“Banking on the State” by Andrew Haldane and Piergiorgio Alessandri is making waves in official circles. Haldane, Executive Director for Financial Stability at the Bank of England, is widely regarded as both a technical expert and as someone who can communicate his points effectively to policymakers. He is obviously closely in line--although not in complete agreement--with the thinking of Mervyn King, governor of the Bank of England.

Haldane and Alessandri offer a tough, perhaps bleak assessment. Our boom-bust-bailout cycle is, in their view, a “doom loop.” Banks have an incentive to take excessive risk and every time they and their creditors are bailed out, we create the conditions for the next crisis.

Any banker who denies this is the case lacks self-awareness or any sense of history, or perhaps just wants to do it again.

The Haldane-Alessandri “doom loop” is fast becoming the new baseline view, i.e., if you want to explain what happened or--more interestingly-- what can happen going forward, you need to position your arguments relative to the structure and data in their paper.

There are two broad views on our newly resurgent global bubbles--the increase in asset prices in emerging markets, fuelled by capital inflows, with all the associated bells and whistles (including dollar depreciation). These run-ups in stock market values and real estate prices are either benign or the beginnings of a major new malignancy.

The benign view, implicit in Secretary Geithner’s position at the G20 meeting last weekend, is most clearly articulated by Frederic (Ric) Mishkin, former member of the Fed’s Board of Governors and author of "The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems To Get Rich," in the Financial Times this morning.

The G20 Finance Ministers and Central Bank governors are meeting today in St. Andrews, talking about the data they will need to look at in order to monitor each other’s economic performance and sustain growth (seriously).

The underlying idea is that if you talk long enough about the U.S. current account deficit and the Chinese surplus, stuff happens and the imbalances will take care of themselves--or move on to take another form.

Warren Buffett seems to agree.

Josef Ackermann, chief executive of Deutsche Bank and chairman of the Institute of International Finance (an influential group, reflecting the interests of global finance in Washington) is opposed to breaking up big banks. According to the FT, he said,

“The idea that we could run modern, sophisticated, prosperous economies with a population of mid-sized savings banks is totally misguided.”

This is clever rhetoric--aiming to portray proponents of reform as populists with no notion of how a modern economy operates. But the problem is that some leading voices for breaking up banks come from people who are far from being populists, such as the UK authorities (in the news today) and the U.S.’s Thomas Hoenig.

The WSJ reports (online): “The U.K.’s top treasury official Sunday said the government is starting a process to rebuild the country’s banking system, likely pressing major divestments from institutions and trying to attract new retail banks to the market.” The British style is typically understated and policymakers always like to play down radical departures, but this is huge news.

Pressure from the EU has apparently had major impact--worries about unfair competition through subsidizing “too big to fail” banks are very real within the European market place. Also, strong voices from within the Bank of England have helped to move the consensus.

The U.S. position on protecting everything about our largest banks is starting to look increasingly isolated and out of step with best practice in other industrialized countries. Time to start planning for the breakup of Citigroup.

[Cross-posted at The Baseline Scenario.]

On Wednesday, Dan Tarullo, a governor of the Federal Reserve and distinguished law school professor, dismissed breaking up big banks as “more a provocative idea than a proposal” and instead put almost all his eggs in the “creation by Congress of a special resolution procedure for systemically important financial firms.” He stressed: “We are hopeful that Congress will, in its legislative response to the crisis, include a resolution mechanism and an extension of regulation to all systemically important financial institutions” (full speech).

This put him strikingly at odds with Mervyn King, governor of the Bank of England, who said Tuesday night, quite bluntly,

 “There are those who claim that such proposals [involving breaking up the largest banks] are impractical. It is hard to see why. Existing prudential regulation makes distinctions between different types of banking activities when determining capital requirements. What does seem impractical, however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.”

Tarullo’s speech actually framed today’s problem just right: “I would suggest … that the reform process cannot be judged a success unless it substantially reduces systemic risk generally and, in particular, the too-big-to-fail problem.” This is consistent with the tone of King’s remarks (even if less pointed than what Neal Barofsky said).

Just when our biggest banks thought they were out of the woods and into the money, the official consensus in their favor begins to crack. The Obama administration’s publicly stated view--from the highest level in the White House--remains that the banks cannot or should not be broken up. Their argument is that the big banks can be regulated into permanently low risk behavior.

In contrast, in an interview reported in the NYT this morning, Paul Volcker argues that attempts to regulate these banks will fail:

“The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company.”

Volcker may not have the ear of the President (as the NYT points out), and Alan Greenspan--also arguing for bank breakup, but along different lines--might also be ignored. But watch Mervyn King closely.

On Warren Olney’s radio show To The Point yesterday, I had a chance to talk with U.S. Chamber of Commerce management directly regarding the issue posed here last week: Why would an organization representing 3 million small businesses come out in support of our largest banks? My question was picked up and focused by the host.

Warren Olney (at the 36:35 mark): “Mr. Hirschmann, back to you. Are you serving the interests of your own members, if you resist the idea of breaking up the big banks?”

David Hirschmann (leading the Chamber’s financial lobbying efforts): “I just don’t think the question is whether we need to break up the big banks. The question is how do we ensure that the kinds of practices that they engaged in--and others outside the banking system--don’t happen any more. Which is why we pointed to transparency in areas like derivatives and leverage.” [my transcription]

Mr. Hirschmann then goes on to talk about the consumer protection agency (he’s opposed).

The conflict between the Chamber’s principles and its actions becomes increasingly clear.

The U.S. increasingly displays characteristics that we have seen many times in middle-income “emerging markets”--new dimensions of vast inequality, forms of financial instability that benefit the best connected, and consistently easy credit for the privileged. But this raises the question: Who exactly is going to dominate our economic and political landscape moving forward? 

The U.S. Chamber of Commerce is opposing the administration’s proposed Consumer Financial Protection Agency, on the grounds that it would hurt small business. Their argument is that this agency will extend the dead hand of government into every small business.

For the Chamber of Commerce, government is the enemy of small business and should always and everywhere be fought to a standstill. Chamber Senior Vice President (and former Fred Thompson campaign manager) Tom Collamore sees this as “advocacy on behalf of small businesses, job creators, and entrepreneurs” (quoted in the WSJ link above), and the Chamber has launched the “American Free Enterprise” campaign.

Somewhere, the Chamber’s senior leadership missed the plot. What brought on the greatest financial crisis since the 1930s? What has hurt, directly and indirectly, small business of all kinds to an unprecedented degree over the past 12 months? What is killing small and medium-sized banks at a rate not seen in nearly 80 years?

On Friday morning, Diana Farrell--a senior White House official--made a significant statement on NPR’s Morning Edition, with regard to whether our largest banks are too big and should be broken up.

“Ms. DIANA FARRELL (Deputy Assistant for Economy Policy): We understand Simon Johnson’s views on this, and I guess the response is the following….  

“Ms. FARRELL: We have created them [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.” (full transcript)

Ms. Farrell is Larry Summers’s deputy on the National Economic Council and the former director of McKinsey Global Institute, and she has a strong background on banking issues--based on extensive professional experience with global financial institutions.

Her statement contains three remarkable points.

Over the past 30 years Wall Street captured the thinking of official Washington, persuading policymakers on both sides of the aisle not to regulate (derivatives), to deregulate (Gramm-Leach-Bliley), to not enforce existing safety and soundness regulations (VaR), and to stand idly by while millions of consumers were misled into life-ruining financial decisions (Alan Greenspan).

This was pervasive cultural capture or, to be blunter, mind control. But when the crisis broke it was not enough. Having powerful people generally on your side is not what you need when all hell breaks loose in financial markets. Official decisions will be made fast, under great pressure, and by a small group of people standing up in the Oval Office. 

If you run a big troubled bank, you need a man on the inside--someone who will take your calls late at night and rely on you for on the ground knowledge. Preferably, this person should have little first-hand experience of the markets (it was hard to deceive JP Morgan and Benjamin Strong when they were deciding whom to save in 1907) and only a limited range of other contacts who could dispute your account of what is really needed.