives off the faint whiff of corruption.

But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.

The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Eventually, as the oligarchs in Putin’s Russia now realize, some within the elite have to lose out before recovery can begin. It’s a game of musical chairs: there just aren’t enough currency reserves to take care of everyone, and the government cannot afford to take over private-sector debt completely.

So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet. The fund will give even a country like Russia a loan eventually, but first it wants to make sure Prime Minister Putin is ready, willing, and able to be tough on some of his friends. If he is not ready to throw former pals to the wolves, the fund can wait. And when he is ready, the fund is happy to make helpful suggestions—particularly with regard to wresting control of the banking system from the hands of the most incompetent and avaricious “entrepreneurs.”

Of course, Putin’s ex-friends will fight back. They’ll mobilize allies, work the system, and put pressure on other parts of the government to get additional subsidies. In extreme cases, they’ll even try subversion—including calling up their contacts in the American foreign-policy establishment, as the Ukrainians did with some success in the late 1990s.

Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. The real fight in Thailand and Indonesia in 1997 was about which powerful families would lose their banks. In Thailand, it was handled relatively smoothly. In Indonesia, it led to the fall of President Suharto and economic chaos.

From long years of experience, the IMF staff knows its program will succeed—stabilizing the economy and enabling growth—only if at least some of the powerful oligarchs who did so much to create the underlying problems take a hit. This is the problem of all emerging markets.

Becoming a Banana Republic

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

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

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.

Of course, the U.S. is unique. And just as we have the world’s most advanced economy, military, and technology, we also have its most advanced oligarchy.

In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts. Although lobbying and campaign contributions certainly play major roles in the American political system, old-fashioned corruption—envelopes stuffed with $100 bills—is probably a sideshow today, Jack Abramoff notwithstanding.

Instead, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W. Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to PIMCO, perhaps the biggest player in international bond markets.

These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service.

Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. Throughout my time at the IMF, I was struck by the easy access of leading financiers to the highest U.S. government officials, and the interweaving of the two career tracks. I vividly remember a meeting in early 2008—attended by top policy makers from a handful of rich countries—at which the chair casually proclaimed, to the room’s general approval, that the best preparation for becoming a central-bank governor was to work first as an investment banker.

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance.

As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large. Works like Barbarians at the Gate, Wall Street, and Bonfire of the Vanities—all intended as cautionary tales—served only to increase Wall Street’s mystique. Michael Lewis noted in Portfolio last year that when he wrote Liar’s Poker, an insider’s account of the financial industry, in 1989, he had hoped the book might provoke outrage at Wall Street’s hubris and excess. Instead, he found himself “knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share. … They’d read my book as a how-to manual.” Even Wall Street’s criminals, like Michael Milken and Ivan Boesky, became larger than life. In a society that celebrates the idea of making money, it was easy to infer that the interests of the financial sector were the same as the interests of the country—and that the winners in the financial sector knew better what was good for America than did the career civil servants in Washington. Faith in free financial markets grew into conventional wisdom—trumpeted on the editorial pages of The Wall Street Journal and on the floor of Congress.

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

America’s Oligarchs and the Financial Crisis

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

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

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

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

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

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

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

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

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

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

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

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

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Two Paths

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

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

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

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

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

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

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

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

The Quiet Coup

http://www.theatlantic.com/doc/200905/imf-advice/4

May 2009 Atlantic

The crash has laid bare many unpleasant truths about the United States. One of the most alarming says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time. 

by Simon Johnson 

One thing you learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you. Typically, your “clients” come in only after private capital has abandoned them, after regional trading-bloc partners have been unable to throw a strong enough lifeline, after last-ditch attempts to borrow from powerful friends like China or the European Union have fallen through. You’re never at the top of anyone’s dance card.

The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear. I should know; I pressed painful changes on many foreign officials during my time there as chief economist in 2007 and 2008. And I felt the effects of IMF pressure, at least indirectly, when I worked with governments in Eastern Europe as they struggled after 1989, and with the private sector in Asia and Latin America during the crises of the late 1990s and early 2000s. Over that time, from every vantage point, I saw firsthand the steady flow of officials—from Ukraine, Russia, Thailand, Indonesia, South Korea, and elsewhere—trudging to the fund when circumstances were dire and all else had failed.

Every crisis is different, of course. Ukraine faced hyperinflation in 1994; Russia desperately needed help when its short-term-debt rollover scheme exploded in the summer of 1998; the Indonesian rupiah plunged in 1997, nearly leveling the corporate economy; that same year, South Korea’s 30-year economic miracle ground to a halt when foreign banks suddenly refused to extend new credit.

But I must tell you, to IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out.

No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis.

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise.

In Russia, for instance, the private sector is now in serious trouble because, over the past five years or so, it borrowed at least $490 billion from global banks and investors on the assumption that the country’s energy sector could support a permanent increase in consumption throughout the economy. As Russia’s oligarchs spent this capital, acquiring other companies and embarking on ambitious investment plans that generated jobs, their importance to the political elite increased. Growing political support meant better access to lucrative contracts, tax breaks, and subsidies. And foreign investors could not have been more pleased; all other things being equal, they prefer to lend money to people who have the implicit backing of their national governments, even if that backing gives off the faint whiff of corruption.

But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.

The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Eventually, as the oligarchs in Putin’s Russia now realize, some within the elite have to lose out before recovery can begin. It’s a game of musical chairs: there just aren’t enough currency reserves to take care of everyone, and the government cannot afford to take over private-sector debt completely.

So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet. The fund will give even a country like Russia a loan eventually, but first it wants to make sure Prime Minister Putin is ready, willing, and able to be tough on some of his friends. If he is not ready to throw former pals to the wolves, the fund can wait. And when he is ready, the fund is happy to make helpful suggestions—particularly with regard to wresting control of the banking system from the hands of the most incompetent and avaricious “entrepreneurs.”

Of course, Putin’s ex-friends will fight back. They’ll mobilize allies, work the system, and put pressure on other parts of the government to get additional subsidies. In extreme cases, they’ll even try subversion—including calling up their contacts in the American foreign-policy establishment, as the Ukrainians did with some success in the late 1990s.

Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. The real fight in Thailand and Indonesia in 1997 was about which powerful families would lose their banks. In Thailand, it was handled relatively smoothly. In Indonesia, it led to the fall of President Suharto and economic chaos.

From long years of experience, the IMF staff knows its program will succeed—stabilizing the economy and enabling growth—only if at least some of the powerful oligarchs who did so much to create the underlying problems take a hit. This is the problem of all emerging markets.

Becoming a Banana Republic

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

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

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.

Of course, the U.S. is unique. And just as we have the world’s most advanced economy, military, and technology, we also have its most advanced oligarchy.

In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts. Although lobbying and campaign contributions certainly play major roles in the American political system, old-fashioned corruption—envelopes stuffed with $100 bills—is probably a sideshow today, Jack Abramoff notwithstanding.

Instead, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W. Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to PIMCO, perhaps the biggest player in international bond markets.

These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service.

Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. Throughout my time at the IMF, I was struck by the easy access of leading financiers to the highest U.S. government officials, and the interweaving of the two career tracks. I vividly remember a meeting in early 2008—attended by top policy makers from a handful of rich countries—at which the chair casually proclaimed, to the room’s general approval, that the best preparation for becoming a central-bank governor was to work first as an investment banker.

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance.

As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large. Works like Barbarians at the Gate, Wall Street, and Bonfire of the Vanities—all intended as cautionary tales—served only to increase Wall Street’s mystique. Michael Lewis noted in Portfolio last year that when he wrote Liar’s Poker, an insider’s account of the financial industry, in 1989, he had hoped the book might provoke outrage at Wall Street’s hubris and excess. Instead, he found himself “knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share. … They’d read my book as a how-to manual.” Even Wall Street’s criminals, like Michael Milken and Ivan Boesky, became larger than life. In a society that celebrates the idea of making money, it was easy to infer that the interests of the financial sector were the same as the interests of the country—and that the winners in the financial sector knew better what was good for America than did the career civil servants in Washington. Faith in free financial markets grew into conventional wisdom—trumpeted on the editorial pages of The Wall Street Journal and on the floor of Congress.

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

America’s Oligarchs and the Financial Crisis

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

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

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

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

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

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

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

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

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

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

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

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

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Two Paths

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

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

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

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

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

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

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

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.
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Disclaimer: I’m not an investment advisor and these articles are for commentary only. For specific advice you should consult your own investment professional.

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