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Monday, September 15, 2014
Stress Fractures by Adam White, City Journal Summer 2014
On market crashes and the arrogance of financial elites
PABLO MARTINEZ MONSIVAIS/AP PHOTO
President Obama’s first Treasury secretary, Tim Geithner, preferred regulatory power to the rule of law.
When Robert Rubin stepped down as Treasury secretary in 1999, Timothy Geithner and other members of Rubin’s team collected their mentor’s wisdom in a framed document, “The Rubin Doctrine of International Finance.” Among its ten principles: “Borrowers must bear the consequences of the debts they incur—and creditors of the lending they provide”; and “never let your rhetoric commit you to something you cannot deliver.” Rubin appreciated the gift, but he recognized that his students’ education was incomplete. In his 2003 memoir, Rubin added “another important rule of mine that Tim and his colleagues neglected. . . . Reality is always more complex than concepts and models.” We may be fond of our analytic prowess, but we cannot count on the world to fit our designs and prejudices.
If Geithner hadn’t learned that lesson during Rubin’s tenure as Treasury secretary, he would not lack for opportunities to absorb it firsthand, the hard way. In the decade to come, as president of the Federal Reserve Bank of New York and then Treasury secretary, Geithner would confront crises far greater than even Rubin had faced in the 1990s. In Stress Test, his new memoir, Geithner recounts these episodes and attempts to justify the actions that he took to avert disaster.
During Geithner’s tenure at the Treasury, another veteran financial regulator was getting a financial reeducation—this time from a distance. As chairman of the Federal Reserve from 1987 to 2006, Alan Greenspan had fought the 1990s financial battles at Rubin’s side. In 1999, after navigating through financial storms in Latin America and Asia, Rubin, Greenspan, and Rubin’s deputy secretary, Larry Summers, appeared on the cover of Time under the headline THE COMMITTEE TO SAVE THE WORLD. But when the financial system melted down in 2007 and 2008, much of the public concluded that the “committee” had not saved the world but had, in fact, doomed it, by laying the regulatory and monetary groundwork for the crash.
Greenspan himself would come to question his well-known premises. Long a believer in markets’ power to regulate themselves, he now saw validity in modern behavioral economists’ (and twentieth-century economist John Maynard Keynes’s) belief that markets are driven not just by rational choices but also by inefficient instincts and counterproductive emotions. And last year, he, too, offered a new book to explain both the crisis behind us and the path ahead: The Map and the Territory.
Geithner and Greenspan disagree on many things, and their books point readers in very different directions. But they both present their stories as almost exclusively technocratic affairs, ill-suited to popular meddling. Indeed, their substantial disagreements should not overshadow their basic agreement on the nature of financial policy and the government that formulates and implements it. They share a fundamental belief that financial policy is developed best when it is insulated from politics and politicians. When it comes to making decisions in a financial crisis, the people and their elected representatives should just get out of the experts’ way.
Though it’s a long book, Stress Test’s message is captured in one short quotation: “Tim was present at all the crises,” said Bank of England governor Mervyn King, “but he didn’t cause the crises. The crises caused him.” Geithner agrees wholeheartedly. “Again and again, I got to see how indulgent capital financed booms, how cracks in confidence turned boom to bust to panic, how crisis managers could help contain panics with decisiveness and overwhelming force, and how the kinds of actions needed to defuse crises were inherently unpopular and fraught with risk,” he writes. Geithner arrived at this position by an “accidental path to history.” His father’s work for USAID and the Ford Foundation made for a remarkable childhood, much of it spent abroad in Africa, India, and Thailand (in an admittedly “quasi-colonial existence, with drivers, maids, gardeners, and night watchmen”). He later lived in the suburbs of New York and Washington, D.C., before attending Dartmouth and later, the Johns Hopkins School of Advanced International Service, where his education focused less on economics and finance than on international studies. After graduation, he joined Henry Kissinger’s consulting firm as an Asia analyst. But he soon tired of “writing about what others were doing in government” and joined the Treasury Department in 1988 as a civil servant.
Treasury’s international trade office sent him to Japan, in the aftermath of the Japanese stock bubble, before bringing him back to Washington to work for then-undersecretary for international affairs Larry Summers, who proved to be the dominant intellectual and professional influence in Geithner’s career. In the “Committee to Save the World” years, Rubin and Summers collaborated with Greenspan to limit the global financial damage wrought by currency crises migrating across the globe: the Mexican peso; the Thai baht; the Indonesian rupiah; the South Korean won; and then fiscal meltdowns in Russia, Ukraine, Brazil, and Turkey. Russia’s default finally brought the trouble home to the United States, putting the heralded Long-Term Capital Management hedge fund on the brink of collapse and threatening broader damage to its counterparties and others on Wall Street.
From this trial by fire, Geithner concluded that the basic source of financial catastrophe is cyclical mania: “a general overconfidence that a long stretch of calm and stability foreshadowed more calm and stability,” leading to increasingly aggressive risk taking, exacerbated by debt (or “leverage”). Geithner also settled upon a basic narrative mind-set, pitting pragmatic financial regulators against both benighted, pitchfork-wielding populists and doom-and-gloom prophets of “moral hazard.” Moral hazard is a theory of incentives: when the government rescues you from a problem of your own making, it may have the perverse effect of fostering expectations among others that the government will save them from similar straits. In banking, the government’s rescue of one troubled bank or fund may encourage others to take on still greater risks, confident that the government will step in if things go wrong.
“There’s no way to solve a financial crisis,” Geithner contends, “without creating some moral hazard, without protecting investors and institutions from some of the consequences of excessive risk taking.” And sometimes, this requires even rescuing particularly bad actors in service of the greater good because “trying to mete out punishment to perpetrators during a genuinely systemic crisis—by letting major firms fail or forcing senior creditors to accept haircuts—can pour gasoline on the fire.” The public may cry out for “Old Testament vengeance,” but “the truly moral thing to do during a raging financial inferno is to put it out. The goal should be to protect the innocent, even if some of the arsonists escape their full measure of justice.”
Geithner carried this mind-set from the Treasury to the International Monetary Fund, where he briefly served as head of policy, before being selected as president of the Federal Reserve Bank of New York in 2003. The Federal Reserve System comprises three basic overlapping bodies: the presidentially appointed Board of Governors, which includes the Federal Reserve chairman; the 12 regional Federal Reserve Banks, largely private entities wielding largely public power; and the Federal Open Market Committee, made up of the board’s seven members and five of the 12 regional bank presidents, which effectively sets the nation’s monetary policy. The New York Fed is more than merely first among equals. It is, in Geithner’s words, “the government’s main outpost in America’s financial center,” the “largest and most influential” of the 12 regional banks. Its president has a permanent seat on the Federal Open Market Committee; its staff “implement[s] monetary policy” by buying and selling government securities; and it “shares responsibility for supervising some of America’s biggest banks.”
In that last respect, the New York Fed is, to a considerable extent, government of the banks, by the banks: its president is selected by a board filled with bank executives. The Blackstone Group’s billionaire cofounder, Pete Peterson—at the behest of Rubin and Summers—tapped the 42-year-old Geithner for the New York Fed presidency. Peterson and the others trumpeted Geithner’s record as a crisis manager and political dealer: “What he brings to the job,” reported Bloomberg News, “are political skills honed over a decade of dealings with bondholders and finance ministries, some of them coping with financial crises.” He would need those skills and then some.
From the outset of his term at the New York Fed, Geithner highlighted the problem of “systemic risk”—that is, the danger that damage to one financial firm might reverberate through the broader financial community. In October 2004, at a conference in Chicago, Geithner discussed a mix of issues that would someday become all too familiar: the increasingly large market share of a few large banks, the role of nonbank financial institutions, and the dangerous balance sheets of Fannie Mae and Freddie Mac. In the context of our “evolving financial system,” he warned, it was “important to recognize that we do not know a lot about the underlying dynamics of financial crises.” Such risks might have been covered by recent years of low inflation and minimal volatility, but it would be a dangerous mistake to assume that such favorable conditions “will be with us indefinitely.”
His concerns soon proved prescient. “Froth” in the housing markets, fueled by easy credit, inflated the subprime bubble. When that bubble burst in 2007, it sent a wave of panic through long-staid money-market funds, putting Wall Street on the edge of its seat.
As Geithner acknowledges in Stress Test, Walter Bagehot’s 1873 classic,Lombard Street—“the bible of central banking”—urges that to stop a run on the banks, the central bank should “lend freely, boldly,” to convince the public that banks are liquid. It also should take care to make those loans at “a penalty rate” in order to deter banks from continuing to borrow after the crisis passes. Geithner and Fed chairman Ben Bernanke, working closely together to ease the crisis, chose to ignore Bagehot’s second point. “We decided to try something unusual right away,” Geithner explains, “to reduce the penalty rate that banks paid to borrow from the Fed’s discount window” in order to “reduce the stigma for banks who feared that using the window would signal distress.” This approach drew criticism from what Geithner describes as “a group of hawkish regional Fed presidents . . . whose main concerns were preserving the Fed’s inflation-fighting credibility and avoiding moral hazard.” Worse still, in Geithner’s opinion, these critics “frequently deployed populist arguments against our lender-of-last-resort initiatives.”
To say that such critics frustrated him would be an understatement. In a theme that dominates Stress Test, Geithner paints them as unserious ideologues—and himself, much in the manner of the man who would become his boss, President Obama, as a practical problem solver:
I don’t think I’m hawkish or dovish by nature. I’ve always been pretty pragmatic, suspicious of ideology in any form, and I took both halves of the Fed’s dual mandate [i.e., employment and steady prices] seriously. But I found the more hawkish obsessions with moral hazard and inflation during a credit crunch bizarre and frustrating.
To Geithner, his critics were not just economists wary of moral hazard. They were—to borrow a phrase he uses throughout his book—“moral hazard fundamentalists.”
Alan Greenspan is a moral-hazard fundamentalist, in word if not in deed. While The Map and the Territory doesn’t use the term “fundamentalist,” one of its key themes is that the American financial system, in the aftermath of the recent crisis, embodies an “extraordinarily large moral hazard”—namely, the markets’ belief that the government will not allow large banks to fail. This is not to say that Greenspan categorically opposes government rescues in exceptional cases. In his 2007 book, The Age of Turbulence, he defended the IMF’s efforts to prevent a South Korean default, despite the potentially negative ramifications: “There was always the chance that a rescue this large would set a bad precedent. . . . Yet the consequences of allowing South Korea to default would have been worse, possibly far worse.” Greenspan’s point is that financial regulators must pay keen attention to moral hazard and make clear that government will not intervene except in extraordinary circumstances.
If that distinction is merely implied in The Map and the Territory, Greenspan has pressed it more explicitly elsewhere. “Hundred-year floods come only once every hundred years,” he said in a 2000 speech. “Financial institutions should expect to look to the central bank only in extremely rare situations.” And yet the book’s core message is an emphatic break with its author’s long-standing faith in financial markets’ capacity for self-regulation. As Greenspan confessed in a widely discussedFinancial Times column and repeats here: “Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief.”
Greenspan had “an almost theological belief that markets were rational and efficient,” according to Geithner. After the crash, Greenspan lost faith not in markets per se but in the people who move them. Drawing on Keynes’s description of investors’ “animal spirits”—their euphorias and panics—Greenspan admits that he has “come around to the view that there is something more systematic about the way people behave irrationally, especially during periods of extreme economic stress, than I had previously contemplated.” (One is reminded of conservative writer Willi Schlamm’s quip, oft-repeated by William F. Buckley, that “the problem with capitalism is capitalists.”) Thus, The Map and the Territoryis Greenspan’s account of losing his religion and, in turn, learning to live in a fallen world. For Greenspan, the task requires attention to how we forecast the future to account for such “animal spirits” and structure markets and institutions to be resilient, not susceptible, to investors’ inevitable moments of panic and euphoria. We need to recognize that our maps may not accurately reflect the territory.
But Greenspan hasn’t lost faith in mapmakers. Quite the contrary—he believes that we can and must draw better maps. Forecasting “will always be somewhat of a coin toss,” but “if we appropriately integrate some of the aspects of animal spirits’ systematic behavior, constrained by market forces reflecting the imperatives of double-entry bookkeeping identities, we should importantly improve our forecasting accuracy,” he writes obscurely—an illustration of his “flair for eloquent fog,” as Geithner describes it.
Turning from the map to the territory, Green-span argues that systemic risk remains the primary financial threat of our time. He gives himself credit for raising these issues long before the crisis hit, quoting a decade-old speech in which he argued that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.” But he conspicuously fails to mention that in the same speech, he opposed “heavier supervision and regulation” of those banks, which he urged “would likely lead to the virtual abdication of risk evaluation by creditors” and thus “increase the risks in the banking system, quite the opposite of what is intended.”
Greenspan attempts subtly to rewrite history elsewhere, too. Buried deep in the footnotes to The Map and the Territory, he dedicates several paragraphs to defending Congress’s late-1990s enactment of the Gramm-Leach-Bliley Act, which repealed the New Deal–era Glass-Steagall Act. Critics argue that Gramm-Leach-Bliley removed the wall between government-insured consumer banking and riskier, uninsured investment banking, and that this change—made at Greenspan’s and Rubin’s behest—fostered the risk taking that led to the financial crisis. Greenspan replies that “the repeal of the Glass-Steagall Act in fact changed very little”—that “the mandatory separation of commercial and investment banking had essentially already been nullified more than a decade earlier.” That’s a remarkable statement, not only in light of Greenspan’s 1990s advocacy for Glass-Steagall’s repeal but also of his more recent writings. In The Age of Turbulence, Greenspan wrote that Gramm-Leach-Bliley “restored sorely needed flexibility to the financial industry.” After the crash, that argument lost its appeal.
For years, banks seen as too big to fail (or, “Systemically Important Financial Institutions”) enjoyed a substantial “SIFI subsidy”: since markets saw them as less risky, because of their implicit government protection, SIFIs were able to attract capital at much lower cost than their non-SIFI competitors. This effect has been documented repeatedly by researchers, including recently by the Bank of England. This problem will persist, Greenspan writes, until the government makes clear that it will “allow large institutions to fail”—an argument that Nicole Gelinas and Luigi Zingales have made in the pages of City Journal. (See “Too Big to Fail Must Die” and “Stop Subsidizing the Street,” Summer 2009.)
This, too, reflects a change in Greenspan’s view of markets and government. For while Greenspan has long railed against moral hazard, he conceded at least some role for central banks to “provide what essentially amounts to catastrophic financial insurance coverage,” as he put it in a 1995 speech. This “public subsidy,” he said, was to be reserved “for only the rarest of disasters, triggered, at most, a handful of times per century.” Without it, Greenspan argued that financial institutions would be too risk-averse, adopting “an attitude of excessive caution that stifles the health of the overall economy.”
Greenspan’s rhetorical commitment to preventing moral hazard should be taken with a grain of salt, however. For even while he urges that from now on, big banks must be allowed to fail, he endorses the government’s aggressive action to stem the 2007–08 crisis. “Almost all agree that activist government policy was necessary” after Lehman Brothers’ bankruptcy, he writes, because the ensuing panic was “arguably a once-in-a-century event” that “necessitated special policy treatment.” Indeed, during his long tenure at the Federal Reserve, he often delivered “special policy treatment” to stem crises. In 1999, when Long-Term Capital Management’s collapse threatened to do substantial harm to Wall Street, Greenspan stepped in to cut interest rates multiple times—“a signal that he would cut and keep cutting until liquidity to the system was restored,” according to Roger Lowenstein’s When Genius Failed, his account of the crisis. Perhaps that, too, was a once-in-a-century event. They seem to occur more frequently these days.
Greenspan’s penchant for reliably pushing interest rates down to keep stock prices high became well-known and widely debated. In effect, he gave investors the sense that they had a “put option,” a right to sell their stocks at a high price. “It’s official,” the Financial Times announced in early 2001. “There is a Greenspan put option.”
There would be a “Geithner put,” too, as Geithner himself describes inStress Test. By February 2009, after President Obama appointed him Treasury secretary, Geithner and his team had devised a strategy to prop up banks by subjecting them to “stress tests,” and then requiring the banks to take on new capital to “plug their shortfalls.” If the bank couldn’t raise the capital itself, then the government would invest Troubled Asset Relief Program (TARP) funds in the bank, buying preferred shares convertible into common stock. The Geithner Put, the author observes, “effectively created a flood under bank stock prices, stopping the death spiral and encouraging private investments in financial firms that otherwise would have looked much too risky.”
But propping up the banks wasn’t just a one-time strategy. Rather, asStress Test makes all too clear, Geithner’s instinctive response to any financial crisis was to throw money at it, the doubts of “moral-hazard fundamentalists” notwithstanding. The bulk of his book, recounting his actions at the New York Fed and at the Treasury, is a long series of such examples. When Bear Stearns faltered in 2008, and Geithner feared that the investment bank was “too interconnected to fail,” the New York Fed arranged to lend money to Bear via JPMorgan Chase, which, unlike Bear, had access to the Fed’s “discount window.” Ultimately, the Fed simply loaned JPMorgan Chase $30 billion to acquire Bear. “We knew we would be crossing a line the Fed had not crossed since the Great Depression, indirectly lending to a brokerage house that was supposed to function outside the bank safety net. . . . But I thought the loan was the right thing to do; we had to buy time to at least try to avert disaster,” Geithner writes.
Geithner would have invested federal money in Lehman Brothers, too, if Treasury secretary Hank Paulson would have let him: “[W]hatever the merits of no-public-money as a bargaining position, I didn’t think it made sense as actual public policy.” When AIG’s mortgage debt securities became the next crisis, Geithner argued that “rescuing AIG was our least-worst option.” And when the housing crash stalled the Obama administration’s hopes for economic recovery, Geithner sounded the call again. “I was no housing expert, but, again, my bias was to do the most aggressive interventions that were sensible and feasible.” The alternative course of action, he opines, would allow mere “politics” to override sound policy. When Paulson and Fed chairman Bernanke disagreed with Geithner’s plan to bail out Lehman, they were simply succumbing to “political expedience”; when they later warmed to Geithner’s approach, they showed “the courage to change course and do what needed to be done.”
Such criticism is not reserved for opponents of a Lehman bailout. The second half of Stress Test brims with disgust for politics. “I know this sounds terribly antidemocratic,” he offers in his discussion of the TARP bill, “but it was ridiculous, at a time when we needed overwhelming force to do unpopular things, to expect elected officials to design the details of an exceedingly complicated rescue in the midst of a full run on the global financial system.” Congress needed to hand the checkbook over to the regulators. The problem isn’t simply that Congress is inefficient or incompetent but that Congress is corruptible: “History suggested that Capitol Hill would be too easily swayed by the clout of the financial industry and the politics of the moment.”
That last criticism is truly ironic. For though Geithner bristles at the suggestion that he is a “Wall Street ally” or “insider,” Stress Test offers ample evidence for these identifications. He may not have been a “Goldman Sachs alum,” as a columnist once erroneously suggested, but at the New York Fed and the Treasury, Geithner unfailingly relieved Wall Street of the cost of its mistakes. His claim that he had let the arsonists go free only so that he could fight the fire rings hollow when he is calling a shaken Lloyd Blankfein, urging the Goldman Sachs CEO to “get that fear out of your voice,” or when Citigroup’s architect, Sandy Weill, approaches him in late 2007 and offers to hire him as Citi’s new CEO, despite his lack of private-sector experience. As journalist Joshua Green put it, “Geithner wasn’t a Wall Street insider. But he knew somebody who was.” In fact, he knew all of them. And when they weren’t recruiting him, he was recruiting them: at one point in Stress Test, he lists the all-star team of bank CEOs and other “prominent financiers” whom he had tapped for the New York Fed’s board. “I basically restored the New York Fed board to its historic roots as an elite roster of the local financial establishment,” he explains.
Geithner’s predisposition toward Wall Street is most apparent when he describes his opposition to bailing out other industries. On the question of whether to bail out over-leveraged homeowners, Geithner suddenly sounds like a moral-hazard fundamentalist: “We had to be careful not to create perverse incentives.” His concern for innocent victims justified letting wrongdoers escape harm on Wall Street; but for homeowners, he took precisely the opposite approach: the government could not be seen “subsidiz[ing] borrowers who splurged on overpriced McMansions,” even if, under the resulting policy, “inevitably, some innocent victims of the crisis would have to move into cheaper homes or rental properties.”
Nor would Geithner consider bailing out the auto industry. At a TARP oversight hearing, Elizabeth Warren pressed him to explain why the government would bail out Wall Street but not Detroit. “The financial industry is very different from the auto industry and every other industry,” he writes, since banks are much more dependent on public trust in their liquidity. But Geithner’s actions demonstrate how he approached the two industries with fundamentally different instincts and sympathies. When the public expressed outrage toward bailed-out bank CEOs, Geithner blanched at what Bill Clinton called their “bloodlust,” agreeing with the former president that the people were “just too angry to be appeased.” Yet just pages later, Geithner takes pleasure in the administration’s effective firing of General Motors CEO Rick Wagoner. “If anything, that move increased my confidence in Team Auto,” he writes, because it reflected “an appropriate disdain for its leadership’s unwillingness to change.”
Geithner admits that after a while, even bankers began stating publicly that Washington was on their side. “We’re all in this together,” Citigroup CEO Vikram Pandit told the press at one White House meeting. Geithner claims that this was “not quite the message the White House wanted,” but the White House made similar statements at this meeting. “The President emphasized that Wall Street needs Main Street, and that Main Street needs Wall Street,” press secretary Robert Gibbs summarized, “that everybody has to pitch in; that we’re all in this together.”
FRANK FRANKLIN II/ AP PHOTO
A lifelong believer in the rationality of free markets, former Fed chairman Alan Greenspan has become more receptive to the idea that “people behave irrationally, especially during periods of extreme economic stress.”
Greenspan sees this government-bank embrace as entirely wrongheaded, but President Obama formalized it when he signed the Dodd-Frank Act in 2010. Three key provisions in the act purported to end “too big to fail”: the “Volcker Rule” would require that banks separate their government-insured consumer deposits from their riskier proprietary investments; the Financial Stability Oversight Council, an interagency body comprising the heads of the Fed, Treasury, FDIC, SEC, and other agencies, would designate particular banks and nonbank financial institutions as “Systemically Important Financial Institutions” (SIFIs); and the “Orderly Liquidation Authority” would empower the Treasury secretary, with the Federal Reserve and FDIC, to “liquidate” troubled SIFIs outside the normal court-managed bankruptcy laws.
By and large, Greenspan sees Dodd-Frank not as solving too big to fail but exacerbating it. By designating banks and nonbanks as “SIFIs,” regulators are officially “rendering them guaranteed by the federal government,” just as Fannie Mae and Freddie Mac were. Investors, in turn, “will continue to underprice the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline”—thus only encouraging the institutions to “take on too much risk.” While Greenspan doesn’t directly discuss Dodd-Frank’s “Orderly Liquidation” process, he does offer his own substantially different framework for how best to allow SIFIs to fail: instead of granting the Treasury and the FDIC effectively unbounded power with minimal judicial oversight (as Dodd-Frank does), Greenspan would turn first to private financing and then, if necessary, would break up the financial institution into smaller units in a process managed by federal judges.
Geithner criticizes Dodd-Frank, too—but from precisely the opposite direction. He argues that Dodd-Frank gives the Fed and the Treasury too little discretion, not too much. He likes the SIFI-designation process but complains that it should be handled by the Fed, not by the interagency Financial Stability Oversight Council. More significantly, he approves of the “Orderly Liquidation Authority” but regrets that Congress combined it with a new limit on the Fed’s power to bail out individual companies. The Fed’s primary tool in the crisis, he explains, was Section 13(3) of the Federal Reserve Act, which empowered the Fed, in “unusual and exigent circumstances,” to lend directly to borrowers unable to obtain credit elsewhere. Dodd-Frank nominally pares back this power, by requiring that such lending be directed not to individual firms, but rather with “broad-based eligibility,” to prevent regulators from bailing out individual, politically favored banks. According to Geithner, this limit on Fed discretion, coupled with other limits on the FDIC’s power to backstop banks, “will hinder the response to the next crisis.”
Geithner’s criticism of these statutory limits is less surprising than his earnest suggestion that the statutes actually limit anything. Throughout the crisis, Geithner and his colleagues consciously pushed their authority as far as possible—if not by exceeding statutory limits on their powers (which he argues they never did) then by interpreting those statutes as generously as possible. We can trust his successors to interpret Dodd-Frank’s new “restrictions” with similar creativity, especially when a variety of commentators (including Richmond Federal Reserve Bank president Jeffrey Lacker, Harvard Law School financial systems professor Hal Scott, and House Financial Services Committee chairman Jeb Hensarling) argue that the amendment leaves more than enough room for the Fed to bail out specific firms.
There are more substantive problems with Geithner’s policy prescriptions. He does not answer the objection, raised by Greenspan and others, that the Financial Stability Oversight Council’s formal “SIFI” designations effectively provide concrete too-big-to-fail status. Geithner surely recognizes the seriousness of this issue. When FDIC chairwoman Sheila Bair attempted, during the crisis, to limit the class of troubled banks that would receive full government protection, Geithner argued that this sort of line-drawing would have perverse effects: “Once a government sets a dividing line between what’s guaranteed and what isn’t, it can spark a run from the debts and firms just beyond the line to the debts and firms on the safe side.” Yet in endorsing Dodd-Frank’s new system of formal “SIFI” designations, Geithner does not seriously grapple with the idea that the new SIFI “dividing line” will spark the very same type of run.
But the most troubling aspect of Geithner’s preferred framework is the corrosive effect that it has on the rule of law and our cultural preference for subjecting executive authority to it—a preference that undergirds our market system. Geithner himself acknowledges this, if only in justifying the administration’s refusal to prevent AIG from paying substantial bonuses to its employees after the government bailout. “We weren’t Venezuela,” he writes. “In a storm, the world needs anchors,” and the “rule of law was arguably our most important anchor.” Yet at every turn—through the crises, and in the construction of Dodd-Frank—Geithner prefers discretion over statutory limits. And even setting aside the Fed’s “exigent circumstances” power, the powers conferred upon regulators by Dodd-Frank’s “Orderly Liquidation” provision—allowing the government to suspend fundamental bankruptcy-code rights and setting draconian limits on judicial review of the liquidation process—threaten the rule of law far more profoundly than limiting the AIG bonuses ever would have done.
On these points, too, Geithner should read more Lombard Street. “Credit means that a certain confidence is given, and a certain trust reposed,” Bagehot writes. “To put it more simply—credit is a set of promises to pay; will those promises be kept?” Geithner’s goal of concentrating ever-greater power and discretion in the hands of regulators only undermines market confidence in the system’s promises.
Geithner’s scorn for statutory limits is matched only by his disdain for political accountability. And on that point, for all their disagreements with each other, Geithner and Greenspan agree wholeheartedly. Indeed, Geithner’s criticism of politics and politicians is matched and perhaps exceeded by Greenspan’s. In The Map and the Territory, Greenspan stresses that “my most worrisome concern” is not Wall Street but “our broken political system,” where sound economic policy developed by elite technocrats can only be corrupted by “the pull of political bias,” the “herd behavior” that presents itself “in any democratic society.”
Of course, momentary public opinion is rarely the best judge of sound policy, particularly when passions outpace reason. But to say that the people and their elected representatives are often wrong is not to say that they are always wrong, much less that unelected financial regulators owe them no obligation to give their concerns some consideration before charging forward with momentous financial decisions.
Yes, public sentiment might give rise to hasty congressional policy—but financial regulators aren’t immune to the same tendencies, even when administering well-intentioned programs. Take, for example, Treasury secretary Paulson’s creation of TARP in late 2008. When Paulson and assistant secretary Neel Kashkari requested a jaw-dropping $750 billion from Congress, was that sum the result of dispassionate, rigorous analysis? Not quite, according to Andrew Ross Sorkin’s 2009 book, Too Big to Fail:
The relevant figure would ultimately be the one that represented the most they could possibly ask from Congress without raising too many questions. Whatever that sum turned out to be, they knew they could count on Kashkari to perform some sort of mathematical voodoo to justify it: “There’s around $11 trillion in residential mortgages, there’s around $3 trillion of commercial mortgages, that leads to $14 trillion, roughly five percent of that is $700 billion.” As he plucked numbers from thin air even Kashkari laughed at the absurdity of it all.
Such immense sums of money, arrived upon by such admittedly arbitrary processes, raised many eyebrows—but not Geithner’s: “I just wanted Congress to pass it as fast as possible while screwing it up as little as possible.” His concern that Congress might be incapable of competently handling this “exceedingly complicated rescue” is perhaps the best distillation of Geithner’s mind-set.
Geithner invokes our first Treasury secretary, Alexander Hamilton, as an advocate “for executive power and a strong financial system.” Hamilton’s famous appreciation of “energy in the executive,” in Federalist 70, echoessub silentio throughout Geithner’s book. But the former Treasury secretary neglects Hamilton’s concomitant appreciation for checks and balances, as expressed in Federalist 78: Congress “not only commands the purse, but prescribes the rules by which the duties and rights of every citizen are to be regulated.” James Madison put the point even more directly in Federalist 58: the Constitution vests Congress with the “power of the purse” in order to serve as the people’s “most complete and effectual weapon” against “the overgrown prerogatives” of the other branches of government—including the executive branch.
Today, we vest immense power, both formally and practically, in the hands of the Treasury and the Federal Reserve, and with good reason. But officials holding those powers ought to consider the doubts and concerns of elected officials and the people they represent, if only to guard against overconfidence in their own abilities. Moreover, while Treasury and Federal Reserve officials may well know more than Congress about the technical policy questions at issue in a financial crisis, there is no reason to presume that regulators have nothing to learn from Congress and the public about the questions of justice and equity. Such questions are central to financial policy, even in emergencies.
“This is the central paradox of financial crises,” Geithner writes in his closing pages. “What feels just and fair is often the opposite of what’s required for a just and fair outcome.” And this is why, he writes, “policymakers generally tend to make crises worse, and why the politics of crisis management are always untenable.” But the second point does not follow from the first. The Treasury and the Fed might handle purely technical questions better than Congress and citizens, but advanced degrees in macroeconomic modeling don’t guarantee superior insight into what constitutes “a just and fair outcome.” Sometimes “animal spirits” are found not merely on Wall Street but in the Treasury and Federal Reserve Buildings, too.
Adam White is a lawyer in Washington, D.C. He works on a variety of financial and energy regulation issues, including a constitutional challenge to parts of the Dodd-Frank Act.