Books@DailyFinance: Too Big to Fail = Too Big

book review
book review

It definitely seemed like a turning point.

Lehman Brothers was bankrupt, Bear Stearns and Merrill Lynch had each been sold for a song, and the biggest institutions were pleading for government aid during the fall of 2008. A new title hit bookstore shelves: The Wall Street Journal Guide to the End of Wall Street as We Know It.

But the end was only a new beginning, it now seems.

"While some fabled institutions have vanished, the survivors have emerged larger, more profitable, and even more powerful," write MIT professor and onetime International Monetary Fund chief economist Simon Johnson and former McKinsey consultant James Kwak. Wall Street only became stronger, they say, thanks to the government ties that allowed its institutions a free ride on the backs of U.S. taxpayers.

"Washington has behaved like an emerging market government in the 1990s -- using public resources to protect a handful of large banks with strong political connections," Johnson and Kwak assert.

Break Up the Oligarchy

The authors' dense but compelling 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (Pantheon, $26.95) is a cri de coeur to break up the "oligarchy" that the authors say now dictates economic policy in the U.S. They are far from the only Establishment figures to take this position. As they point out, this past October former Federal Reserve Chairman Alan Greenspan, the onetime champion of an unfettered free market, declared of the biggest financial institutions: "If they're too big to fail, they're too big."

The government bailout -- cheap capital infusions to the nine biggest banks, an $85 billion credit line to insurer AIG (AIG) and the $700 billion Troubled Asset Relief Program (TARP) that allowed government purchase of worthless financial instruments -- represented nothing less than a blank check, say the authors. Unless further steps are taken, they go on, the effect will be further extravagant risk-taking and further financial crises in the future.

What really steams Johnson and Kwak is that the Obama administration seems as susceptible to Wall Street influence as did that of George W. Bush. This is not only a reflection of the fact that the Street spreads its largesse around, say the authors, who track the recent quadrupling of financial-sector campaign contributions, from $61 million in 1990 to $260 million in 2006. It's also because of the revolving door that circulates policymakers between Wall Street and Washington.

Same as the Old Bosses

If Goldman Sachs (GS) veteran Henry Paulson was the face of government economic policy at the end of the Bush term, the Street's influence hardly diminished as a new team stepped in, featuring the likes of ex-New York Fed chief Timothy Geithner, hedge-fund veteran Lawrence Summers, former Goldman partner Gary Gensler, and former investment banker Rahm Emanuel.

Perhaps even more important, the authors say, is the fact that the ideology of Wall Street -- the idea that "unfettered innovation and unregulated financial markets were good for America and the world" -- has become "the consensus position in Washington on both sides of the political aisle." As evidence, they offer a quote from Obama, speaking before a gathering of the 13 powerful bankers referred to in the book's title: "My administration is the only thing between you and the pitchforks" of an aroused mob."

How can this be, when a seemingly wide gulf separates the pro-business GOP from the reformist Democrats? One answer: The increasingly technical nature of investing.

"On many issues crucial to the financial sector -- such as derivatives, securitization, or capital requirements -- all the people with relevant expertise were Wall Street veterans." As finance took on "the trappings of a branch of engineering," few outsiders have had the knowledge to intervene or even comment.

A Safe System Got Dismantled

It took decades for this state of affairs to develop. In a brief recounting of U.S. economic history, the authors describe past efforts to control bankers' power, beginning with Thomas Jefferson and Andrew Jackson and culminating in the regulatory legislation passed under Franklin D. Roosevelt.

"The Great Depression created the opportunity for a sweeping overhaul of the relationship between government and banks," the authors write. With passage of the Glass-Steagall banking act of 1933 and other laws, policymakers achieved "the safest banking system that America has known in its history."

But step by step, that state of affairs broke down, first with new financial innovations in the 1970s and 1980s -- junk bonds, arbitrage trading, derivatives -- and with wave after wave of bank mergers that created new, multistate mega-institutions. Glass-Steagall, regarded as quaint thanks to the pace of change, was repealed in 1999.

Johnson and Kwak also examine numerous emerging-market crises of the 1990s, including those in Korea, Indonesia and Russia. At the time, "few people, if any, thought that these crises had anything to teach the United States," say the authors, who recount how a smug U.S. regularly offered such lands a formula for reform.

Nationalize, Break Up Banks

But by 2009, the worm had turned: "If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say," the authors wrote then in The Atlantic: "Nationalize troubled banks and break them up as necessary."

That's still a formula that Johnson and Kwak favor.

"All banks, including risk-seeking ones, should be limited to a size where they do not threaten the stability of the financial system," they say. That's probably no more than 4% of GDP, or roughly $570 billion in assets, and no more than 2% of GDP, or $285 billion, in the case of investment banks.

In fact, such limits would affect only six banks now: Bank of America (BAC), JP Morgan Chase (JPM), Citigroup (C), Wells Fargo (WFS), Goldman Sachs and Morgan Stanley (MS).

Breaking them up would hardly be so very radical. Antitrust prosecution led to the end of the Standard Oil trust in 1911 and threatened Microsoft in 2000. The alternative, say the authors: Another crisis, sooner or later, and another no-win choice for taxpayers between bailout and disaster.