-- John Maggs, NationalJournal.com

First, we have to recognize that a vast majority of the mainstream economics profession either actively or passively believed in financial innovation as a good thing.  Some of this was intimidation and peer pressure, but most of this was genuine.  There were critics (Rajan, Stiglitz...) and most did not quite go as far along as the Rubin and Greenspan crowd did.  But it was sincere, and it was part of an overall climate of market dominance.  This was MISTAKEN.  I made some of those mistakes in my own thinking and writing.  And it was exploited by opportunists in the financial sector.  Ultimately, we have to recognize the intellectual failure's role and correct that.

Second, as Nicolas kindly cites, I would argue that capture and cronyism is in part a function of government centralization.  While centralization is not a sufficient condition to prevent corruption (far from it), having a more permeable and localized government in a federalist system offers more opportunities for local capture by particular interests.  In short, the US was more susceptible to this sort of thing than the UK or Spain or Ireland, which had bubbles and busts but not cronyism to the same degree.  Ultimately, we have to recognize that strong government matters.

So to me the implication for policy of the intellectual failure and the government weakness, along with the trend Simon raised, is to move to a more centralized rules-based system for supervising financial markets.  That does not mean give the Fed total control.  If anything, it says the Fed's discretion in this area has to be severely curtailed, given the way Greenspan and those working for him abused it.  But move towards a 'precautionary principle' on financial regulation and have one authority enforcing it bluntly, without worrying too much about niceties, and without ability to make judgment calls.

 Johnson rightly worries that Wall Street firms whose behavior helped bring on the crisis are now working round the clock to prevent changes that would help restore the financial system to long-term health. While the U.S. bank “oligarchs” are happy to accept government aid if it will bring their institutions back to profitability, they single-mindedly oppose steps that have been applied in other financial crises to bring the economy back to life. Simon Johnson has no doubt about the proper course of action. It is to “… nationalize troubled banks and break them up as necessary.” He is also frank in acknowledging the price tag -- $1.5 trillion, or 10 percent of U.S. GDP. This is only step #1, however. The second step is to break the economic and political power of the financial oligarchs.  In a future economic recovery financial institutions cannot be allowed to take on risks that endanger the broader economy. Johnson is sensible to worry that financial institutions will use their political influence to prevent or minimize meaningful reform.

Before proceeding to step #2, however, we should consider a bit more carefully whether it will be possible to take step #1. Although Johnson and a number other observers are confident that several major banks deserve immediate nationalization, I’m less certain nationalization is legally or politically feasible. The fifth amendment protects U.S. residents against uncompensated government seizure of their property: “.. nor shall any person be … deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.” This implies that for nationalization to legally occur the government must either satisfy itself a bank is insolvent or provide just compensation to the bank’s owners. As my colleague Douglas Elliott points out, demonstrating bank insolvency will not be easy and providing compensation to a bank’s owners will not be cheap [http://www.brookings.edu/papers/2009/0325_bank_nationalization_elliott.aspx and http://www.brookings.edu/papers/2009/0225_bank_nationalization_elliott.aspx]. 

Johnson and other critics may be right that a careful appraisal of bank assets would show that several big ones do not meet current tests for liquidity or capital adequacy. However, the government must develop good evidence that this is true if it does not want to set off panic in other banks and among investors who own bank stocks and bonds. The regulations covering banks are complicated. At the beginning of this year it appeared that the major banks were liquid and had adequate capital to satisfy their minimum capital requirements. Congress could change the laws under which capital adequacy is judged.  The takings clause of the fifth amendment means the government will have to be prepared to compensate bank equity and bondholders if courts later decide nationalization was unconstitutional. In resolving the savings and loan crisis in the late 1980s, the Congress took decisive action to redefine how S&L assets could be valued for purposes of assessing their solvency. The redefinition reduced the apparent solvency of many S&Ls. Federal courts later ruled the government owed substantial compensation to S&L owners whose institutions lost value as a result of the change in law.

The alternative to involuntary seizure is to buy a bank from its current owners. However, as Douglas Elliott argues, this could prove costly. If the transaction is voluntary, equity owners will demand a premium over the current market price of their shares. Bank bondholders will see an appreciation in the value of their bonds, because the government is likely to pay 100 cents on the dollar for bond principal and interest payments. In light of the current unpopularity of banks and bankers, it is hard to imagine Congress appropriating huge sums that would directly enrich bank officers, stock owners, and bondholders. In sum, cheap nationalization of a bank may be illegal and voluntary nationalization of the same bank would almost certainly be costly. More to the point, in the current environment voluntary nationalization is politically infeasible.

The plain fact is that bank nationalization requires political will and a lot of money. Until the Administration’s critics can show us the money, we may have to wait for a couple of big banks fail before bank nationalization becomes a live possibility.

Of course, very little of this is new. Machiavelli masterfully captured the oligarchy question's complexity when writing: "I maintain that those who blame the quarrels of the Senate and the people of Rome condemn that which was the very origin of liberty, and that they were probably more impressed by the cries and noise which these disturbances occasioned in the public places, than by the good effect which they produced; and that they do not consider that in every republic there are two parties, that of the nobles (i grandi) and that of the people; and all the laws that are favorable to liberty result from the opposition of these parties to each other, as may easily be seen from the events that occurred in Rome." (Discourses on Livy, First Book, Chapter 4, translation by Christian Detmold)

To expand on Johnson's story, three remarks are worth mentioning.

1. The U.S. has not one moneyed oligarchy, but several. Specifically during most of the presidency of George W. Bush, the financial community has been far from dominant in national political power structures. It has been noted that during the years in which President Bush pushed a radical policy agenda, and until well after the Katrina turning point in his popularity, financiers had been rather underrepresented in the administration, certainly when compared with the Clinton era. This situation was symbolized by the successive tenures of Paul O'Neill and John Snow, two non-financial business figures, at the head of the U.S. Treasury. This obviously changed in the spring of 2006 when Joshua Bolten replaced Andrew Card as presidential chief of staff, and other Goldman Sachs alumni including Paulson were appointed to a number of key positions. But the dominant oligarchy during most of the Bush years was made of non-financial CEOs and company owners, not Wall Street types.

2. The U.S. financial oligarchy is surprisingly meritocratic. This is attested by the modest social origins of most latter-days Wall Street titans: think of Sandy Weill, Chuck Prince, John Mack, Dick Grasso, Stan O'Neal, or Lloyd Blankfein. This echoes some other crony capitalism contexts - Russia comes to mind - but differs from others, such as many cases in Latin America, and is unusual in a country with as much recent political stability as America.

3. Even as Johnson argues that the US has "the world's most advanced oligarchy", it is arguably not the most entrenched, even among developed economies. America has so far been more willing to clamp down on its financial oligarchy than many European countries, and by some measures the gap is increasing as we advance through the crisis. In France, large financial firms exert dominant influence on the government's stance on financial reform. In Germany, both the finance minister and his state secretary for financial affairs have been involved in the governance of now-failed banks, respectively WestLB and IKB. In the UK, the current prime minister spent many years at the Treasury courting the favors of the financial industry. The European Commission has a track record of being generally less captured than individual member states (as analyzed in Adam Posen's insightful piece) but Charlie McCreevy's tenure as Commissioner in charge of financial services has lowered its moral ground.

4. Since the November elections, there is continued evidence that the U.S. Congress is at least partly captured by the financial oligarchy, such as the pressure it recently exerted on the Financial Accounting Standards Board to bend accounting standards and allow banks to further hide the bad news. But the jury is still out as regards the executive branch, and so far there are arguments to give the Obama team the benefit of the doubt. Specifically, the primary reason why the U.S. has not treated its banking sector as Sweden successfully did in 1992 is arguably not the Treasury's capture by the industry, but rather the lack of broad domestic political consensus, an indispensable condition to take a step as radical as nationalizing a significant number of banks. The key role played by bipartisan consensus in the Swedish crisis is well illustrated by Governor Bäckström's speech at Jackson Hole in 1997.

All this does not modify Johnson's harsh verdict, it only puts it into perspective. As to the policy prescriptions, I agree with the need to nationalize insolvent banks à la Sweden 1992, but am less sure that reducing the oligarchy's power should be an aim in itself; in any case it will not be sufficient. This makes me somewhat skeptical of the proposal to practically put a cap on the size of financial service firms. In other words, I fail to be convinced that the U.S. needs to arbitrarily detain its Mikhail Khodorkovskys or break up its Yukoses. What is needed instead is to upgrade the authority and capability of public institutions (mantenere lo stato, as Machiavelli put it) so that they can keep the oligarchs in check. And as our oligarchy has been going global in the past few years, this is not only a U.S. task, but increasingly a supranational one as well.

But I question whether the entire explanation for imperfect US policies in the past -- much less the current response -- is regulatory capture by the financial sector.    It is ironic that these charges are coming at a time when both the Chairman of Federal Reserve and the Secretary of the Treasury are men who, so far as I know, have not spent any part of their respective careers on Wall Street or, for that matter, anywhere else in the private sector.   When was the last time that condition held?

A broad-brush critique that our government has been too heavily influenced by the financial sector has a lot of truth.  But it can also fan flames of populism that ignore other contributing factors (yes, almost everyone bears some responsibiltiy for a history of excessive tilt toward homeownership).    Such populism at the current juncture could easily make things worse rather than better.

JF