Wednesday, April 15, 2009

“The Quiet Coup” started in 1980

The estimable Martin Wolf’s very mildly critical piece on Simon Johnson’s “The Quiet Coup” article in The Atlantic propagates the misperception, in my view, that fixing the capital structures of the banks is going to reinvigorate lending.  As I've pointed out before, lending is slow and is likely to remain so because the economy is depressed.  As I read it, though, Wolf seems to be saying that the financial oligarchy in the U.S. is somehow more high-minded and bipartisan than that in Russia, to which Johnson compares the U.S.—while acknowledging  a resemblance to an emerging country. This seems to me a distinction without a difference.  In Russia they don’t have meaningful parties—and some would say, neither do we! 

Ronald Regan (or his shape-shifting persona) initiated three trends in 1980:  bust the federal budget, run up massive deficits and blame it on Congress; deregulate the financial markets so tricksters waving copies of papers by Merton and Miller could make billions leveraging up the corporations; and banks could soak the lower classes striving to keep up with subprime loans; then, with bipartisan support, repeal Glass-Steagall so the financial tricksters could add a bevy of stupid banks, insurance companies, and international investors to the class of suckers to whom they sold AAA securitized, magically transmuted subprime debt; and then create an off-the-books casino of side bets on the above, the infamous credit default swaps, and let anyone sell them whether they could honor them or not, because everyone knew “real estate prices never fall”; and of course, as the capstone, lower tax rates on the most highly compensated Americans as Wall Street was extracting gobs of wealth from ordinary Americans, with special treatment for employees of hedge funds.  Cover this all with a veneer of phony Christianity and free market capitalism, with a wink and a nod, and you’ve got a quiet coup.  American-style.  The Russians could never do this.

Wolf states correctly that a significant portion of recent growth was merely debt being converted to GDP that got at least a year or two ahead of true trend growth.  He correctly states that having financial institutions too big to fail is socialism (he might have chanted, “privatization of gains, socialization of losses”).  But he conveys, to me, at least, the impression that fixing the banks is somehow necessary to stimulate the economy.  The banks can continue to lend if insolvent if the feds tell them they can, it’s fiat money; the problem is credit demand. 

Using inclusive measures of unemployment the number of unemployed or seriously underemployed (and probably working poor) people in the country is over 20 million.  Only a small portion are covered by unemployment insurance, and most probably don’t have health insurance.  The safety net is full of holes.  This is barbaric.  If the federal government wants to instill confidence in the United States of America, fixing the banks is not the place to start.  Giving people a helping hand, giving them a poverty level dole while they’re looking for a new job, one created by the private economy and not by a wasteful and probably corruptly awarded government contract (“use it or lose it” is not the way to go here), is in my humble opinion the best way to prop up aggregate demand and instill confidence in the social contract in America.  The bad banks will ultimately have to fail, but fixing them does nothing to prop up aggregate demand—and bailouts are literally wasting tax dollars that would enter spending one-for-one if spent on a viable safety net.  This is principles level economics, and yet the well-heeled debaters never seem to see those below….  (Watch Titanic again, it’s so brilliant—and that Hollywood screwed James Cameron on it is bitterly appropriate.)

Is America the new Russia?

By Martin Wolf

Published: April 14 2009 21:47 | Last updated: April 14 2009 21:47

Is the US Russia? The question seems provocative, if not outrageous. Yet the person asking it is Simon Johnson, former chief economist at the International Monetary Fund and a professor at the Sloan School of Management at the Massachusetts Institute of Technology. In an article in the May issue of the Atlantic Monthly, Prof Johnson compares the hold of the “financial oligarchy” over US policy with that of business elites in emerging countries. Do such comparisons make sense? The answer is Yes, but only up to a point.

“In its depth and suddenness,” argues Prof Johnson, “the US economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets.” The similarity is evident: large inflows of foreign capital; torrid credit growth; excessive leverage; bubbles in asset prices, particularly property; and, finally, asset-price collapses and financial catastrophe.

“But,” adds Prof Johnson, “there’s a deeper and more disturbing similarity: elite business interests – financiers, in the case of the US – played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.” Moreover, “the great wealth that the financial sector created and concentrated gave bankers enormous political weight.”

Now, argues Prof Johnson, the weight of the financial sector is preventing resolution of the crisis. Banks “do not want to recognise the full extent of their losses, because that would likely expose them as insolvent ... This behaviour is corrosive: unhealthy banks either do not 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 cycle.”

Does such an analysis make sense? This is a question I thought about during my recent three-month stay in New York and visits to Washington, DC, now capital of global finance. It is why Prof Johnson’s analysis is so important.

Unquestionably, we have witnessed a massive rise in the significance of the financial sector. In 2002, the sector generated an astonishing 41 per cent of US domestic corporate profits (see chart). In 2008, US private indebtedness reached 295 per cent of gross domestic product, a record, up from 112 per cent in 1976, while financial sector debt reached 121 per cent of GDP in 2008. Average pay in the sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007.

In recent research, Thomas Philippon of New York University’s Stern School of Business and Ariell Reshef of the University of Virginia conclude that the financial sector was a high-skill, high-wage industry between 1909 and 1933. It then went into relative decline until 1980, whereupon it again started to be a high-skill, high-wage sector.* They conclude that the prime cause was deregulation, which “unleashes creativity and innovation and increases demand for skilled workers”.

Deregulation also generates growth of credit, the raw stuff the financial sector creates and on which it feeds. Transmutation of credit into income is why the profitability of the financial system can be illusory. Equally, the expansion of the financial sector will reverse, at least within the US: credit growth and leverage masked low or even non-existent profitability of much activity, which will disappear, and part of the debt must also be liquidated. The golden age of Wall Street is over: the return of regulation is cause and consequence of this shift.

Yet Prof Johnson makes a stronger point than this. He argues that the refusal of powerful institutions to admit losses – aided and abetted by a government in thrall to the “money-changers” – may make it impossible to escape from the crisis. Moreover, since the US enjoys the privilege of being able to borrow in its own currency it is far easier for it than for mere emerging economies to paper over cracks, turning crisis into long-term economic malaise. So we have witnessed a series of improvisations or “deals” whose underlying aim is to rescue as much of the financial system as possible in as generous a way as policymakers think they can get away with.

I agree with the critique of the policies adopted so far. In the debate on the Financial Times’s economists’ forum on Treasury secretary Tim Geithner’s “public/private investment partnership”, the critics are right: if it works, it is because it is a non-transparent way of transferring taxpayer wealth to banks. But it is unlikely to fill the capital hole that the markets are, at present, ignoring, as Michael Pomerleano argues. Nor am I persuaded that the “stress tests” of bank capital under way will lead to action that fills the capital hole.

Yet do these weaknesses make the US into Russia? No. In many emerging economies corruption is egregious and overt. In the US, influence comes as much from a system of beliefs as from lobbying (although the latter was not absent). What was good for Wall Street was deemed good for the world. The result was a bipartisan programme of ill-designed deregulation for the US and, given its influence, the world.

Moreover, the belief that Wall Street needs to be preserved largely as it is now is mainly a consequence of fear. The view that large and complex financial institutions are too big to fail may be wrong. But it is easy to understand why intelligent policymakers shrink from testing it. At the same time, politicians fear a public backlash against large infusions of public capital. So, like Japan, the US is caught between the elite’s fear of bankruptcy and the public’s loathing of bail-outs. This is a more complex phenomenon than the “quiet coup” Prof Johnson describes.

Yet decisive restructuring is indeed necessary. This is not because returning the economy to the debt-fuelled growth of recent years is either feasible or desirable. But two things must be achieved: first, the core financial institutions must become credibly solvent; and, second, no profit-seeking private institution can remain too big to fail. That is not capitalism, but socialism. That is one of the points on which the right and the left agree. They are right. Bankruptcy – and so losses for unsecured creditors – must be a part of any durable solution. Without that change, the resolution of this crisis can only be the harbinger of the next.

*Wages and Human Capital in the US Financial Industry 1909-2006, January 2009,

US financial sector


  1. Great Post, Love your blog.

    I usually agree with Wolf, but he's dead wrong here, Simon Johnson has it completely right.

  2. Thanks. I recommend the sites I follow for daily news that I don't have the time to cover. Mish and Calculated Risk are the best for hard news.

  3. Thanks, been following CalcRisk since 2007, will add Mish to the reading list.

  4. You should add Zero Hedge to your reading list as well.
    Tyler is doing some outstanding work over there.