A Banana Republic?

It was not too long ago Paul Krugman was calling the United States a banana republic with nukes. Although he made this statement in jest, Simon Johnson and James Kwak have been arguing in print and on their blog that the United States has, in fact, all the characteristics of an emerging market economy with respect to its financial sector. Acording to Johnson and Kwak, the U.S. financial sector is oversized, politically influential, and as a result is preventing the necessary restructuring needed for the U.S. economy to start recovering. Martin Wolf agrees with much of their assessment:

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... 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 [financial] sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007

Martin Wolf, however, questions their claim that the reason the problems in the financial sector have not be forcefully addressed is because of its political influence. I too agree the financial sector is bloated and effectively insolvent. However, I am with Martin Wolf in being skeptical of the political influence of Wall Street view. My own take on why there has been a lack of meaningful action in financial sector--mainly fixing the insolvency problems with the big banks through restructuring--is the fear of creating another systemic credit crisis.

Johnson and Kwak in their most recent blog posting direct us to this article by Desmond Lachman, someone who has spent 30+ years following emerging markets. Lachman has seen many emerging market crises and knows them well. Lachman is someone you take seriously. Here is some of the article:

Back in the spring of 1998, when Boris Yeltsin was still at Russia's helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to "emerging markets" throughout Asia, Eastern Europe and Latin America, and I thought I'd seen it all. Yet I still recall the shock I felt at a meeting in Russia's dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia's economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia's economic czar at the time.

At the time, I could not imagine that anything remotely similar could happen in the United States. Indeed, I shared the American conceit that most emerging-market nations had poorly developed institutions and would do well to emulate Washington and Wall Street. These days, though, I'm hardly so confident. Many economists and analysts are worrying that the United States might go the way of Japan, which suffered a "lost decade" after its own real estate market fell apart in the early 1990s. But I'm more concerned that the United States is coming to resemble Argentina, Russia and other so-called emerging markets, both in what led us to the crisis, and in how we're trying to fix it.

[...]

The parallels between U.S. policymaking and what we see in emerging markets are clearest in how we've mishandled the banking crisis. We delude ourselves that our banks face liquidity problems, rather than deeper solvency problems, and we try to fix it all on the cheap just like any run-of-the-mill emerging market economy would try to do. And after years of lecturing Asian and Latin American leaders about the importance of consistency and transparency in sorting out financial crises, we fail on both counts: In March 2008, one investment bank, Bear Stearns, is bailed out because it is thought to be too interconnected with the rest of the banking system to fail. However, six months later, another investment bank, Lehman Brothers -- for all intents and purposes indistinguishable from Bear Stearns in its financial market inter-connectedness -- is allowed to fail, with catastrophic effects on global financial markets.

In visits to Asian capitals during the region's financial crisis in the late 1990s, I often heard Asian reformers... complain about how the incestuous relationship between governments and large Asian corporate conglomerates stymied real economic change. How fortunate, I thought then, that the United States was not similarly plagued by crony capitalism! However, watching Goldman Sachs's seeming lock on high-level U.S. Treasury jobs as well as the way that Republicans and Democrats alike tiptoed around reforming Freddie Mac and Fannie Mae -- among the largest campaign contributors to Congress -- made me wonder if the differences between the United States and the Asian economies were only a matter of degree.

Maybe we are closer to being a banana republic than I realized.