Simon Johnson: The financial community's quiet coup

Simon Johnson today writes in the Atlantic an interesting article (HT Felix Salmon). It starts off with a description of the typical country that looks to the IMF for assistance. Being a former chief economist for the IMF, he should know: 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.

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.

Johnson’s main point in the article is that the US response to its current crisis situation is indistinguishable from the typical emerging economy country that has sought IMF assistance. In place of the traditional crony oligarchs of the emerging economy, just insert “the financial community”. In the last three decades, the US financial community has grown tremendously in power, and has been perceived to be successful in lobbying the government for bailouts and massive subsidies, just as the problems they are now in are due to their own over-reaching. In the end, it is the taxpayers who pay, the very people who never participated in the gains. So what is Simon Johnson’s prescription?

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.

Of course, for this prescription to be followed, you would have to assume that the US is not yet a fully-evolved banana republic, and that its oligarchs – the financial community - are not yet so fully entrenched. If they already are, to the extent oligarchs are in emerging economies, then the propagation of their power is paramount to the continuity of incumbent political power.

In emerging economies, it is common to find oligarchs fully entrenched in the capitalization of the country’s most key natural resources, or they have cornered a monopoly on a staple franchise in the economy, that shrinking the oligarch’s influence is tantamount to shrinking economic activity. And since they tend to be key political kingpins, sitting politicians typically owe their positions to their alliances with the oligarchs.

So ask yourself this: Is this now the case with the financial community in the US? If it is, then the nationalization prescription won’t be followed, in Johnson’s words “at least until the riots grow too large”.

Update: Dani Rodrik responds to Simon Johnson.