"Now, the Senate Republican leader, he paid a visit to Wall Street a week or two ago,” said President Obama at a California fundraiser for Barbara Boxer in mid-April, putting on a mocking, homespun voice. “He took along the chairman of their campaign committee. He met with some of the movers and shakers up there. I don’t know exactly what was discussed. All I can tell you is when he came back, he promptly announced he would oppose the financial regulatory reform.”
To judge from the guffawing that followed, few in attendance realized that Obama is more dependent on “movers and shakers” in the financial sector than any president of our time, although the files of the Federal Election Commission make this clear as day. The movers at Goldman Sachs, whose top employees were grilled before the Senate Banking Committe last week, gave Obama’s party three times as much money in the last cycle ($4.5 million) as they gave to Mitch McConnell’s ($1.5 million). The shakers at Citicorp gave Democrats almost twice as much ($3.1 million) as they gave Republicans ($1.8 million).
So every time the president accuses Republicans of trying to “block progress” or of defying “common sense,” as he did that night, he is executing a dangerous tightrope walk. His party’s electoral fortunes depend on his making forceful calls for reform of our banking laws. His party’s fundraising fortunes depend on his ensuring that no serious reform—of the kind that endangers the big banks’ size and power—ever happens. That may be why the Democrats’ strategy of painting the Republicans as obstructionists on finance reform has gained little traction. By the same token, if Republicans ever did get serious about reforming the banks—and even about breaking up an industry that has turned into a Democratic war chest—they would put Democrats in mortal peril. There seems no chance of this. Obama’s taunts show a confidence, verging on certitude, that Republicans’ hypocrisy is as deep as his own.
What does it mean, the inability or unwillingness of either party to change or discipline the big banks in any way, even after all the havoc they have lately caused? In the year and a half since the implosion of Lehman Brothers, Simon Johnson, who was the chief economist of the International Monetary Fund in 2007 and 2008, is the only person to have come up with a plausible explanation. He has done so by examining the United States as an IMF analyst would examine some bankrupt basket-case of a country in what used to be called the Third World. Johnson believes that the leaders of the American finance industry have turned into the sort of oligarchy more typical of the developing world, and that they have “captured” the government and its regulatory functions. Johnson laid out this bombshell thesis in the Atlantic a year ago.
There are many ways for countries to blunder their way into big economic trouble: Kleptocracy, capital flight, or a commodity-price crash can all spark a panic or collapse. Nevertheless, Johnson wrote, “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.” In a gripping new book, 13 Bankers (Pantheon, 304 pages, $26.95), written with his brother-in-law James Kwak, Johnson explains why those changes aren’t happening in the United States.
Most countries rescued by the IMF are marked by tight links between the business elite and the political elite. They are oligarchies. Johnson defines oligarchy as a system whereby economic power can be translated into political power (and vice versa). When you try to fix a country dominated by an oligarchy, you immediately hit a frustrating paradox: Rescue plans make the oligarchy more powerful. An IMF loan is a lifeline. Somebody has to decide which banks and industries get to use it, and which ones are set adrift. In this process, the cement company owned by the finance minister’s cousin does better than the cement company run by some schmuck in the hinterland. And it is not just that politically favored companies get the original infusion of IMF cash. Private investors can see what is going on and realize that it is “best to invest in the firms with the most political power (and hence the most assurance of being bailed out in a crisis).” So if the politically connected rich don’t pay, who does? “Most emerging-market governments,” according to Johnson, “look first to ordinary working folk—at least until the riots grow too large.”
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.
Other narratives weave in and out of this one. Bill Clinton’s claim that minorities were excluded from housing markets turned into a self-congratulatory crusade (under Clinton himself, but much more so under George W. Bush) to push loans on un-creditworthy poor people. The Gramm-Leach-Bliley Act of 1999 took the solemn and expensive guarantees provided to the savings of working families in the 1930s and extended them, willy-nilly, to the banking industry’s worst shysters. Plenty of economists and regulators saw what was coming. Akerlof and Romer warned about the “looting” of savings & loans in 1993 and were ignored. Brooksley Born of the Commodity Futures Trading Commission urged regulating off-exchange derivatives in 1998 through the Commodity Exchange Act. Congress opted instead to ban most regulation of derivatives.
Up to a point, Johnson and Kwak’s views of this history are conventional. Like a majority of economists, they find the economic policies of the George W. Bush administration poor, and even appalling. They leave aside the questionable judgments that leap out even at the non-economists among us—like cutting taxes while waging two wars, doubling the federal education budget, and adding a new Medicare entitlement. They focus more on countering claims that the past decade was a difficult one in which to formulate economic policy. Yes, they grant, China’s high propensity to save created huge flows of money that were hard to manage. But the job of banks is to allocate money efficiently, and under Bush the American system did a “phenomenally poor job” of it.
The real estate boom of the last decade would have been bad even if it had been sustainable. “The more money that flowed into new subdivisions in the desert,” Johnson and Kwak write, “the less flowed into new factories where Americans could go to work.” That is why growth was lower in the past decade than in any decade since the 1930s, and median incomes were falling steeply even before the crash of 2008. Even the worst speculative bubbles have left behind a good deal of useful physical infrastructure: canals, roads, railroads. This one left nothing. “What do we get out of the meta-financial crap?” Johnson asked in an interview with Salon last year.
It is notable then, that for all their criticism of George W. Bush’s economic policy, Johnson and Kwak do not hold him responsible for the bankers’ takeover of the levers of power. Nor do they blame Ronald Reagan. Either Republican president would have been sympathetic to a deregulatory agenda, but Reagan confronted a recalcitrant Democratic Congress, and by the time Bush took office, Washington had already been offered up to Wall Street. Johnson and Kwak place the establishment of an American oligarchy squarely in the administration of Bill Clinton. “One of history’s curiosities,” they write, “is that this shift happened within a Democratic administration, headed by a president elected largely because of middle-class economic insecurity.”
It was in the 1990s that regulatory agencies were delivered into the hands of people who had close personal relationships with the people they were regulating. The system persists to this day. For every Roger Altman who comes from Lower Manhattan to the executive branch, there is a Richard Gephardt who goes from Congress to Goldman Sachs. This pantouflage is usually defended on the grounds that structured finance has grown so complex that only participants, or former participants, in these markets can understand them well enough to regulate them.
Johnson and Kwak’s diagnosis is excellent. But using the terms of their own argument, they are wrong to see it as a “curiosity” that these changes came about during the Clinton administration. Ideologically, of course, Republicans have long been the party more amenable to financial deregulation—and that is an important consideration if you believe that democracy is functioning properly. If you believe it has degenerated into a kind of oligarchy, however, the important question becomes not the ideology of the respective parties but the allegiances of the oligarchs. What are the allegiances of our oligarchs? Which is their political party?
Johnson locates the oligarchy in the upper reaches of the investment banking profession. What he doesn’t note is that these are overwhelmingly Democratic. There is nothing “curious” about a president’s seeking to arm his most reliable supporters with political power. And when you look at it this way, the intermarriage of financial and executive branch elites could only have happened in the Clinton years, simply because there is not sufficient Republican manpower in New York’s investment banks to permit it. Robert Rubin, Larry Summers, Jon Corzine, Timothy Geithner … one could make no similar list of partisan Republicans who have made the trek from Wall Street to Washington. Josh Bolten, George W. Bush’s chief of staff, who came from Goldman Sachs, is one Republican exception. You might be tempted to list former Treasury Secretary Henry Paulson as another. But he is better thought of as the closest approximation to a Republican the investment banking world could offer up. His wife is one of Hillary Clinton’s oldest friends and most important fundraisers. In Paulson’s autobiography, On the Brink, he describes his family’s reaction to Bush’s offer of the Treasury post. His wife and son urged him not to take it. His mother wept.
That Democrats are the party of the oligarchy gets more, not less, obvious when you move beyond Wall Street. The cliché that Republicans are the rich people’s party makes a certain amount of common sense if you are just looking around your Middle American suburb. You will notice that the man making $200,000 a year is marginally more likely to vote Republican than his neighbor making $50,000. But in suburbia, the word “rich” is really a kind of slang, meaning “slightly better off.” Johnson isn’t talking about those people. He is talking about people who are rich-with-a-capital-R, the ones who can convert wealth into political power, the ones whose annual income is measured in millions, or tens of millions. Again, how do they vote, and who is their party?
We can formulate a guess by looking at the 20 ZIP codes that pour the most money into the political system. (See the chart on page 23.) This list coincides fairly well with any list of the 20 richest neighborhoods in the United States. All but one of those 20 neighborhoods give the majority of their money to Democrats. (The exception is McLean, Virginia, which gives 48 percent to Democrats.) Most of them give the overwhelming majority of their money to Democrats. For example, none of the 7 Manhattan neighborhoods listed—where we can assume Johnson’s oligarchs live—gives less than 71 percent of its money to Democrats.
That presents a challenge to the usual way of looking at things, doesn’t it? Republicans have been paying a high price in both public opinion and political coherence to defend the prerogatives of a class that despises them. It was to cosset just these people with tax cuts that George W. Bush destroyed the balanced budget. It would seem that Republicans are either an exceptionally idealistic political party (pursuing their ideology to the point of self-destruction) or an exceptionally foolish one (convinced that anyone with a great big pile of money is their friend). There may be another explanation. To paraphrase something Clinton aide David Dreyer said many years ago, Republicans have done Lord Acton one better—they’ve been corrupted by power they don’t even have.
No book on the meltdown will make you angrier than 13 Bankers. On the off-chance that it doesn’t make you as angry as you’d like to be, though, Johnson and Kwak also have an excellent blog, Baseline Scenario, that addresses some of these questions in a more heated way. Go there and you will find an interesting take on the present negotiations over financial regulatory reform. Democratic Senate Finance chairman Chris Dodd, in Johnson’s view, is not negotiating with Republicans in order to peel off one or two senators and get the toughest bill possible; he is aiming for the weakest possible bill that will be palatable to the public, and is negotiating in order to pin the blame for its weakness on Republicans.
The sympathies of Johnson and Kwak are with the left of the Democratic party, specifically with the SAFE Banking Act sponsored by Senators Sherrod Brown of Ohio and Ted Kaufman of Delaware. It would break up the big banks along a sensible formula similar to the one the authors suggest in their book. They have little hope that it will pass, however, even though there are potentially Republican votes for it. (Kentucky’s Jim Bunning backed it in committee.) Illinois senator Dick Durbin, a champion of modest banking reform, calls it “a bridge too far.” The SAFE Banking Act is a bridge too far because the fundraising needs of the Democratic caucus and the White House make it a bridge too far. Since the financial crisis began, the system of too-big-to-fail banks that caused it appears to have grown more entrenched.
But are the banks in fact too big to fail? Not necessarily. The banks are certainly too big to fail without destroying the economy. But that is not the same as saying they are too big to fail. The first duty of a sovereign public is to defend its sovereignty, not to prop up its banking system. The public is in a mood to risk cutting off its nose to spite its face. If voters are again offered a choice between bailouts and a likely second Great Depression, it is by no means certain they will choose the bailouts.
Christopher Caldwell is a senior editor of The Weekly Standard and author of Reflections on the Revolution in Europe: Immigration, Islam, and the West.