Simon Johnson Is Such A Downer!

Too bad he's right.

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Simon Johnson, an MIT prof and former IMF chief economist, is behind the The Baseline Scenario blog, which has been a vital read during this crisis. This week he's particularly smart and scary on both upcoming policy decisions and wider structural problems that still need to be addressed in the economy.

First in the WSJ: With Peter Boone, Simon writes about Tim Geithner's "nuclear option" for the banks -- basically giving the government power to liquidate or restructure large troubled banks at the expense of bondholders and creditors who until this point have been largely protected to prevent the sort of investor flight from the banks that caused Lehman Bros./Bear Stearns-style failures. Such a move would take the impetus off of taxpayers, but would almost certainly send bond and equity markets into a severe swoon. Simon says if the government grants "resolution authority" power and regulators move quickly (as in yet another long weekend), the strategy could work. If the process takes months, uncertainty could result in market panic.

Bottom line for everyday investors: There's no real upside, other than the possibility of long-term financial stability (which might make it worth the risk). Whatever happens, if Geithner is granted authority and uses these new powers, the end result will likely be Very Bad Things for stocks even if the plan goes off without a hitch. He writes:

This route to recapitalization would not be pleasant. Bank shareholders and creditors will cry foul. There will be several months of turmoil in markets, and there will be substantial disruption since bond holders and some creditors may be required to take losses when they receive equity. It will also send shockwaves to other undercapitalized institutions around the world, and could lead to their share and debt prices falling in anticipation that other governments will follow America’s example.

For a broader look at the crisis, Johnson also shows up in May's The Atlantic where he puts on his IMF hat and takes a look at the U.S. economy. What he finds are scary parallels between our current situation and the sort of structurally unsound emerging market economies forced to reach out to the IMF for help:

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Banana Republic, here we come? Read the whole thing.

  • Kirk Shinkle

    Kirk Shinkle is a senior editor for U.S. News Money and manages the Best Funds portal. Follow him on Twitter @KirkS or email him at kshinkle@usnews.com.

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