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American Oligarchy

Don’t expect real reform from the Wall Street Democrats.

May 10, 2010, Vol. 15, No. 32 • By CHRISTOPHER CALDWELL
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This is a terrifying truth, if you think about it. It means that you cannot take for granted that “once burned, twice shy” will describe the aftermath of an oligarchy-driven financial crisis. Serious reform is not inevitable. On the contrary: The “reforms” that follow a bubble-binge-bailout cycle tend to consolidate the privileges of the oligarchs who caused it. That is why the IMF tends to judge the good faith of a country seeking debt relief by whether it is willing to “squeeze at least some of its oligarchs,” in Johnson’s words. Back in the day when the United States was on its moral high horse, our bankers and government officials derided the fledgling market economies of Southeast Asia and Eastern Europe as havens of “crony capitalism.” We demanded not just the squeezing of oligarchs but the squeezing of government. Freewheeling monetary policy and write-downs were anathema. Discipline was the order of the day.

When our own day of reckoning came, though, we behaved less responsibly than the governments we used to lecture. There are two ways that a government can fix industries that have gone bankrupt: It can take them over or it can bail them out. We are bailing them out. Treasury Secretary Hank Paulson sat his capital-starved former colleagues down at a table in October 2008 and told them to accept $25 billion apiece from the government, with few strings attached, or else. Cash infusions of that order were necessary to stop a contagion of bank failures. But reforms were necessary, too, to ensure that the crash did not repeat itself. And no reforms came.

Without reforms, Johnson shows, bailouts exacerbate many of the problems they were meant to fix. U.S. banks were rescued in such a way that, as he and Kwak put it, “taxpayer money could pass straight through to bankers’ Ferraris and vacation homes in the Hamptons.” Bailouts create a moral hazard—a country that rescues banks once is more likely to have to do so again. And this likelihood gets priced into the operating expenses of the surviving banks. The financial behemoths pay 0.78 percentage points less for money than small banks. To tolerate banks deemed too big to fail is to subsidize them. 

What Johnson thinks we should have done is take those banks over—“nationalize” them, if you like—and put the banks’ overvalued assets on the government’s books, where we could wait patiently to sell them, making depositors whole but letting shareholders take the loss. Then we should have broken them up, on grounds similar to the ones Theodore Roosevelt used for breaking up big industrial trusts, to ensure that none of them was too big to fail. “A central pillar of  …  reform must be breaking up the megabanks,” Johnson and Kwak write. They would limit assets to 2 percent of GDP (about $285 million) for investment banks and 4 percent for all banks (roughly what Bank of America, Chase Manhattan, Citibank, and NationsBank each had in the mid-1990s). Some people think that large banks provide economies of scale. Johnson and Kwak think the evidence is mixed. The evidence of the problems that big banks can cause, however, is now unambiguous.

How did America’s bankers go from being just a bunch of fairly rich people to the untouchable “captains of the financial sector” whose interests get placed above those of the general public? The near-collapse of the U.S. financial system has already been recounted at book length dozens of times. At a basic level, we all know what happened, starting around the mid-1970s: The profession of banking became more varied, complex, and opaque, and as it did, government deregulated and misregulated. Wall Street’s consolidation of power in Washington came about largely through the dismantling of regulations that had prevented it. 

The Calvary of structured finance has familiar stations of the cross: Orange County’s loss of $2 billion on the derivatives called “inverse floaters” (1994), the near-meltdown of the global economy due to the overenthusiastic use of the Black-Scholes option-pricing formula at the hedge fund Long Term Capital Management (1998), and the cost-shifting accounting trickery at Enron (2002), which later proved as useful in designing a government health care plan as it had in running an oil-futures racket.

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