NEW YORK (MarketWatch) — If you want to know the fate of bank stocks, why Bank of America Corp. may bring down the industry and the economy with it, you need to change how you think about how banking works in this country.

We tend to think of Washington and Wall Street as two separate entities. We think of the latter as private enterprise, and the former as the rule maker.

But with the financial crisis, along with the bailouts and “reforms” that followed, banking and government are more than just intertwined. They’re essentially the same entity. If one falters, so goes the other.

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The U.S. banking industry is more like China’s than we want to admit. Except it’s worse. At least China’s managed financial system works in harmony and the centralized decision-making there is part of a bigger plan.

In the U.S. market, there is no plan. Instead, competing agendas of lawmakers, regulators and bankers have ground the system to a halt. Lawmakers want to please the industry as well their own constituents — an impossible task since those interests are by nature opposed. Regulators want to flex their muscle, cover their butts and justify their existence. The bankers just want to make a lot of money.

In the years following the banking reforms of the 1930s, even that imperfect system basically worked. But beginning with the government’s promotion of home ownership and the creation of Fannie Mae and Freddie Mac, the arms-length relationship between responsible government and the private enterprise of banking has been corrupted.

During the last 30 years, banking has morphed into an arm of government, indeed a controlling one. There have been a lot of missteps, but the big blow came at the end of the Clinton administration, with the abolition of Glass-Steagall — the law that separated retail banking from investment banking.

That move created two massive problems: It created massive too-big-to-fail entities, and allowed casino-style gambling with money vital to the nation’s economic system: retail credit, mortgages, deposits and retirement savings.

What we’ve created is a system that is entirely dependent on huge, poorly run banks. With the bailouts, we acknowledged that the nation’s fortunes and the fortunes of those banks were one in the same.

We then made a bad situation worse with another critical mistake. Instead of realizing that banks, in fact, had become a part of government, we kept pretending that it really so, that the banks were private institutions. They “paid back” the bailout money by bilking their shareholders with stock offerings.

What’s becoming clear now is that when nationalization of too-big-to-fail banks was on the table in early 2009, it was an opportunity to acknowledge what the facts were: Big banks were too important to be run by a bunch of doddering managers. Bank of America BAC, +1.34% and Citigroup Inc. C, +1.62% should have been seized by the government or at least forced to keep their bailout funds until they stabilized.

Today, we know at least in Bank of America’s case, that was a big mistake. The government, counterparties and investors are suing the bank into submission over mortgage products sold by the bank and its predecessors — Countrywide and Merrill Lynch.

The lawsuits, which could cost tens of billions and force Bank of America into more drastic moves, are silly. Just two years ago, the government was rescuing the bank because it was vital to the nation’s economic system. Today, it’s suing the bank, pretending that any wounds inflicted won’t hurt credit and the economy.

Again, the Chinese wouldn’t make this sort of mistake. For all of that government’s flaws, the one thing it has right is that it understands banking is vital to economic planning. You can bet the Chinese wouldn’t sue their own banks for practices the government planners tacitly or directly approved.

So, you can see the problem. The bad news is that Washington is in denial; Wall Street is in denial. The good news is that most investors aren’t. They’ve pounded bank stocks, and they’ve pounded them for good reason.

Until government officials and bankers acknowledge the depth of the crisis and that it’s in their interests to work together, we’re going to be stuck in this mess.

Legal liability will hang over the banks. They’ll have to hoard cash to meet capital requirements. They’ll be reluctant to lend. And don’t think this is a problem just for B. of A. Banks continue to be intertwined through derivatives and counterparty agreements. If there’s a run on one bank, you can bet the problem will cascade through the system like it did in 2008. One only needs to look at the dominoes in Europe to see how little has changed. Read our coverage of European markets.

The solution would be to end the charade. The government could acknowledge that these megabanks are too important to the system and back their balance sheets with an explicit guarantee. Washington could call off the legal dogs and give the banks amnesty from financial penalties for fraudulent practices made leading up to the financial crisis.

If it sounds like socialism, you’re right. But we’re already there. We just won’t admit it. Investors shouldn’t pretend it’s some other way either.