Robert Wade 2009: How to Stop the Money Men from Taking Over the World

Robert Wade[1]


What a great title, Only Their Purpose Is Mad: The Money Men Take Over NZ. Jesson adapted the first part  from Herman Melville’s Captain Ahab, who in a rare moment of self-awareness says, “all my means are sane, my motive and my object mad”. Ahab was indeed very  rational in his pursuit of his goal of hunting down the whale which had sunk his ship and caused him to loose a leg; he was not a madman. But he was gripped obsessively by his goal or purpose, and the combination of rationality and obsession produced the ultimate disaster.

Jesson draws the parallel. “Modern capitalism is highly rational in the methods it uses but it is ultimately deranged in the purposes to which it puts them” (10).

In particular, he is concerned to show the harmful effects on individuals, families, social cohesion, and even on the productivity of the NZ economy of the government  allowed the financial sector to take over the Commanding Heights, and of failing to curb the sharp rise in income inequality at the top.


He does not put it this way, but his concern could be paraphrased as:  how is it that we have allowed a sector which is essentially a service sector — like transportation, electricity distribution, sewage networks — to become the High Command for the whole economy?  How is it that we have allowed many western economies to become so “financialized”? Afterall, even Adam Smith, for all that he is invoked as patron saint by champions of free markets, treated financial services as an administrative expense which should be deducted from the wealth of nations.


Here are some more indicators of just how big and powerful the financial sector has become. In the US, the finance sector’s share of total corporate profits shot up from less than 16% through the period 1973 to 1985, to 41% in the 2000s.[2] 41% of total corporate profits going to a sector that is essentially a service sector for others?


Financial sector pay in the US, compared to pay in comparable professions like law and medicine (holding lots of things constant like the risk of being fired), rose from about the same as in comparable professions in 1980, to between 30 and  50% more than in comparable professions between 1997-2007.  In a sample of Harvard graduates since 1970, those who went into finance were getting, by 2005, almost 200% more than their colleagues in other comparable professions. In the technical phrase, financiers have been getting a giant “wage premium”.[3]  Which helps to explain why mathematicians, physicists, engineers and the like have been heading for jobs in finance.   Why?


Going beyond finance to CEOs of big companies in general (financial and non-financial), their remuneration in the US rose from 42 times the average employee’s wage in 1982 to and 344 times in 2007. Did the value-added to their companies by these CEOs really rise  8 times between 1982 and 2007?


On a world scale, the world stock of financial assets (equity, public and private bonds, and bank assets) soared from 1.2 times world output in 1980 to 4.4 times world output in 2007.


Thanks to the enormous size of the financial industry and its world-wide reach, Wall Street traders in their 20s can produce deep changes in the welfare of populations all around the world.


How did we get to this situation, with finance in the driving seat?  Part of the answer is that the financial industry has grown to its present size partly on the back of gigantic US trade (or current account) deficits in most years since the early 1990s. In 2006, the US current account deficit equalled the entire GDP of India. The deficits have to be financed, and their financing generates huge capital flows – from which the financial services industry has accrued giant profits.


The consumers, of course, have benefitted handsomely from the US’s ability to import much more than it exports, by borrowing abroad from the surplus countries. The poet and playwright of ancient Rome, Plautus, in the second century BC, succinctly summarized the mechanism of US prosperity.


“I am a rich man as long as I do not repay my creditors”.


But this was a very fragile growth mechanism, because of what happens when Plautus’ dictum goes into reverse, it did in 2008.


Another related part of the reason why finance became so powerful is that it mounted what Simon Johnson, professor of economics at MIT and chief economist of the IMF from 2007 to 2008 describes as a “quiet coup”, thanks to which Wall Street firms captured key parts of the US government, notably the US Treasury,  the central bank, and the US Congress. [4] Not a violent coup, a quiet coup.  It happened partly through the familiar mechanism of lobbying and campaign contributions: the US has about 5 registered banking lobbyists for every member of the House of Representatives. But more important,  the coup took place through a shared belief system, or “cultural capital”: namely, the belief, shared by Wall Street and the key policy agencies, that large financial firms, which were only lighted regulated, and free-flowing capital markets around the world, were crucial to America’s pre-eminent economic, political and military power in the world. Individuals holding this belief moved backwards and forwards between Wall St firms and senior positions in Washington, making a great echo chamber for the affirmation of this key belief.


Ben Bernanke, the current chair of the central bank, said as recently as 2006,


“The management of market risk and credit risk has become increasingly sophisticated….Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks”.


This was the belief that justified the idea that firms in financial markets could be relied upon largely to regulate themselves, provided there was competition. Just how far the belief was carried is captured in what happened at the US Office of Thrift Supervision, an important regulatory agency, when a new head was appointed in 2003.[5] He turned up at the press conference waving a chain saw, to show to the world what he intended to do to financial regulations. Next to him on the podium was the deputy head of the Federal Deposit Insurance Corporation, another regulatory agency, who wave waving pruning shears. And standing next to them on the podium were three banking lobbyist, smiling broadly and also each waving pruning shears. The OTC liked the image so much that it gave a photo of the event prominent place in its Annual Report for 2003.


The chickens came home to roost in 2008. The costs of the ensuring crisis are  summarized in one fact.  As the Great Unwind of the credit-debt mountain proceeded over the past year the world economy contracted for the first time since the Great Depression of the 1930s – despite what The Economist estimates as “the biggest peacetime fiscal expansion in history”.


Remember that the current crisis is only the most recent in a long line of crises which have erupted in national financial systems that are ostensibly designed to manage and control risks, and yet in practice, under the existing regulations, have operated to increase risks, with devastating effects on workers, consumers and taxpayers.   The frequency of such crises began to increase in the early 1980s, with the general change around the world towards deregulation or light-touch regulation. Since the early 1980s a major financial crisis has erupted somewhere in the world at a frequency of roughly once every three years, compared to hardly any in the period from 1950 to 1980 when finance was more closely regulated, when capital had an “address”, and international capital flows were much smaller. Most but by no means all of them have been in developing countries, which perhaps explains why the G7 developed country states have not been alarmed enough to institute serious reforms to international financial regulation – until now, when the crisis hit the heartland.


All these are indicators of a world economy seriously out of joint, malfunctioning by any plausible notion of the common good or the public interest.


In this paper I shall give a brief account of what I understand to be the main causes of the crisis – emphasising two points that have received little attention elsewhere, namely, failures in the distinctly international system of financial regulation, and the spectacular rise of income inequality.  Then I come to the question of the title, how to stop the money men, or how to rein in finance.


But first I shall say something about the prospects for economic recovery over the next few years.




In September 2009, on the anniversary of the Lehman Brothers collapse, Federal Reserve chairman Ben Bernanke declared that the recession was “very likely over”.  We should certainly not take his statement at face value.  Wall Street and the Federal Reserve are pushing a rosy scenario for the good reason that Wall Street makes profits from rising asset prices and from retail investors buying stock. And mainstream economists tend to agree with the rosy scenario – because their models assume that full employment is a gravity point to which the economy is automatically pulled.


Certainly, the surviving big banks are reporting big profits and again paying giant bonuses;  stocks markets are soaring, commodity futures are booming, and even house prices look to be on the upturn.  Yet the outlook for output, employment, and unemployment is gloomy. Unemployment in the US is over 10%, the highest since the Great Depression; and in some states the figure is closer to 15% or more. If this is a “recovery”, its central feature is that it is a jobless recovery. Millions of people have been and are still being forced to leave their homes because of bank foreclosure on their mortgages. Churches are stepping in to provide free food and shelter. That’s part of the reason why there have so far been remarkably few bellows of rage or other signs of class warfare.  But the sense of deep grievance and disillusion is everywhere, not just in the US but in many other parts of the high-income world. Much of the grievance against bankers and government in the US is being deflected into the debate about health care reform, where it is being cleverly exploited by those opposed to “socialist medicine”, as they call it. However, there are limits to its deflection, and it seems quite likely that it will spill over into more class-like conflict in the next few years, as the economy is seen to be working well for bankers and others at the top of the income distribution, but not working well for ordinary people.


It is not hard to understand why finance is doing well while the productive economy is doing badly.  In current conditions it is easy for surviving banks to make big profits and pay giant bonuses because they have been getting central bank money almost free, and face fewer competitors than before.


The sheer scale of public support given to one industry – finance – over the past year beggars belief, and has certainly never been seen before in human history. IMF’s recent World Economic Outlook reports that over the past year, the governments of the developed countries have spent about 30% of their combined GDP on bailing out the banks, in the form of capital injections, asset purchases, guarantees, and provision of liquidity.


The turnaround in the role of government is dramatic, and is captured in the following New Yorker cartoon, where Reagan’s dictum, “The government is not the solution, it is the problem”, is reversed. A messenger runs into the castle where an executioner is about the behead the kind, shouting, “Stop! Wait! Government is not the problem, it’s the solution”.




So yes, government has been heralded as part of the solution over the past year, and this represents a substantial change from the predominantly negative evaluation placed on government in the neoliberal thinking which has dominated economic policy-making in the Anglo countries over the past two and more decades.  The trouble is that government intervention to direct a waterfall of public money at the financial sector has occurred with barely any conditions attached. In the absence of conditions on lending, the banks are neither lending much to collapsing manufacturers or high street retailers, nor rebuilding their capital (they can go slow on rebuilding their capital because they know that the government is unlikely to allow them to fail, provided they are above a certain size).  Rather, much of bank lending is doing directly or indirectly into equities, commodities and property and blowing up bubbles.


Meanwhile, in the “real” or “productive” economy there is not much sign of a revival of private spending by households or firms (beyond inventory restocking).  To understand why recovery in the real economy is fragile, think of a household as a car.[6] Households borrowed heavily through the 2000s, which is like stepping on the accelerator.  But borrowing also loads up the car with debt. When the borrowing stops and the foot is removed from the accelerator, the car not only slows but slows much faster than otherwise because of the additional weight of debt. And then the household has to repay its debt, which is like stepping on the brake.  Replicated across an entire economy, braking the car causes a multiplier process of lower spending, job losses, business failures, and bank failures. [7]


There are at least two real and present dangers right now. The first is that, as result of this huge public support for finance, much of the West is now in the early stages of new bubbles in stock markets and commodities, perhaps with houses to follow. It looks uncomfortably like déjà vu all over again, to quote Yogi Bera  —  like we are starting to re-run what happened in 2003-2004 when the earlier bubbles were being formed. As of September 2009 the US & UK stock markets were 35-40% overvalued, according to a variety of measures, and the figure would be higher today. [8]  Emerging market stock markets are even more overvalued. And as for the banks, neither market competition nor regulation seems to be effective in reining them in; which means they will tend to take bigger risks – and probably generate more crises in the not distant future.


In short, it looks uncomfortably as though the countdown to the next crash may already be under way.


The second real and present danger is that governments  – under pressure from financial markets, fearing inflation and a bond market crash – will reverse the fiscal and monetary stimulus too soon.  The resulting big cut in aggregate demand could send still fragile economies crashing into a worse recession. This is what happened in the US in the 1930s when monetary and fiscal policy were tightened before the recovery was well established, which sent the economy into renewed recession in 1937.


In Britain, David Cameron said in his speech to the Conservative Party conference in the first week of October 2009 that in his view, the “only option” for the next government was: “We must pay down this deficit. The longer we leave it, the worse it will be for all of us”. The Labour government is adrift and has not even come up with the retort that the longer the public stimulus to aggregate demand is left in place, until recovery is well established, the better it will be for all of us. Not that what the Labour government says matters much now, because the Conservatives are almost sure to form the next government and to cut public goods and services hard, as they have long wanted to do.


In my view, deflation in the next few years is a bigger danger than inflation, and we should therefore err on the side of continuing the monetary and fiscal stimulus, despite the real dangers posed by higher public deficits, in the form of a bond market crash. Deflation, we should remember, is not just something that happened in the distant 1930s. It happened in Japan starting with the crash of its bubble in the late 1980s, and continued for almost 20 years of very low growth.  [9]  It could also return to the West.


My forecast then is that many developed countries, including the US, the UK, some of the eurozone countries, and some emerging market economies especially in eastern Europe, will probably experience a prolonged, anaemic U shaped recovery rather than a V.  They will remain close to recession for another couple of years, till 2011, and it will be even longer before output, employment and unemployment return to 2007 levels. And as I said, there is a real danger of another big financial crash in the West in the not distant future.


Having made such an apparently precise forecast, I should remind you of J.K. Galbraith’s quip, “Astrology was invented so that economic forecasting would look good.”


The age of turbulence


Looking further ahead than just the next few years, I think much of the world will experience a long period of  turbulence in both economics and politics – more than in the past two decades. Let me mention just three of bulldozer forces that will keep generating turbulence.


First, soaring income inequality. Roughly 80% of the world’s population lives in countries where income distribution has become more unequal over the past 20 years. I come back to income inequality in a moment. Here I will note that as the super-rich buy palaces it is unlikely, to say the least, that those who are anxious about jobs and homes and protracted fiscal austerity will just sit and watch. And it is very likely that the rise in income inequality in the West will intensify the already ubiquitous cynicism about the public realm and about professionals like financiers, politicians, police and TV executives – the cynicism captured by George Bernard Shaw when he remarked that all professions are conspiracies against the public.


A second engine of turbulence is that the US government has become institutionally a war government. It seems that every president seeking election and re-election now needs a war in small and troublesome countries, to show that America is still leading the world in its own good. “Liberal interventionism”, the doctrine is sometimes called. We see it being played out right now. Obama trapped himself in his election campaign when he promised to have his “own” war – not Iraq but Afghanistan – in order to protect himself from Republican accusations of military weakness. Now the debate in his administration is not about a troop surge in Afghanistan versus disengaging US military forces from that part of the world, but about a troop surge in Afghanistan versus a likely troop surge in Pakistan. Critics of the Afghan troop surge within the administration say that Afghanistan is the wrong war, while Pakistan is the “right” war. Pakistan presents a more exciting challenge than Afghanistan because it has the Taliban, Al Qaeda, and nuclear weapons. To justify US military involvement in Pakistan they invoke the scenario that Al Qaeda will take control of the Taliban, the Taliban will take control of Pakistan, and the Al Qaeda-Taliban alliance will then take control of nuclear weapons. Then the dominoes will start to fall around the region, as was said about Vietnam. In other words, even those in the Obama administration who oppose more troops for Afghanistan are keen to keep America in a war. In short, the US presidency’s institutionalized need for a war is another driver of  global turbulence.


Third, climate change and energy scarcity. In the longer run, as world population rises from the present 7 billion to 8 or even 9 billion, ever-expanding consumption – including raising global living standards to the median of the West —  is likely to hit constraints of energy, food, water, and the absorptive capacity of the atmosphere and oceans. To avoid large-scale disruption we will have to reduce not only the carbon emissions from growing consumption (switch to more fuel efficient vehicles, switch from fossil energy to renewable energy) but also cut the quantity of western consumption – and more broadly, reduce the dependence of western societies on endless economic growth. I don’t see this happened without a great deal of conflict, especially because income and wealth distribution are already very unequal. And I don’t see it as likely that western populations will be prepared to make large enough resource transfers to populations in developing countries in order to finance the switch to lower-carbon growth and the adaptation to sea level rise and other effects of global warming.


One plausible scenario is that some national elites will respond to the turbulence by trying  to assert state control over markets – but in the form of a fascist kind of regime in democratic dress, because a fascist regime promises a more effective defence of their wealth and power. If this happens, it would be another déjà vu all over again with respect to what happened in parts of continental Europe in the 1920s and 1930s, and in much of the developing world more recently.  The return of fascism in response to elite perception of internal and external enemies is a real possibility.[10]


This raises a question which runs as a subtext through Jesson’s book: when and how will a more generous social democratic movement emerge in response to the fascistic movement, and steered by what ideas?  The Left has been conspicuously missing in action in the current crisis.  Will a Left movement emerge?




There is by now a widely shared understanding about the causes of the crisis that goes something like this. East Asia’s high savings and large export surpluses were lent back to the West, particularly the US, in a kind of “reverse Marshall Plan”.  In the West this kept inflation low and consumption up. Central banks, focussed on price inflation, kept interest rates low and ignored what was happening in asset markets – which began to bubble in 2003. Bank regulators let bankers do as they pleased, because they, including Alan Greenspan and Ben Bernanke, believed in the “efficient market theory” which said that bankers had strong incentives to carefully manage risks. So bank regulators adopted a “light touch” approach, and ignored rising “systemic” risks.


For example, the UK Financial Services Authority classified Northern Rock, which by 2005 was making 20% of UK mortgages, in the lowest of four risk categories. In 2005 it had not a single meeting with Northern Rock, in 2006, one, and in 2007 it had seven meetings, five on one day – presumably just before Northern Rock went bankrupt in September.[11]


The upshot was that the financial sector became far too big, too profitable, and too fragile because too dependent on asset bubbles, from which it was making gigantic profits.


There is a lot of truth in this story. But I want to amplify it with two neglected points. First, about the failure of international regulation. Second, about the neglected role of rising income inequality.


The global financial regime


One of the striking things about the current crisis is that the international financial regime failed spectacularly to rein in the rise of financial fragility.  About the only agency which consistently warned of the growing dangers was the Bank for International Settlements, the club of rich country central bankers, which has rather little political clout.


The problem is not that there are too few international regulatory agencies, which was the problem in the 1920s. On the contrary, in the wake of earlier financial crises a dense array of international financial regulatory agencies has been built up. It includes the G20 finance ministers and central bankers forum, the IMF, the Financial Stability Forum, the Basel Committee on Banking Supervision, and much more.  Figure 2 gives a map of just some of the main agencies in this international financial regulatory regime.




The first problem is that these various regulatory agencies operate together in what might politely be called “anarchic inefficiency”.  They are hardly coordinated, they trip over each other, and they leave large cracks (including tax havens).


We could say, then, that the existing regulatory regime suffers from a “capacity problem”, or rather “incapacity problem” .


It also suffers from a second problem, a “responsibility problem”, or better, “irresponsibility problem”. Organizations of global financial governance, such as the IMF and the Financial Stability Forum, have tended to marginalize states representing the large majority of the world’s population; yet the financial and exchange rate policies of dominant states may impose high costs on those who have little role in causing the costs while giving them little voice.


As an extreme case, think of the Volker interest rates shock of 1979 and its multiplier effect on Latin American debt service obligations.  When we were both teaching at Princeton in 1990 I once asked Volcker over lunch how much analysis the Fed, of which he was the chair in 1979, had done of the impact of the coming Fed interest rate hike on the heavily indebted Latin American countries.   He replied rather nonchalantly, “None”. I asked him why. He replied, “We didn’t have the capacity”. Indeed, today, of the Fed’s 250 economists, only five are dedicated to developing countries, and only recently has one of the five been dedicated to China.


The responsibility problem is captured in the fact that still today, more than a year after the global financial crisis swept around the world, Belgium and Netherlands each have larger voting shares in the IMF and World Bank than either China or India. Indeed, Belgium and the Netherlands each have larger voting shares than all the states of Sub-saharan Africa combined; and the combination of Belgium, Netherlands and mighty Luxemburg has more votes than the combination of China, India and Brazil.

What about the G20 finance ministers forum, which was intended to be the apex financial coordination body? Does the G20 not help solve the capacity problem and the responsibility program in global financial governance?  How did it perform in sounding the alarm about the build up of financial fragility in the world economy?


First a word about its history.  The G20 finance forum was established in 1999 when the G7 states (US, Canada, UK, France, Germany, Italy, and Japan) finally accepted that it made no sense for them to be meeting to discuss how to handle the ongoing East Asian crisis without the crisis-affected countries or other countries which could help the crisis-affected countries being present. They needed to bring in more countries representing a much higher proportion of world population and world GDP, because on their own they were like the captain of a ship who stands at the wheel moving it backwards and forwards, pretending to steer the ship, while in fact the wheel is not connected to the rudder; the captain’s actions are all theatre.


Since 1999 the G20 finance ministers and central bankers have met annually, and their deputies have met much more often. [12]  And in November 2008, in response to the financial crisis, the G20 countries met at heads of government level, and since then has met twice more at heads of government level. The G20 – both the one for finance and the other for heads of government – claim to be the world’s new all purpose problem-solver.


On the face of it, this expansion of the top table of global financial governance is a good thing.  The expansion from G7 to G20 seems to partly solve the “responsibility” problem in global governance, because the top table  now reflects the changing balance of power and the changing level of economic integration in the world economy brought about by the rise of states like China, India, Brazil and others.


Some sympathetic observers even herald the  formation of the G20 finance forum in 1999, and now the G20 heads of government forum in 2008, as a turning point in world history, a shift away from the long-established US and G7 hegemony towards a more collectivist or multilateral cooperation between states. [13]  On the other hand,  American conservatives have predictably been rendered dyspeptic at what they see as a sell-out of capitalist democracies to corrupt developing countries.


So how did the world’s apex problem-solver in the financial domain perform over the 2000s as financial fragility rose and rose.  The short answer is: the G20 was mainly a cheerleader for what was happening. This reflects the fact that in its decade of existence it has functioned mostly as a rubber stamp for the G7.  The G7 states have mostly got the G20 to agree to what they want it to agree to – partly reflecting the fact that the G7 states have long-established practices of consultation with each other and the other G20 states do not. So the G20’s image of collective cooperation is, at least partly, a fig leaf for continued US and G7 dominance, a fig leaf for the reality of what could be called “hegemonic incorporation”.


From the perspective of the US and G7, the G20 is valuable above all as a means to solidify a neoliberal policy model in major states beyond the G7. Documents such as The G20 Accord for Sustained Growth, a product of the 2004 ministerial meeting, promote a strongly neoliberal policy agenda, with particular emphasis on free trade, free capital movements, and light-touch financial regulation. In short, the continuing dominance by the G7 is a large part of the reason why the G20 failed spectacularly to warn of the build up of financial dangers after 2003.


Income inequality


Economists tend to pay rather little attention to income inequality, in the spirit captured by my LSE colleague Willem Buiter, who said recently, “[Absolute] poverty bothers me. Inequality does not. I just don’t care.”[14]


I argue that rising income inequality, especially  in the US, had a major background role in the build up of financial fragility.


Consider figure 3. It shows the share of US pre-tax income going to the top 1% of income recipients, based on tax returns, between 1913 and 2006. The share rose fast through the 1920s, peaked at over 22% in 1929, fell almost continuously till 1977, hit bottom at about 9%, and then, with the elections of Reagan and Thatcher, took off like a July 4th skyrocket to reach more than 22% by 2006, the same as in 1929.




These trends in income distribution help to explain both the Great Depression and the current global crisis.


The Great Depression was preceded by a decade of fast rising income inequality in the US. Between 1922 and 1929 the top 1% of US taxpayers increased their disposable income by 63%, and corporate profits rose by 62%. Meanwhile, 90% of US taxpayers had lower disposable income in 1929 than in 1922.


These trends in income distribution helped to bring on the crisis because of a scissors effect. On one hand, the falling share of income going to the bottom 90% choked off demand for the consumer goods which were the new growth sectors of the US economy (automobiles, refrigerators, radios).  On the other hand, with limited opportunity for investment in goods production, booming incomes at the top went into real estate and stock markets, and blew up asset bubbles — until October 1929 when bubbles turned into what Shakespeare might have called “trubbles”, or bubbles deflating.


In the build up to the current crisis a similar mechanism was at work. Stagnant incomes in the bottom 90% of the US income distribution choked demand for mass consumption goods, and soaring income at the top sent a waterfall of financial resources into finance and property. Figure 4 shows how real incomes of the middle 60% of US households, and the bottom 20%, have been stagnant since the 1980s, while top incomes surged.


FIGURE 4: US: INCOMES OF TOP 1%, MIDDLE 60%, BOTTOM 20%,  1979-2005


The latest list of billionaires, from Forbes, shows that the US, as of February 2009, is the only large country with more than one billionaire per million inhabitants, and has the second highest number of billionaires per unit of GDP behind Saudi Arabia. The density of billionaires in the EU, by contrast, is about a third of the US’s. China including Hong Kong has a billionaire density much higher than the EU’s, but well below the US’s.


However, this time, income polarization over the 1990s and 2000s, in contrast the 1920s, was offset by the US government opening the floodgates of credit (helped by the inflow of funds from Asia). This enabled households in the bottom  90% of the income distribution to borrow so that they could increase  consumption even out of stagnant incomes – borrow against the rising value of their houses, which they were assured would continue to rise indefinitely.


Then, as is by now well known,  Wall St bundled up mortgages and other consumer debts into securities, got the ratings agencies to give them high ratings, and sold them around the world, even to municipalities in northern Norway.  The rest is history.


So the rapid rise of income inequality at the top in the US – and also in Britain, Canada and NZ — is directly implicated in the run up of financial fragility and the ensuing crash.


This raises the question of why income inequality rose so fast during and since the Reagan/Thatcher years, with only modest offsets from transfer payments? Part of the answer goes back to the argument I mention earlier, that the finance industry has carried out a “quiet coup”. One sees this by looking across the whole raft of policies adopted for the finance industry since the Clinton presidency: pruning financial regulations, cheap money, insistence on free flows of capital across borders, the Chinese-American financial alliance, repeal of legislation putting a firewall between commercial and investment banking, increases in the amount of leverage allowed to investment banks, an international agreement to allow banks to measure their own risks (the Basel 2 agreement), and more. All of these have in common that they benefitted the finance industry.


Conversely, measures which would have limited financial profits were blocked. A good example is the failure of attempts by the Commodity Futures Trading Commission in 1998 to gain acceptance for the idea of regulating credit-default swaps and other over-the-counter derivatives. [15]

In short, one of the background causes of the current financial crisis was the preceding fast rise of income inequality in US and other Anglo economies; which in turn was driven by the growth of finance in size and profitability, and in its power to shape not only specific public policy but the whole intellectual climate of ideas.



Even to ask the question, “How to stop the money men…?” seems almost quaint, given what has happened in the past several months. Banks have got away with thumbing their noses while rubbing our noses in the mess that they have made.[16]  Their threats to abscond to another country have made make governments draw back in alarm and refuse to use the instruments at their disposal to rein them in – taxes, regulation, law, even moral suasion.  On the evidence so far, this crisis marks a turning point in history when financiers decisively escaped democratic accountability, just when public accountability had most reason to bite.


Nevertheless, it is worth keeping the debate going about what should be done in terms of public policy – within the realm of what is remotely feasible.  I shall touch on just a few of the top priorities. I won’t discuss how to reduce income inequality, though my earlier argument identifies the run up of inequality as an important background driver of financial fragility.


Slim down the financial sector and change its incentives


First, we should take inspiration from Adam Smith and treat financial services as a deduction from the wealth of the nation.  Or lest this be deemed infeasible, then at least the financial sector’s performance should be judged not by its growth and profits but by its ability to support economic growth and equitable distribution at low cost. It should be treated as a sector serving other sectors, like transportation, electricity, and sewage.


That means changes in regulation and legislation so as to change the incentives on bankers in ways which make their activities less risky and less profitable. How to do so? There are many good ideas on the table.  Higher capital requirements, calibrated to be countercyclical, is one obvious idea; and that would help to restrain both profitability and bonuses (without having to try to put direct caps on bonuses, which is undoable).  A credible threat of bankruptcy, is another. [17]


Most important of all, in terms of national-level reform, is to prohibit banks from owning and trading risky securities – because this is the key practice that got big US banks into deep trouble in 2008, and they got into trouble because they got most of their profits from owning and trading risky securities on their own behalf, using borrowed money, and it was out of these giant profits that they paid the giant bonuses. We need to re-instate an updated version of the Glass-Steagall act (the Depression era act which separated commercial banking and investment banking). Commercial banks should take deposits, manage the payments system, make standard loans, and even trade securities on behalf of clients (but not on behalf of themselves). They should be rescued by governments when they failed, but their managers should face the same penalties as managers in other non-rescued industries. Investment banks, on the other hand, should not be rescued, when they fail they should be liquidated, and the government should use competition rules to ensure that none are too big to fail – to ensure that too big to fail means too big to exist.


This proposal has received strong support from Paul Volcker, who chairs the US president’s Economic Recovery Advisory Council,[18] and also from Mervyn King, governor of the Bank of England.  It has received a distinct frosty reception from the US Treasury and Larry Summers (Obama’s chief economic advisor), and from Alistair Darling, the UK Chancellor. They say that the policy thrust should be for tighter regulation, including higher capital requirements, and even guidelines on pay; but no structural changes of the Glass-Steagall kind. They further say that any significant constraints on bankers should only be introduced in cooperation with all the other financial centers.


To which the response is that, yes, regulation needs to be tightened; but tighter regulation, as distinct from structural change, is insufficient, because of the difficulty of enforcing regulation when the financial sector is anything like as big and profitable as it is.  Here’s another cartoon from the New Yorker which illustrates the problem.


FIGURE 5: “These new regulations will fundamentally affect the way we get around them”


Legislation to bring about the structural separation of commercial and investment banking is needed. And it should not be made hostage to the agreement of “everyone else”, because that is an invitation to free-riding and no action, which may be the point of calling for it.


Slim down international capital flows


Second, it is important that the volume of international capital flows be reduced, relative to GDP; and that capital should be regulated in such a way that it has an address, a national base. The reason is that when capital has an address, it is forced to operate in a context where key prices which have a big impact on economic growth and its distribution – interest rates, wage rates, exchange rates – are shaped by negotiations between capital, labor, and the state, a context which is more likely to produce an equitable distribution than one in which capital has no address and is free to move from one polity to another.


Middle-income countries, in particular, should learn the lesson that while “trade globalization” (a fairly free trade regime) is in general a good thing, “financial globalization” (free capital flows across the national border)  exposes them to great danger. In particular, middle-income countries should reject advice emanating from Washington, New York and London to supplement their domestic savings by foreign borrowing.  There is now a long track record which shows that countries which try to follow the strategy of “economic growth with foreign borrowing” tend to experience an overvalued exchange rate, and are quite likely to experience a financial crisis.[19] East Asian economies in the 1990s are Exhibit A.


It is worth recalling that Hans Morganthau, the US Treasury Secretary at the time of the Bretton Woods negotiations in 1944, said that the aim of the negotiations was to put in place an international economic architecture which would ensure that the system never again fell prey to international speculators.  Keynes returned from the negotiations declaring that the most important single achievement of the Bretton Woods conference was that it accepted the legitimacy of capital controls, reversing orthodox belief of the previous many decades.


Keynes’ argument in favour of national governments being able to manage capital flows still holds today, yet the IMF, the US and UK Treasuries and many other western agencies have been pushing for developing countries to open their capital accounts and stop managing cross-border capital flows. The norm of capital account management  needs to be restored in current global policy, so that national governments can legitimately slow down the inflow or outflow of capital, especially short-term speculative capital.




One should acknowledge that the G20’s image of collective cooperation is not all fig leaf to disguise the reality of non-G7 states’ incorporation into G7 hegemony. As the G7 states come to perceive their own “intervulnerability”, their need to obtain cooperation from non-G7 states gives the non-G7 states some bargaining power. Also, the big developing country members of the G20, like China, India and Brazil,  are beginning to caucus on their own and work out common positions, in a way they did not before.


In response to the global crisis some small steps in global financial governance are being taken which help to reduce both the capacity problem and the responsibility problem. Previously closed networks of the G7 core states are being opened up at a remarkable speed, in a way which will be difficult to reverse. For example, the Financial Stability Forum, previously limited to some high-income countries, has been expanded to include all the G20 countries. The private-sector based International Accounting Standards Board has been prevailed upon to add G20 states to its top governance bodies.[20]

But it is likely that the G20 will either not survive, or will become marginalized by a much smaller top-table group within it, raising the chances that the G20 remains little more than a photo opportunity.


First, it is too big to function as a decision-making body. Above about 15 members, a committee rapidly ceases to be effective as a collective decision-maker and problem-solver. But the G20 meetings have 50 or more people sitting at the table (because each member state brings more than one representative); and so they can only ratify decisions made elsewhere. The obvious route to sliming it down is to cut the representation of European states and replace them with EU and European Commission seats; but only over the dead bodies of the European states.


Second, G20 membership is permanent – a state is either in or out; there is no provision for rotating membership. This certainly has advantages in encouraging the included states to “buy in” to the process rather than just use it as a photo-op. But many excluded states are not inclined to grant it legitimacy as the premier global problem-solver.


Third, the G20’s legitimacy is also contested because of how the selection of countries was made, and by whom.  The history is complicated, but at its core is a transatlantic telephone call in 1999 between Timothy Giethner, then a deputy secretary at the US Treasury and now Treasury Secretary, with his opposite number at the German Finance Ministry, Ciao Koch-Weser. They each had in front of them a list of the world’s countries together with the relevant data about population, GDP, trade, and so on. They worked down the list to identify another 13 or so countries which together would make a representative group and would total around 20. As they came to each country they discussed whether it should be in or out.   Argentina  in, Spain out, South Africa in, Nigeria and Egypt out. And so on. With their tentative list in hand they consulted with the other G7, especially with the Canadians, and then the invitations went out.


So the composition of the extended in-group was decided by the hegemonic in-group, the G7. The question is what might be a process for arriving at the composition of the top-table group which better matches democratic criteria?


Establish international – regional, global – financial surveillance bodies which are independent of states


The world economy needs watch dogs, with independent surveillance capacity – that is, with capacity which is independent of states. The IMF’s surveillance, in the form of Article IV consultations, is much less effective than it could be because the IMF’s conclusions are, in practice, subject to negotiations between it and the surveilled state. States can get it to take out or tone down messages which the government in power does not want to receive an IMF imprimatur.


When the IMF team visiting Iceland in 2006 wrote its draft Article IV consultation report, it said that Iceland’s macroeconomic imbalances were “staggering”, as they were for anyone with two eyes to see. However, the Prime Minister protested, and the IMF toned down “staggering” in the published report to “remarkable”.


Similarly, the Financial Stability Forum gave precious little warning of the build up of financial stability in the world economy during the 2000s, to a large extent because what it says has to be approved by its member states – indeed it had no independent analytical capacity of its own, its staff were seconded from national civil services. In the expansion to include the G20, the renamed Financial Stability Board at least has a permanent secretariate, with a total of 9 members.


The question then is how to institute a world economy surveillance body which is not composed of representatives of nation states?


What can be done?


What are the chances that finance will be significantly reined in, with constraints and not just voluntary codes of conduct?


On the one hand, it looks as though the financial sector is so politically powerful in the US and the UK that no serious constraints on its size, profitability, and power will be introduced.  The crisis has not (yet) been bad enough, it has not yet generated enough mass unrest, and there is no external enemy like the Soviet Union or Nazi Germany – which helped to produce the consensus behind the New Deal reforms and the later Bretton Woods reforms.


So the executives in still another cartoon may well get their wish.  Then we really do face a turbulence future!




On the other hand, the chances of real reform are raised by the fact that US and British ideological hegemony – the wide acceptance of a distinctly neo-liberal ideology – is much weaker than it was.  The Iraq war helped to erode it, and the current crisis has also helped. Both these events  have encouraged opinion-makers in much of the rest of the world, notably in China, India and Brazil, to recognize the failure of neoliberal institutional reforms and the corresponding macroeconomic policies to promote economic growth.


More people now understand that neoliberalism — as distinct from both liberalism and conservatism (both political philosophies worthy of respect) — tends to deny the very idea of a common good or public interest, and to endorse instead an all-justifying acquisitive individualism.


But on the other hand again, there is no alternative epic narrative to set against the neoliberal one, because  the earlier standard socialist epic has long languished in disrepute and is unlikely to be resuscitated.


What about economics, the queen of social sciences, the most influential in shaping public policy? Will the Anglo-American version soften its insistence on the epistemology of deductive logic and the method of mathematical model building, and tolerate more  historically-based inductive theory? Will it soften its negative presumption about governments?  Will it treat the new findings in economic psychology as more than “idle curiosities”, or will it cling to a microeconomics based on the assumption that, apart from Black Swan events which nobody can foresee, markets are efficient?


My guess is that the heartlands of the discipline will be much the same in five years time as they have been over the past five years, because in the heartlands engaging in the analysis of current crises, even big ones, tends to be treated as equivalent to “following newspaper headlines”.[21]  But surveys of American economists’ opinions have been made every ten years since 1980, and it will be interesting to see what has changed in the consensus between 2000 and 2010.  Will observation trump theory?










We can get some sense of the possibilities of re-regulating markets by going back to th1      `e analysis of  Karl Polanyi and his book, The Great Transformation, a book which Jesson also draws on.  Polanyi, writing in London during the Second World War, gave an analysis of modern capitalism as a continual to and fro movement from deregulation to reregulation and back to



[1] = including realised capital gains; and [2] = excluding capital gains.  3-year moving averages.  Source: Piketty and Sáez (2003; updated to 2006 in TabFig2006.xls).[22]



Figure 4:  US, share of top 1%, middle 60%, bottom 20%,  1980-2005









[1] Professor of Political Economy, London School of Economics. This paper – a tribute to Bruce Jesson and Only Their Purpose Is Mad – builds on earlier ones about the current crisis and the East Asian crisis. They include: _______

[2] Simon Johnson, “The quiet coup”, The Atlantic, May 2009.


[4] Simon Johnson, “The quiet coup”, The Atlantic, May 2009.

[5] Robert Wade, “Reflections: Robert Wade on the financial crisis”, Development & Change, November 2009.

[6] I take the metaphor, with modification, from Thomas Palley, “A second great depression is still possible”, at, 12 Oct 2009.

[7] Also, on the back of publicly-backed credit given without conditions, speculative demand has been driving up oil, energy and food prices. If these key prices continue to rise, they could cause a contractionary shock in the world economy, helping to cause a double-dip recession.


[8] Wolfgang Munchau, “Countdown to the next crisis is already under way”, Financial Times 19 October 2009.

[9] In the UK, Howard Davies, director of LSE and former head of the Financial Services Authority, said recently that

“the next six months are going to be extremely delicate in the UK. It is very clear that something drastic has to happen to control spending; but is the economy robust enough to survive fiscal tightening?”  Quoted in Ambrose Evans-Pritchard, “Ex-FSA chief Sir Howard Davies sees ‘drastic’ risks for Britain”, Daily Telegraph, 15 October 2009.

[10] Manfred Bienefeld, “Suppressing the double movement to secure the dictatorship of finance”, in Ayse Bugra and Kaan Agartan, Reading Karl Polanyi for the Twenty First Century,  Palgrave, 2007.

[11] REFC  FT

[12] Membership includes Australia, Argentina, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Brazil, Saudi Arabia, South Africa, Turkey, UK, US, plus representatives of the EU, IMF, and World Bank.

[13] Mark Beeson and Stephen Bell, “____”,  Global Governance, ___.

[14] REFC

[15] Simon Johnson, “The quiet coup”, The Atlantic, May 2009.

[16] Thanks to Polly Toynbee for this phrasing, in “If ever there was a time for an emergency super-tax it’s now”, Guardian 17 Oct 09. Toynbee reports that the UK Revenue and Customs department is alarmed that banks are legally using existing accounting rules to spread their colossal losses forward for many years, offsetting them against their taxes, so that they will pay no taxes for years to come.


[17] Governments have treated the banks with extraordinary leniency because they believed that rescuing bankrupt banks was the way to rescue the economy.  That is why almost none of the big banks in the US or the UK have been allowed to fail.  It is certainly debatable whether more banks should have been allowed to fail. But it hardly debatable that governments should have placed conditions on the banks’ use of public funds and public guarantees; and that governments should have been a lot faster in bringing prosecutions against bankers. It is salutary to compare the penalties handed down to Savings and Loan officials in the US in the wake of the Savings and Loan crisis in the late 1980s and early 1990s, with what has happened today in the wake of a crisis which has been much more damaging than the S&L crisis. Between 1990 and 1995 in the US,  almost 2,000 S&L officials were prosecuted and over 1,000 were placed behind bars. As of today, very few prison sentences have been handed down, Bernie Madoff being a rare exception. Gillian Tett, “More prison sentences may renew financial credibility”, Financial Times, 4 Sep 09.


[18] Louis Uchitelle, “Volcker at odds with Obama team on banks”,  International Herald Tribune, 22 Oct 2009.

[19] Luiz Carlos Bresser-Pereira, Globalization and Competition: Why Some Emergent Countries Succeed While Others Fall Behind,  Cambridge University Press, 2010.

[20]  The first ever G20 heads of government summit, in Washington in November 2008,  asked the Financial Stability Forum, whose core had been the G7 states plus a few other mostly developed country governments, to admit all the remaining G20 states as members; and to create a permanent secretariate. The  expanded Financial Stability Forum signalled its upgraded status by changing its name to Financial Stability Board.  The G20 also requested the FSB to develop “supervisory colleges” to track major international financial markets and assess their systemic risk.


Also, the G20 agreed to inject a substantial new amount of capital into IMF, which had been on the road to oblivion because hardly any states were borrowing from it.  What is more, the G20, led by its developing country members, has pushed voting reform within the IMF and World Bank so as to give developing countries a bigger share of votes. So far they have had limited success, as seen in the voting shares I reported earlier. In the 2008 revisions, the share of the developed countries fell from 61.9% to “only” 60.0%, and the share of the “low income countries” rose from 3.3% to 3.8%.

The G7 states which dominate the IMF and the World Bank are certainly in no hurry to dilute their dominance. As of late 2009 there is talk of a “G20-IMF” merger, such that a new council of politicians, modelled on the G20 and perhaps with the same membership, should run the IMF. The new council would replace both the existing Executive Board, made up of full time officials, and the International Monetary and Financial Committee (IMFC) which is made up of ministers but has only an advisory role. See Phil Thornton, “G20-IMF merger sought”, Emerging Markets, 4 October2009, 3.  One of the champions of this governance change is Stanley Fischer, former IMF first deputy managing director.


Also in response to the G20, other international standard setting bodies, like the Basel Committee on Banking Supervision and the International Accounting Standards Board, have expanded their membership to include all the G20 countries. Another promising development is that the G24 of developing countries, which has long existed as a coordinating body for the borrowing countries of the IMF and World Bank but which has been noticeably feeble compared to the G7’s ability to concerted its actions, has been invigorated by the global crisis.



[21] George Bortz’s response in 1999 to: are you following the East Asian crisis?”  Anwar Shaikh story

[22]  Computations by authors on tax return statistics (the number of tax returns in 2006 was 138 million).  Income defined as annual gross income reported on tax returns excluding all government transfers (such as social security, unemployment benefits, welfare payments, etc.), and before individual income taxes and employees’ payroll taxes (but after employers’ payroll taxes and corporate income taxes).