We featured a story by a former chief economist of the IMF that we consider one of the best (if not the best) about the credit crisis and political economy in general. Here is a summary and an update co-authored by the same person, Simon Johnson. The dire consequences predicted seem a bit overblown though, simply because the chosen solution (virtually unlimited money creation) is a powerful one as well.

“The crash has laid bare many unpleasant truths about the United States. One of the most alarming is that the finance industry has effectively captured our government”, says Simon Johnson, a chief economist with the International Monetary Fund in 2007 and 2008. In an article entitled “The Quiet Coup” in the May, 2009 issue of the Atlantic magazine he (with James Kwak) goes on to say that “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”.

How true! America is in financial crisis but instead of the financial oligarchy being broken up to permit essential reform they are continuing to use their influence to prevent precisely the sorts of reforms that are needed immediately to pull the economy out of its nosedive. Unfortunately, our legislators seem unwilling to act against these powerful financiers opting instead to succumb to their power and influence and continue to give them what they deem to be in their best interest instead of that of the taxpayers’. All this is happening because of the false belief by all concerned that large financial institutions and free-flowing capital markets are crucial to America’s position in the world and that whatever the banks say is true and what they want is necessary.

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. There is no better time to take such action than now but it is evident that reform is but a pipe dream. America’s financial oligarchy is still in control and, as such, the long-term consequences will be dire!

The Powerful Elites have Over-reached

Johnson says that (and I paraphrase an edited version of ‘The Quiet Coup’ article in the following pages) typically countries in crisis are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. That certainly is the case with the powerful elites – the financial oligarchy – in America. In the case of the U.S. economic and financial crisis, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. That fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay and this weakness in the banking system quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

Financial Industry has Gained Political Power

The American financial industry gained political power over the years by amassing a kind of cultural capital, a belief system in which Washington insiders believe that large financial institutions and free-flowing capital markets are crucial to America’s position in the world … and always and utterly convinced that whatever the banks said was true.

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.

As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large. 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.

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

While many other factors contributed to the financial crisis that exploded last year, including excessive borrowing by households and lax lending standards, 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. 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. (See the article I wrote entitled “Our Worst Nightmare: The Puncture of the U.S Housing Bubble” back in early 2006 for a detailed account on just how such loans were handled.)

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.

When the crisis first began the government was slow to react and then did so with a lack of transparency, and an unwillingness to upset the financial sector. The response so far is perhaps best described as “policy by deal” in that when a major financial institution got into trouble, the Treasury Department and the Federal Reserve engineered a one-of bailout and then announced that everything is fine without stating what combination of interests were being served, and how. 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. This velvet-glove approach 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.

The Way Out

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 actually 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 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. (See reference to the new mark-to-market legislation below as a case in point.)

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: 1) nationalize the banks, 2) limit individual bank size, 3) update antitrust legislation, 4) cap executive compensation, 5) improve banking regulations, 6) increase taxation, 7) increase transparency and 8) increase competition.

(Regretfully, none of the above remedies are going to happen any time soon, if ever. Take a look at what happened just last week on April 2, 2009. The financial oligarchy’s lobby group, the American Bankers Association, was successful in having political pressure brought to bear, by legislators from both parties, against the Financial Accounting Standards Board to do their bidding which now gives banks more discretion in reporting the value of mortgage securities. These new mark-to-market rules will enable all financial institutions with such securities to report higher profits by assuming that the securities are worth more than anyone now is prepared to pay for them i.e. avoid recognizing losses from bad loans that they had made. As a result of having their way the financial institutions affected are now free to apply the new rules to their financial statements for the quarter that ended on March 31^st. How convenient!)

If no remedies are going to be initiated what does the future hold. According to Johnson it includes a global economy continuing to deteriorate and the collapse of the banking system in east-central Europe and then throughout the Continent This dramatic worsening of the global environment would force the U.S. economy, already staggering, down onto both knees and perhaps then, under this kind of pressure, and faced with the prospect of a national and global collapse, the American people will demand in no uncertain terms that their government finally break up the financial oligarchy and implement the abovementioned reforms.

Unfortunately, Johnson concludes, 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. There is no better time to take such action than now but it is evident that reform is but a pipe dream. America’s financial oligarchy is firmly in control and, as such, the long-term consequences will be dire!