Readings on U.S. Economy I need to study for my Government Paper:
TARP and the Treasury:
Time to Allow Markets to Work
James L. Gattuso, David C. John, and J. D. Foster, Ph.D.
Treasury Secretary Henry Paulson recently
announced yet another change in direction of the
“Troubled Asset Relief Program” (TARP), sowing
more uncertainty and confusion in the very financial
markets the program is supposed to stabilize.
Instead of buying mortgage-backed assets as originally
intended, Paulson says he is now considering
three alternative initiatives:
1. Stock purchases in non-bank financial firms;
2. Federal financing for investors in securities
backed by consumer debt such as car loans, student
loans, and credit cards; and
3. Subsidies to mitigate mortgage foreclosures.
Rather than moving forward with these new and
troubling approaches, Paulson should follow his
own advice and let the markets work—including
time for them to absorb his earlier initiatives.
TARP: Then and Now. Less than six weeks
ago, Congress enacted legislation authorizing a
massive $700 billion rescue plan for the nation’s
financial markets. The goal, as outlined by Paulson,
was to prevent a massive, systemic failure of
global financial markets. The solution, according
to Paulson, was a “Troubled Asset Relief Program”
consisting of massive purchases of illiquid “toxic”
assets by the federal government from financial
firms so that markets could continue to function.
The focus was widely expected to be on mortgagebacked
securities, whose value was often extraordinarily
uncertain, leading to a freezing up of
The ink was barely dry on the legislation, however,
when Treasury adopted a new—and more
problematic—approach: directly infusing selected
U.S. banks with capital by purchasing non-voting
preferred equity shares. Granted, Treasury’s hand
in this was in part forced by European governments,
which paved the way with massive capital
infusions into their own banking systems. However,
the original TARP plan, as envisioned when
Congress adopted the authorizing legislation,
never went forward.
On November 12, Paulson announced that Treasury
no longer planned to buy any mortgagebacked
securities, except perhaps in certain targeted
instances. Instead, he put forth a number of other
possible initiatives the Treasury might pursue with
the $700 billion that Congress authorized, as well as
other authorities such as: purchases of stock in nonbank
financial firms; federal financing for investors
in securities backed by consumer debt such as car
loans, student loans, and credit cards; and subsidies
to mitigate mortgage foreclosures.
Paulson’s Course Changes Confuse Markets.
These possible moves, however, would likely exacerbate
rather than ease the current financial probNo.
2131 WebMemo November 14, 2008
lem. Not only are there serious questions about the
need for these specific actions, but—and perhaps
more importantly—the uncertainty created by yet
another game plan for the rescue casts doubt on the
financial rescue plan as a whole, its administration,
and the prospects for its success.
Certainly, the Treasury Department can legally
forego the mortgage-backed security purchase program.
From the outset, Secretary Paulson emphasized
the dynamic and rapidly changing nature of
the financial crisis, and the need to be able to adapt.
And under the terms of the legislation passed by
Congress, although it was clear that the primary
intent was to buy toxic mortgage-backed securities,
the flexibility to purchase other assets was explicitly
provided. Even more clearly, no one would want to
require the federal government to intervene in markets
where its intervention is no longer necessary, as
seems to be the case with the mortgage-backed
No Bailouts for Non-Banks. Nevertheless, each
of the various plans for expanding the program
raises serious questions.
Capital purchases—the acquisition of ownership
by the government in private-sector firms—presents
inherent and inevitable dangers. Already,
political pressure is growing for the government to
exercise greater control over the activities of banks
participating in the capital program. Moreover, as
Paulson himself noted, because many such institutions
are not regulated and engage in a variety of
businesses, protecting taxpayers would be more difficult.
The Treasury should not extend the capital
purchase program to non-bank firms.1
Need for Consumer Credit Bailout Dubious.
The second possible new initiative—the purchase
of consumer credit securities—raises different concerns.
Treasury argues that since the problem has
shifted, so should the focus of their attention. But to
justify intervention, Treasury needs to show that the
problems in these markets present a potentially catastrophic,
systemic threat to the ability of the financial
system as a whole to function.
In his statement, Paulson argued that “illiquidity
in this sector is raising the cost and reducing
the availability of car loans, student loans and
credit cards.” This he said “is creating a heavy burden
on the American people and reducing the
number of jobs in the economy.” Such harms are
real and should not be minimized. But they fall
short of the sort of systemic threat to the operation
of the financial sector as a whole that led Congress
to create the TARP program. If such a threat is
indeed present, then Treasury should demonstrate
this explicitly, and make a clear and compelling
case for such purchases.
New Program for Mortgages Unnecessary. The
third initiative discussed by Paulson—reducing
mortgage foreclosures—is the least well defined.
The general goal is to encourage mortgage holders
to modify mortgages on a streamlined basis, reducing
payments for struggling homeowners. That
goal, he said, was to be pursued using leverage
gained from mortgage-backed securities purchases.
Now that Treasury has decided not to purchase
such assets, he explained, other means are needed
to pursue it. He did not specify those means,
although he said any would require “substantial
Yet such a separate program would be unnecessary
if, as Treasury asserts, other actions succeed in
ensuring functioning credit markets. On top of this,
there are already many other programs in place to
help homeowners. In any case, intervening directly
in the mortgage market promises only further market
distortions, as well as inequity for hard-working
Americans who resisted the urge to take on debts
they could not afford.
Single Most Disruptive Force in the Global
Economy? The biggest problem with Paulson’s
announcement yesterday, however, goes deeper
than whether this or that new program is justified or
1. Even without formal expansion of the capital purchase program, the initiative has had some troubling consequences for
non-bank firms as companies rush to reorganize as bank holding companies in order to qualify for assistance. As a result,
otherwise efficient structures are displaced. This process fortunately should end with the November 14 deadline for
participation in the bank program. That deadline should not be extended.
No. 2131 WebMemo November 14, 2008
acceptable. By once more shuffling the deck of possible
interventions, Paulson has jeopardized the
very stability of the markets that he was intended
Markets need to engage the price discovery process
and to clear transactions. These functions are
being hindered by uncertainty regarding Treasury’s
next move. In his own statement he acknowledged
as much, saying, “We must allow markets and institutions
to absorb the extensive array of new policies
put in place in a very short period of time.”
Unfortunately, Paulson ignored his own advice,
sowing the markets with additional confusion. The
constant array of new ideas, new strategies, and
changed courses mean that the Paulson Treasury
has become perhaps the single most disruptive force
in the global economy.
It is time for this to end. Henry Paulson should
stop tinkering and allow the world’s financial markets
time—and freedom—to work.
—James L. Gattuso is Senior Research Fellow in
Regulatory Policy, David C. John is Senior Research Fellow
in Retirement Security and Financial Institutions,
and J. D. Foster, Ph.D., is Norman B. Ture Senior Fellow
in the Economics of Fiscal Policy in the Thomas A. Roe
Institute for Economic Policy Studies at The Heritage
Tarp the TARPIt’s time for a reality check about what works and what doesn’t in fighting recession and promoting long-term economic growth.By Larry Kudlow
Treasury Secretary Henry Paulson has called for a pause in the financing request for the Troubled Assets Relief Program (TARP), halting it at $350 billion. (The original request was for $700 billion.) I think that’s an excellent idea. But in a recent hearing of Barney Frank’s Financial Services Committee, Democrats went ballistic at the thought of no more TARP money. They want to keep spending. They want to throw money at GM, the other Detroit car makers, plumbers, auto-parts suppliers, homeowners, mortgage problems, and foreclosures. Candy stores all over America now want TARP money.Meanwhile, Senior Obama advisors are talking about another $600 billion to pull us out of recession. Some reports even suggest the development of a new industrial policy for big-government interference in housing, banking, energy, autos, and more.But all this brings up a whole new problem in American finance: How are we going to transport and deliver trillions of dollars of new government money? It’s not an easy task. We’ve moved beyond show me the money. This is throw me the money. And shovels alone won’t do.We’ll need to convert Caterpillar earth movers into money movers. We’ll need new streamlined helicopter fleets to drop money from the sky. We’ll need a trucking armada and full use of the railroads. And we’ll need an army of smaller trucks and SUVs to reach folks in the off-road areas. And let’s not forget FedEx and UPS — we’ll need them to make sure the money arrives on time.We may even need high-level planners at the Department of Transportation to help coordinate this vexing money-delivery problem. Sending out trillions of dollars may sound great to your average liberal Congress member. But this will not be easy. Perhaps the transitioning Obama administration can designate a Transportation Monetary Tsar. These logistical realities must be dealt with.Or maybe there’s a better idea: Maybe we take Mr. Paulson at his word but go one step further. Let’s stop any new TARP money — period. Enough is enough. The TARP has already done some good. Banks have more capital. Credit spreads in the money markets are narrowing. And there even are signs that business and consumer loans are flowing once again. So let’s cap the TARP — or tarp the TARP. The new congressional Keynesians believe government can spend us into prosperity. They’re wrong. Everything we have learned in the last four decades tells us that governments don’t create permanent new jobs or capital investment. In fact, the more we spend, the more we’ll have to raise tax rates. And that depresses growth. Europe went down this road and failed. So did Latin America and parts of Asia before they wised up.And for some reason no one in Washington is talking about cutting tax rates, which would strengthen incentives to work, invest, and take new business risks. We should be making it pay more after tax for entrepreneurial activity of all kinds. How about this: Let’s get back on the path of free-market capitalism.Even at the G-20 meeting in Washington this past weekend, all one heard was “global fiscal stimulus” — or more spending on a worldwide scale to fight recession. It won’t work. It never has. Hundreds of academic studies over the past 25 years show clearly that countries that spend more, grow less; but that nations that tax less, grow more.Why these lessons have been forgotten is beyond me. We have to restore market discipline and personal accountability. We should reward the economic good, but punish the bad. Instead we have launched a demoralizing government-spending nymphomania.Incidentally, all this talk of big-government bailouts and a never-ending flow of government spending has disheartened the stock market, which is now down five of the past seven days. Since the November 4 election, the Dow is off 15 percent, or more than 1,400 points.All this shows why, like the grounds crew at a baseball stadium on a rainy evening, we need to roll out the tarpaulin in order to preserve the field. To safeguard today’s economic field, it’s time to tarp the TARP. Let’s stop right here at $350 billion before everyone in the country demands a piece of the new TARP action. At the same time, let’s cut taxes to grow the economy. Slash the corporate tax rate. Reduce personal rates across-the-board. Promote investment with a lower capital-gains tax and a lower estate tax. Let’s restore the incentive model of economic growth.Current political trends in Washington are gonna push us off some left-wing economic cliff. Instead, let’s have some sanity. It’s time for a reality check about what works and what doesn’t in fighting recession and promoting long-term economic growth.I say tarp the TARP.
Keep TARP Alive
How Obama can save the bailout Bush bungled.
Clay Risen, The New Republic Published: Thursday, November 20, 2008
If nothing else, the Treasury's $700 billion bailout has been a boon for unintentional black comedy. Take an announcement last week by Hartford Financial Services Group that it's buying a Florida bank for $10 million, just so it can qualify for $3.4 billion in bailout funds. That's a good one! Or take a plan by San Jose to nab $14 billion of the bailout, even though its annual budget is just $3.3 billion. Zing! Unfortunately for San Jose, almost all the funds in the first chunk allotted by Congress--all but $60 billion of the original $350 billion--have been doled out to banks, who are either hoarding the money or using it to buy other banks; they're certainly not opening the credit tap, which was the whole idea in the first place. Oh, and did you hear the one about Treasury Secretary Hank Paulson forgetting to staff the bailout's oversight offices?
When corporations are openly gaming the system, city governments don't understand who qualifies for the bailout, no one's watching the watchers, and the well is running dry, clearly something has gone terribly wrong. The Troubled Asset Relief Program has, in no uncertain terms, failed. And, predictably, libertarian and populist opponents of the original bill are dancing with joy. To use one (self-serving) example, Katherine Mangu-Ward, over at Reason's blog, teased me for buying into a big government plan in the first place: "Ah, New Republic. Life holds so many shocking disappointments for you. Like today, when you figured out that the bailout wasn't going to be a smooth transition to economic health guided by a selfless, rational public servant."
But the poor execution of the plan doesn't mean that a bailout, or even the bailout as approved by Congress, was a bad idea. On the contrary, the bailout helped avert a major crisis from becoming cataclysmic. And the case for strong action remains. Consumers, and too many industries, find themselves in free fall without a net. Fortunately, it's not too late to reset--and with $350 billion left in the bag for January 21, there's a lot the next White House can do. Obama's first challenge coming into office won't just be cleaning up the mistakes Bush made over the last eight years. It will be cleaning up the mistakes he and Paulson made in the last four months of their terms.
Let's begin with two important premises, both of which are debatable but also defendable. First, a rescue plan of some sort was necessary. In a matter of days in late September, Lehman Brothers and Washington Mutual had failed, while AIG had gone on government life support. The credit markets dried up. The Dow tanked. The investment banking sector, through a mix of bankruptcies, takeovers, and restructuring, ceased to exist. Most significantly, a mood of cautious optimism was replaced with an impending dread over the next bank failure, with rumors flying about even solid institutions like Goldman Sachs. Fear and confusion were so rampant that the market's usual self-correcting mechanisms--like investors looking for cheap deals--were nowhere to be found.
In this situation, only a shot of confidence from the government could avert further collapse--even most critics of the Paulson plan agreed on that. And with the crisis centered in the banking sector, it made most sense for the government to focus its efforts there. Paulson and Fed Chairman Ben Bernanke insisted that the best way to shore up the sector was to buy complex mortgage-backed securities, the "troubled assets" that gave the Paulson Plan its official name. There was significant debate over that notion, but the real value of the package was psychological, and for a few days it worked: By showing that the government was able and willing to act comprehensively, Wall Street calmed, the Dow rose, and the credit markets began to loosen.
Soon after the plan's passage, however, Paulson and Bernanke decided that, in fact, buying troubled assets was a bad idea, and that a better course was to inject money directly into banks--a strategy that Paulson had explicitly rejected earlier, but that a range of economists, including Paul Krugman, had supported. The problem is that while the shift in strategy was defendable, they never bothered to defend it, or even explain it, and their keeping quiet made the whole program appear rudderless. What's worse, while the original TARP required participating banks to help out homeowners, Paulson's on-the-fly stock-buying plan didn't, making it essentially free money.
Indeed, Paulson has proved surprisingly naïve. He and TARP's interim director, Neel Kashkari, haven't applied much pressure on banks to open the lending spigots, assuming that the banks would do so on their own thanks to market logic or virtue. And they were wholly unprepared for the onslaught of lobbying that came after the bailout, combined with a spate of restructurings and consolidations that repositioned everyone from American Express to Goldman Sachs as bank holding companies, thus qualifying them for bailout funds. These were not the people who needed money, and yet Paulson was apparently unwilling to develop rules to keep them out--or even use his own discretion to do so. The result is a massive government program that to all the world looks like a banker's boondoggle, with little to no positive impact on the economy.
Which brings us to the second premise: that the bailout was not destined to fail; it was just handled terribly. To his credit, Paulson is right to point out, as he has done several times this week, that the bailout was never designed as a panacea. It was designed as a solution for the financial industry, leaving it up to the administration to develop parallel responses for the crises hitting mortgages and state and local coffers. Yet so far it has been the beginning and end of the government's response. There has been no complementary action for credit-starved small businesses or swamped homeowners. And while there's no impending collapse like in September, the economy desperately needs a well-planned, broad-based response from Washington.
What all this recommends is a reboot by the Obama Administration. There are, of course, an unlimited number of approaches to the economic crisis, but any strategy should include a few key steps. The first thing Obama and his people need to do once in office is reboot TARP. Before adding more programs, they need to make sure that the existing, faltering ones are up to par. That means instituting new, more stringent requirements for banks looking to tap the funds--not only higher bars for who can access it, but stronger requirements to force open the lending spigot for those who do. It means putting real teeth into oversight. Paulson has been slow to set up the mandated oversight offices that would force him to explain his sea-changes, a failure that has produced much political, investor, and taxpayer doubt about whether he's improperly benefitting his former Wall Street colleagues. Rebooting TARP also means putting someone outside the "Government Sachs" nexus into the driver's seat--for example, Sheila Bair, head of the Federal Deposit Insurance Corporation, a woman with a track record of fierce independence. Finally, it means implementing a mortgage assistance package, yet another unfulfilled mandate in the original bill. This isn't just a sop to flooded homeowners--until investors see some sort of support under collapsing home prices and shuttering mortgages, they'll continue to be spooked.
None of this is to preclude the other pieces in an economic recovery package. Stimulus measures in the form of tax cuts, expanded health insurance, and infrastructure investments are important pieces, as well as, yes, funds for ailing industries. But the critical element is to present all of this as a unified project. Banks aren't lending because, even though they're getting free money, they don't see anything being done about mortgages. Consumers are cutting back because they aren't seeing anything being done to help them pay off those mortgages or provide tax relief. Obama was right to support the bailout as it was originally approved by Congress. Now he needs to put it back together again, properly finishing the job Bush started.
Public Worried But Not Panicked About Economy
Obama Clearer than McCain in Addressing Crisis, Holds Sizeable Lead in Matchup
October 15, 2008
Americans are concerned about the nation's economic problems almost to the exclusion of every other issue, and they register the lowest level of national satisfaction ever measured in a Pew Research Center survey. Just 11% say they are satisfied with the way things are going in the country -- down 14 points in the past month alone.
However, there is little indication that the nation's financial crisis has triggered public panic or despair. Most Americans express confidence that the government still possesses the power to fix the economy, though that belief has lost adherents since July. There has been no decline in people's perceptions of their own financial situations. Looking ahead to next year, Americans are more confident than they were in July about an improvement in the national economy and in their own personal finances.
This is not to say that the public has been spared the effects of the financial crisis: Over the past three weeks, the percentages saying they plan to rein in spending in a number of areas have increased sharply. Moreover, for the first time in a Pew survey, more Americans say that "people should learn to live with less," rather than that "there are no limits to growth in this country."
The latest national survey by the Pew Research Center for the People & the Press, conducted Oct. 9-12 among 1,485 adults reached on landlines and cell phones, finds that an increasing number say that jobs are difficult to find locally, and views of local real estate values remain negative. In addition, fewer people than in February say that their employer is in excellent financial shape. But these perceptions notwithstanding, there are no signs that the crisis has eroded people's fundamental confidence in either their own personal financial outlook or the nation's. As in July, a solid majority of Americans (54%) says the economy is in a recession, but the percentage saying the nation is in a depression has not grown significantly (22%). Compared with this summer, more Americans think that economic conditions will improve next year (46% vs. 30%).
Continued optimism about the economy may well reflect the fact that while polls have shown that the president and Congress receive low grades for dealing with the financial crisis, most Americans continue to say that the federal government still has the power to fix the economy. A 56%-majority of the public expresses this view, though that is considerably less than the percentage saying this in July (68%).
Perhaps more important, the public's personal financial ratings are no lower than they were in mid-summer; 41% rate their finances as excellent or good, which is virtually unchanged since July (42%). Notably, 59% say they expect their financial situation to improve over the next year, up from 51% in July. Declining energy prices may be playing some part in the public's resilience in the face of the financial crisis. The proportion citing fuel or gas prices as the top economic problem facing the country has fallen steeply, from 38% in July to 10% currently.
Overall, fewer people now say that their incomes are falling behind the cost of living (57% vs. 64% in July). However, while inflation concerns have eased somewhat, nearly four-in-ten (38%) say that rising prices is the economic issue that worries them most; by comparison, 31% cite problems in the financial markets. Among those who describe themselves as working class or struggling financially, far more say their biggest economic worry is rising prices rather than problems in the financial markets. By contrast, those who describe themselves as professional or business class are far more likely to cite problems in financial markets than rising prices.
The new poll finds no evidence that fundamental American optimism has eroded in the face of the financial crisis. Even after a week of some of the largest stock market declines since the Great Depression, 64% of the public say that "As Americans, we can always find ways to solve our problems and get what we want." That is up from 59% since December 2004, shortly after the last presidential election.
Yet the survey does show a shift in basic public values regarding the limits of growth. A 49%-plurality now says that "people in this country should learn to live with less" -- the highest percentage expressing this sentiment since the question was first asked in 1994.
In this regard, Americans clearly signal they intend to scale back their own spending. Nearly six-in-ten (59%) say they have delayed or cancelled vacation spending while 55% say they have been eating out at restaurants less often. Roughly half (48%) say they are changing the way their money is saved or invested, while substantial minorities are either delaying or shelving plans to make major household purchases (39%) or to buy a new car (36%). The percentages saying they are reining in spending have risen sharply in the past three weeks.
Views on Regulation of Business Unchanged
As Americans' fundamental optimism remains unabated by the financial crisis, basic views about the role of government have shown only modest changes. The public continues to be divided about the efficacy of government regulation of business. Currently, 50% believe such regulation is necessary to protect the public interest, while 38% think government regulation of business does more harm than good. The balance of opinion is largely unchanged since December 2004 (49% vs. 41%).
Overall views of government are more negative they have been since the late 1990s. Nearly six-in-ten (57%) say that "government is almost always inefficient and wasteful" -- up 10 points since December 2004. And somewhat fewer Americans say "the government should do more to help needy Americans even if it means going deeper into debt" than did so in 2004 (51% now, 57% then).
Views of business also have become more negative. Roughly eight-in-ten (78%) believe that "too much power is concentrated in the hands of a few large companies," which is largely unchanged from past years; but a greater percentage strongly express this sentiment (70%) than at any point since the question was first asked in 1994. In addition, there has been a modest increase in the percentage saying "business corporations make too much profit" -- from 53% in December 2004 to 59% currently.
Debtors and Banks Blamed for Crisis
There is a broad public consensus regarding the causes of the current problems with financial institutions and markets: 79% say people taking on too much debt has contributed a lot to the crisis, while 72% say the same about banks making risky loans. Far fewer say weak governmental regulation of financial institutions (46%) or other factors have contributed a lot to the recent problems.
There are substantial partisan differences in opinions about the causes of the crisis. Far more Democrats than Republicans say weak government regulation is a major contributing factor (56% vs. 38%); 45% of independents express this sentiment. By contrast, fully 91% of Republicans place a lot of blame on people taking on too much debt, compared with 80% of independents and 74% of Democrats.
Crisis Favors Obama
With few Americans expressing a positive view of national conditions and President Bush's approval rating reaching a new low (25%) in a Pew survey, the political environment favors the Democrats. Barack Obama holds a sizable 50%-to-40% lead over John McCain, and a greater share of his supporters back him strongly. Moreover, the percentage of voters saying they have definitely decided not to vote for McCain has risen steadily, from 37% in early August to 45% in the current survey.
Voters continue to express more confidence in Obama than in McCain to handle the financial crisis; 47% say Obama could best address the current problems while 33% choose McCain. Voters are especially critical of McCain's performance in explaining how he would handle the crisis. Just 29% say he has done an excellent or good job in explaining his approach to the crisis while 67% say he has done only a fair or poor job.
Obama's ratings for explaining how he would handle the crisis are much better than McCain's. Still, fewer than half (48%) say Obama has done an excellent or good job in this regard, while about as many (47%) say he has done only fair or poor.
Read the full report at people-press.org
Debt Man Walking
Economists know the fatal flaw in our system--but they can't agree how to fix it.
John B. Judis, The New Republic Published: Wednesday, December 03, 2008
For those Americans who are not daily readers of the Financial Times, the past few months have been a crash course in the abstract and obscure instruments and arrangements that have derailed the nation's economy. From mortgage-backed securities to credit default swaps, the financial health of the country has undergone a gory public dissection. And yet, as Barack Obama prepares to take office, one particularly frightening problem has escaped public notice; indeed, it may not even make the agenda of the global summit being held this weekend, dubbed "Bretton Woods II" after the postwar system of currency controls. The international monetary system is in big trouble.
For decades, the United States has relied on a tortuous financial arrangement that knits together its economy with those of China and Japan. This informal system has allowed Asian countries to run huge export surpluses with the United States, while allowing the United States to run huge budget deficits without having to raise interest rates or taxes, and to run huge trade deficits without abruptly depreciating its currency. I couldn't find a single instance of Obama discussing this issue, but it has been an obsession of bankers, international economists, and high officials like Federal Reserve Chairman Ben Bernanke. They think this informal system contributed to today's financial crisis. Worse, they fear that its breakdown could turn the looming downturn into something resembling the global depression of the 1930s.
The original Bretton Woods system dates from a conference at a New Hampshire resort hotel in July 1944. Leading British and American economists blamed the Great Depression and, to some extent, World War II on the breakup of the international monetary system in the early 1930s and were determined to create a more stable arrangement in which the dollar would replace the British pound as the accepted global currency. The new system, devised by economists Harry Dexter White and John Maynard Keynes, fixed the dollar's value at $35 for an ounce of gold. National governments, rather than speculators, were to set the value of their currencies in relation to the dollar and would have to disclose any changes in advance to the new International Monetary Fund (IMF).
The dollar became the accepted medium of international exchange and a universal reserve currency. If countries accumulated more dollars than they could possibly use, they could always exchange them with the United States for gold. But, with the United States consistently running a large trade surplus--meaning that countries always needed to have dollars on hand to buy American goods--there was initially little danger of a run on the U.S. gold depository.
TNRtv: Judis discusses "Debt Man Walking"
Bretton Woods began to totter during the Vietnam war, when the United States was sending billions of dollars abroad to finance the war and running a trade deficit while deficit spending at home sparked inflation in an overheated economy. Countries began trying to swap overvalued dollars for deutschmarks, and France and Britain prepared to cash in their excess dollars at Fort Knox. In response, President Richard Nixon first closed the gold window and then demanded that Western Europe and Japan agree to new exchange rates, whereby the dollar would be worth less gold, and the yen and the deutschmark would be worth more relative to the dollar. That would make U.S. exports cheaper and Japanese and West German imports more expensive, easing the trade imbalance and stabilizing the dollar.
By imposing a temporary tariff, Nixon succeeded in forcing these countries to revalue, but not in creating a new system of stable exchange rates. Instead, the values of the currencies began to fluctuate. And, as inflation soared in the late 1970s, the system, which still relied on the dollar as the universal currency, seemed ready to explode into feuding currencies.
That's when a new monetary arrangement began to emerge. Economists often refer to it as "Bretton Woods II"--not to be confused with the name given this weekend's gathering--but it was not the result of a conference or concerted agreement among the world's major economic powers. Instead, it evolved out of a set of individual decisions--first by the United States, Japan, and Saudi Arabia, and later by the United States and other Asian countries, notably China.
Bretton Woods II took shape during Ronald Reagan's first term. To combat inflation, Paul Volcker, the chairman of the Federal Reserve, jacked interest rates above 20 percent. That precipitated a steep recession--unemployment exceeded 10 percent in the fall of 1982--and large budget deficits as government expenditures grew faster than tax revenues. The value of the dollar also rose as other countries took advantage of high U.S. interest rates. That jeopardized U.S. exports, and the U.S. trade deficit grew even larger, as Americans began importing underpriced goods from abroad while foreigners shied away from newly expensive U.S. products. The Reagan administration faced a no- win situation: Try reducing the trade deficit by reducing the budget deficit, and you'd stifle growth; but try stimulating the economy by increasing the deficit, and you'd have to keep interest rates high in order to sell an adequate amount of Treasury debt, which would also stifle growth. At that point, Japan, along with Saudi Arabia and other opec nations, came to the rescue.
At the end of World War II, Japan had adopted a strategy of economic growth that sacrificed domestic consumption in order to accumulate surpluses that it could invest in export industries--initially labor-intensive industries like textiles, but later capital-intensive industries like automobiles and steel. This export-led approach was helped in the 1960s by an undervalued yen, but, after the collapse of Bretton Woods, Japan was threatened by a cheaper dollar. To keep exports high, Japan intentionally held down the yen's value by carefully controlling the disposition of the dollars it reaped from its trade surplus with the United States. Instead of using these to purchase goods or to invest in the Japanese economy or to exchange for yen, it began to recycle them back to the United States by purchasing companies, real estate, and, above all, Treasury debt.
That investment in Treasury bills, bonds, and notes--coupled with similar purchases by the Saudis and other oil producers, who needed to park their petrodollars somewhere--freed the United States from its economic quandary. With Japan's purchases, the United States would not have to keep interest rates high in order to attract buyers to Treasury securities, and it wouldn't have to raise taxes in order to reduce the deficit. As far as historians know, Japanese and American leaders never explicitly agreed that Tokyo would finance the U.S. deficit or that Washington would allow Japan to maintain an undervalued yen and a large trade surplus. But the informal bargain--described brilliantly in R. Taggart Murphy's The Weight of the Yen--became the cornerstone of a new international economic arrangement.
Over the last 20 years, the basic structure of Bretton Woods II has endured, but new players have entered the game. As Financial Times columnist Martin Wolf recounts in his new book, Fixing Global Finance, Asian countries, led by China, adopted a version of Japan's strategy for export-led growth in the mid-'90s after the financial crises that wracked the continent. They maintained trade surpluses with the United States; and, instead of exchanging their dollars for their own currencies or investing them internally, they, like the Japanese, recycled them into T-bills and other dollar-denominated assets. This kept the value of their currencies low in relation to the dollar and perpetuated the trade surplus by which they acquired the dollars in the first place. By June 2008, China held more than $500 billion in U.S. Treasury debt, second only to Japan. East Asia's central banks had become the post-Bretton Woods equivalent of Fort Knox.
Until recently, there have been clear upsides to this bargain for the United States: the avoidance of tax increases, growing wealth at the top of the income ladder, and preservation of the dollar as the international currency. Without Bretton Woods II, it is difficult to imagine the United States being able to wage wars in Iraq and Afghanistan while simultaneously cutting taxes. For their part, China and other Asian countries enjoyed almost a decade free of financial crises; and the world economy benefited from low transaction costs and relative price stability from having a single currency that countries could use to buy and sell goods.
But there have been downsides to Bretton Woods II. Often noted was how the accumulation of dollars in foreign hands--particularly those of a potential adversary like China--threatens America's freedom of action. A hostile nation could blackmail the United States by threatening to cash in its dollars. Of course, if a nation like China actually began to unload its dollars, it would jeopardize its own financial standing as much as it would jeopardize America's. But economists Brad Setser and Nouriel Roubini argue that even the implicit threat of dumping dollars--or of ceasing to purchase them--could limit U.S. maneuverability abroad. "The ability to send a 'sell' order that roils markets may not give China a veto over U.S. foreign policy, but it surely does increase the cost of any U.S. policy that China opposes," they write.
To date, however, that strategic impact has been chiefly theoretical. The more tangible drawbacks of Bretton Woods II have been social and economic. Bretton Woods II has perpetuated the U.S. trade deficit, particularly in manufactured goods. Forced to compete against foreign products kept cheap not only by low wages abroad but by the dollar's high value, U.S. manufacturers have had little incentive to expand or even retain their operations in the United States. Since the early '80s, the United States has lost about five million manufacturing jobs. True, the United States has gained some highly skilled manufacturing jobs, but most of the lost jobs have been replaced by low- wage service sector employment. This has been a factor in creating a U.S. workforce with an overpaid financial sector at one extreme and a sprawling low- wage service sector at the other.
In Japan, China, and other Asian countries, there has been a similar downside to the grand bargain. The surplus dollars gained from trade with the United States have not been used to raise the standard of living, but rather have been squirreled away in Treasury securities--"sterilized" is the technical term. Writes Wolf, "China has about 800 million poor people, yet the country now consumes less than half of GDP and exports capital to the rest of the world. " In an odd way, the contrast between the concentration of new wealth in China's coastal cities and the grating poverty of its countryside has mirrored the contrast between the lavish lifestyle of the Wall Street wizard and the plight of immigrant and illegal-immigrant workers in America's barrios.
Of more immediate concern, Bretton Woods II contributed to the current financial crisis by facilitating the low interest rates that fueled the housing bubble. Here's how it happened: In 2001, the United States suffered a mild recession largely as a result of overcapacity in the telecom and computer industries. The recession would have been much more severe, but, because foreigners were willing to buy Treasury debt, the Bush administration was able to cut taxes and increase spending even as the Federal Reserve lowered interest rates to 1 percent. The economy barely recovered over the next four years. Businesses, still worried about overcapacity, remained reluctant to invest. Instead, they paid down debt, purchased their own stock, and held cash. Banks and other financial institutions, wary of the stock market since the dot-com bubble burst, invested in mortgage-backed securities and other derivatives.
The anemic economic recovery was driven by growth in consumer spending. Real wages actually fell, but consumers increasingly went into debt, spending more than they earned. Encouraged by low interest rates--along with the new subprime deals--consumers bought houses, driving up their prices. The "wealth effect" created by these housing purchases further sustained consumer demand and led to a housing bubble. When housing prices began to fall, the bubble burst, and consumer demand and corporate investment ground to a halt. The financial panic quickly spread not only from mortgage-backed securities to other kinds of derivatives but also from the United States to other countries, chiefly in Europe, that had purchased these American financial products.
And that's not all. As American demand for Chinese exports has stopped growing, China's economy has begun to suffer. Roubini has argued that, if China's export-dependent growth drops from 12 percent to 5 or 6 percent per year, China will be unable to provide jobs to the 24 million new workers that join the labor force each year. China would experience the equivalent of a recession, with repercussions throughout Asia. More importantly for the United States, China would no longer have the surplus dollars to prop up the market for U.S. Treasury bills. The Obama administration could, of course, reduce its dependence on China by reducing the budget deficit, but doing that now would deepen the recession, as well as preventing the new president from pursuing many of his domestic initiatives.
The consequences could be even more dire. In the past, countries in recession could count on countries with growing economies to provide outlets for their exports and investments. The hope this time is that economic growth in Asia and particularly China can backstop a U.S. and European recession. But, as a result of Bretton Woods II, prosperity in the United States is intertwined with prosperity in Asia. China depends on exports to the United States, and the United States depends on capital from China. If that special economic relationship breaks down, as it seems to be doing, it could lead to a global recession that could morph into the first depression since the 1930s.
Economists and Treasury officials might dispute specific parts of this analysis, but the bulk of it is neither original nor controversial. For the last three years, if not longer, Bernanke, former Treasury secretary Larry Summers, Roubini, Setser, Wolf, and other economists have been making similar points. Their concerns did not penetrate the presidential campaign, but the Obama administration will have to address the breakdown of Bretton Woods II in January, if not earlier. Wrote Summers this August, "The next administration faces the prospect of having to make the most consequential international economic policy choices in a generation at a time when the confidence of governments in free markets is being increasingly questioned."
In making these choices, policymakers have to recognize that, while Bretton Woods II is not the product of an international agreement, it is not a "free market" system that relies on floating currencies, either. Rather, it is sustained by specific national policies. The United States has acquiesced in large trade deficits--and their effect on the U.S. workforce--in exchange for foreign funding of our budget deficits. And Asia has accepted a lower standard of living in exchange for export-led growth and a lower risk of currency crises.
Some of the policies that Obama championed during the presidential campaign can help move us to a new system--as long as they are not seen merely as temporary palliatives to get the United States out of a recession. These steps include public investments that would make U.S. industries more competitive; subsidies under strict conditions to U.S. automobile manufacturers; and the encouragement of new "green" industries. (By contrast, Obama's principal proposal--a tax cut for the middle class--would not necessarily improve America's economic standing.)
But China, Japan, and other Asian countries--either on their own or with prodding from the new administration--will also have to play a part. Indeed, China may have already begun to do so by announcing a $586 billion stimulus plan of public investment in housing, transportation, and infrastructure. If China plows its trade surplus back into its domestic economy, it will increase demand for imports and put upward pressure on the yuan, reducing China's trade surplus with the West.
This kind of adjustment--in which the United States commits itself to reducing its trade deficit and China, Japan, and other Asian countries abandon their strategy of export-led growth--is what many American policymakers favor. But there is also growing sentiment, particularly in Europe, that beyond these measures, the world's leading economies have to agree on a new international monetary system--or at least dramatically reform the existing one. British Prime Minister Gordon Brown has explicitly called for a "new Bretton Woods--building a new international financial architecture for the years ahead." Brown would strengthen the IMF so it functions as "an early warning system and a crisis prevention mechanism for the whole world." He would also have it or a new organization monitor cross-border financial transactions. French President Nicolas Sarkozy would go further, replacing the dollar as the single international currency. "The time when we had a single currency, one line to be followed, that era is over," he declares.
Brown's proposals for regulatory reform make sense and are likely to be considered in the new Obama administration, but Sarkozy's are premature. The dollar isn't going anywhere in the short term. The euro has little presence in Asia; and the Chinese don't want the yen to dominate Asia, let alone the world. The current crisis has, if anything, strengthened the dollar as the least untrustworthy of global currencies.
But adjustments to the dollar's role are certainly needed. The era of the dollar may not be over, but the special conditions under which it reigned during the last decades are being dashed on the rocks of the current recession and financial crisis. In the worst case, the system could descend into chaos, as it did in the 1930s. More likely a new Bretton Woods (call it "III") will emerge, but the question will be whether it does so willy-nilly, as its predecessor did, and invite repeated crises, or whether, like the original Bretton Woods, it will be the product of deliberate agreement and lay the basis for stable growth. Which it is will depend a good deal on the choices the new Obama administration makes.
Anatomy of a Meltdown
Ben Bernanke and the financial crisis.
by John Cassidy December 1, 2008
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Bernanke says that he was “mistaken early on in saying that the subprime crisis would be contained.” Photograph by Platon.
Some are born radical. Some are made radical. And some have radicalism thrust upon them. That is the way with Ben Bernanke, as he struggles to rescue the American financial system from collapse. Early every morning, weekends included, Bernanke arrives at the headquarters of the Federal Reserve, an austere white marble pile on Constitution Avenue in Foggy Bottom. The Fed, which is as hushed inside as a mausoleum, is a place of establishment reserve. Its echoing hallways are lined with sombre paintings. The office occupied by Bernanke, a soft-spoken fifty-four-year-old former professor, has high ceilings, several shelves of economics textbooks, and, on the desk, a black Bloomberg terminal. On a shelf in a nearby closet sits a scruffy gym bag, which in calmer days Bernanke took to the Fed gym, where he played pickup basketball with his staffers.
At Princeton, where Bernanke taught economics for many years, he was known for his retiring manner and his statistics-laden research on the Great Depression. For more than a year after he was appointed by President George W. Bush to chair the Fed, in February, 2006, he faithfully upheld the policies of his immediate predecessor, the charismatic free-market conservative Alan Greenspan, and he adhered to the central bank’s formal mandates: controlling inflation and maintaining employment. But since the market for subprime mortgages collapsed, in the summer of 2007, the growing financial crisis has forced Bernanke to intervene on Wall Street in ways never before contemplated by the Fed. He has slashed interest rates, established new lending programs, extended hundreds of billions of dollars to troubled financial firms, bought debt issued by industrial corporations such as General Electric, and even taken distressed mortgage assets onto the Fed’s books. (In March, to facilitate the takeover by J. P. Morgan of Bear Stearns, a Wall Street investment bank that was facing bankruptcy, the Fed acquired twenty-nine billion dollars’ worth of Bear Stearns’s bad mortgage assets.) These moves hardly amount to a Marxist revolution, but, in the eyes of many economists, including supporters and opponents of the measures, they represent a watershed in American economic and political history. Ben Bernanke, who seemed to have been selected as much for his predictability as for his economic expertise, is now engaged in the boldest use of the Fed’s authority since its inception, in 1913.
Bernanke, working closely with Henry (Hank) Paulson, the Treasury Secretary, a voluble former investment banker, was determined to keep the financial sector operating long enough so that it could repair itself—a policy that he and his Fed colleagues referred to as the “finger-in-the-dike” strategy. As recently as Labor Day, he believed that the strategy was working. The credit markets remained open; the economy was still expanding, if slowly; oil prices were dropping; and there were tentative signs that house prices were stabilizing. “A lot can still go wrong, but at least I can see a path that will bring us out of this entire episode relatively intact,” he told a visitor to his office in August.
By mid-September, however, the outlook was much grimmer. On Monday, September 15th, Lehman Brothers, another Wall Street investment bank that had made bad bets on subprime mortgage securities, filed for bankruptcy protection, after Bernanke, Paulson, and the bank’s senior executives failed to find a way to save it or to sell it to a healthier firm. During the next forty-eight hours, the Dow Jones Industrial Average fell nearly four hundred points; Bank of America announced its purchase of Merrill Lynch; and American International Group, the country’s biggest insurance company, began talks with the New York Fed about a possible rescue. Goldman Sachs and Morgan Stanley, the two wealthiest investment banks on Wall Street, were also in trouble. Their stock prices tumbled as rumors circulated that they were having difficulty borrowing money. “Both Goldman and Morgan were having a run on the bank,” a senior Wall Street executive told me. “People started withdrawing their balances. Counterparties started insisting that they post more collateral.”
The Fed talked with Wall Street executives about creating a “lifeline” for Goldman Sachs and Morgan Stanley, which would have given the firms greater access to central-bank funds. But Bernanke decided that even more drastic action was needed. On Wednesday, September 17th, a day after the Fed agreed to inject eighty-five billion dollars of taxpayers’ money into A.I.G., Bernanke asked Paulson to accompany him to Capitol Hill and make the case for a congressional bailout of the entire banking industry. “We can’t keep doing this,” Bernanke told Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”
Paulson agreed. A bailout ran counter to the Bush Administration’s free-market principles and to his own belief that reckless behavior should not be rewarded, but he had worked on Wall Street for thirty-two years, most recently as the C.E.O. of Goldman Sachs, and had never seen a financial crisis of this magnitude. He had come to respect Bernanke’s judgment, and he shared his conviction that, in an emergency, pragmatism trumps ideology. The next day, the men decided, they would go see President Bush.
On October 3rd, Congress passed an amended bailout bill, giving the Secretary of the Treasury broad authority to purchase from banks up to seven hundred billion dollars in mortgage assets, but the turmoil on Wall Street continued. Between October 6th and October 10th, the Dow suffered its worst week in a hundred years, falling eighteen per cent. As the selling spread to overseas markets, the Fed’s failure to save Lehman Brothers was roundly condemned. Christine Lagarde, the French finance minister, described it as a “horrendous” error that threatened the global financial system. Richard Portes, an economist at the London Business School, wrote in the Financial Times, “The U.S. authorities’ decision to let Lehman Brothers fail will be severely criticised by financial historians—the next generation of Bernankes.” Even Alan Blinder, an old friend and former colleague of Bernanke’s in the economics department at Princeton, who served as vice-chairman of the Fed from 1994 to 1996, was critical. “Maybe there were arguments on either side before the decision,” he told me. “After the fact, it is extremely clear that everything fell apart on the day Lehman went under.”
The most serious charge against Bernanke and Paulson is that their response to the crisis has been ad hoc and contradictory: they rescued Bear Stearns but allowed Lehman Brothers to fail; for months, they dismissed the danger from the subprime crisis and then suddenly announced that it was grave enough to justify a huge bailout; they said they needed seven hundred billion dollars to buy up distressed mortgage securities and then, in October, used the money to purchase stock in banks instead. Summing up the widespread frustration with Bernanke, Dean Baker, the co-director of the Center for Economic and Policy Research, a liberal think tank in Washington, told me, “He was behind the curve at every stage of the story. He didn’t see the housing bubble until after it burst. Until as late as this summer, he downplayed all the risks involved. In terms of policy, he has not presented a clear view. On a number of occasions, he has pointed in one direction and then turned around and acted differently. I would be surprised if Obama wanted to reappoint him when his term ends”—in January, 2010.
Bernanke and Paulson’s reversals have been deeply unsettling, perhaps especially so for the millions of Americans who have lost jobs or defaulted on mortgages so far this year. And yet, for the past year and a half, the government has confronted a financial debacle of unprecedented size and complexity. “Everyone knew there were issues and potential problems,” John Mack, the chairman and chief executive of Morgan Stanley, told me. “Nobody knew the enormity of it, how global it was and how deep it was.” In responding to the crisis, Bernanke has effectively transformed the Fed into an Atlas for the financial sector, extending more than $1.5 trillion in loans to troubled banks and investment firms, and providing financial guarantees worth roughly another $1.5 trillion, making it global capitalism’s lender of first and last (and sometimes only) resort.
“Under Ben’s leadership, we have felt compelled to create a new playbook for the Fed,” Kevin Warsh, a Fed governor who has worked closely with Bernanke, told me. “The circumstances of the last year caused us to cross more lines than this institution has crossed in the previous seventy years.” Paul Krugman, the Times columnist, a former colleague of Bernanke’s at Princeton, and the winner of this year’s Nobel Prize in Economics, said, “I don’t think any other central banker in the world would have done as much by way of expanding credit, putting the Fed into unconventional assets, and so on. Now, you might say that it all hasn’t been enough. But I guess I think that’s more a reflection of the limits to the Fed’s power than of Bernanke getting it wrong. And things could have been much worse.”
Six and a half years ago, Bernanke was a little-known professor living in Montgomery Township, a hamlet near Princeton. Long hours, enormous stress, and constant criticism have left him looking pale and drawn. “Ben is a very decent and sincere person,” Richard Fisher, the president of the Dallas Fed, told me. “The question is, Is that an asset or a liability in his job? If he were six feet seven, like Paul Volcker”—a former Fed chairman—“that would be a big advantage. If he was a tough S.O.B., like Jerry Corrigan”—a former head of the New York Fed, who successfully managed a previous financial crisis, in 1987—“that would be a big advantage. But you make do with what you have—a prodigious brain, a tremendous knowledge of past financial crises, and a personality that is above reproach. And you surround yourself with good people and use their expertise.”
As Fed chairman, Bernanke inherited an unprecedented housing bubble and an unsustainable borrowing spree. The collapse of these phenomena occurred with astonishing speed and violence. The only precursor for the current financial crisis is the Great Depression, but even that isn’t a very good comparison. In the nineteen-thirties, the financial system was much less sophisticated and interconnected. In dealing with problems affecting arcane new financial products, including “collateralized debt obligations,” “credit default swaps,” and “tri-party repos,” Bernanke and his colleagues have had to become expert in market transactions of baffling intricacy.
Bernanke grew up in Dillon, South Carolina, an agricultural town just across the state line from North Carolina, where, in 1941, his paternal grandfather, Jonas Bernanke, a Jewish immigrant from Austria, founded the Jay Bee Drugstore, subsequently operated by Ben’s father and an uncle. The eldest of three siblings, Bernanke learned to read in kindergarten and skipped first grade. When he was eleven, he won the state spelling championship and went to Washington to compete in the National Spelling Bee. He made it to the second round, but stumbled on the word “edelweiss,” an Alpine flower featured in “The Sound of Music.” He hadn’t seen the movie, because Dillon didn’t have a movie theatre. Had he spelled the word correctly and won the competition, Bernanke tells friends, he would have appeared on “The Ed Sullivan Show,” which was his dream.
In high school, Bernanke taught himself calculus, submitted eleven entries to a state poetry contest, and played alto saxophone in the marching band. During his junior year, he scored 1590 out of 1600 on his S.A.T.s—the highest score in South Carolina that year—and the state awarded him a trip to Europe. In the fall of 1971, he entered Harvard, where he wrote a prize-winning senior thesis on the economic effects of U.S. energy policy. After graduating, he enrolled at M.I.T., whose Ph.D. program in economics was rated the best in the country. His doctoral thesis was a dense mathematical treatise on the causes of economic fluctuations. He accepted a job at the Stanford Graduate School of Business, where Anna Friedmann, a Wellesley senior whom Bernanke married the weekend after she graduated, had been admitted into the master’s program in Spanish.
The couple lived in Northern California for six years, until Princeton awarded Bernanke, then just thirty-one, a tenured position. Settling in Montgomery Township, they brought up two children: Joel, who is now twenty-five and applying to medical school, and Alyssa, a twenty-two-year-old student at St. John’s College. By 2001, Bernanke was the editor of the American Economic Review and the co-author, with Robert Frank, of “Principles of Economics,” a well-regarded college textbook. His scholarly interests ranged from abstruse matters such as the theoretical merits of setting a formal inflation target to historical questions, including the causes of the Great Depression. Even when Bernanke was writing about historical events, much of his scholarship was couched in impenetrable technical language. “I always thought that Ben would stay in academia,” Mark Gertler, an economist at New York University who has known Bernanke well since 1979, told me. “But two things happened.”
In 1996, Bernanke became chairman of the Princeton economics department, a job many professors regard as a dull administrative diversion from their real work. Bernanke, however, embraced the chairmanship, staying on for two three-year terms. Under his stewardship, the department launched new programs and hired leading scholars, among them Paul Krugman, whom Bernanke wooed personally. Bernanke also bridged a long-standing departmental divide between theorists and applied researchers, in part by raising enough money so that the two sides could coexist peaceably, and by engaging in diplomacy. “Ben is very good at respecting minority opinion and giving people the feeling they have been heard in the debate even if they get outvoted,” Alan Blinder said.
The other event that changed Bernanke’s career occurred in the summer of 1999, at the height of the Internet stock boom, when he and Gertler were invited to present a paper at an annual policy conference organized by the Federal Reserve Bank of Kansas City. The topic of the conference—which takes place at a resort in Jackson Hole, Wyoming—was New Challenges for Monetary Policy. Then, as now, there was vigorous debate among economists about whether central banks should raise interest rates to counter speculative bubbles. By increasing the cost of borrowing, the Fed, at least in theory, can restrain speculative activity and prevent the prices of assets such as stocks and real estate from rising excessively.
Bernanke and Gertler argued that the Fed should ignore bubbles and stick to its traditional policy of controlling inflation. If a bubble inflated and burst of its own accord, they said, the Fed could always bring down rates to alleviate damage to the broader economy. To support their case, they presented a series of computer simulations, which appeared to show that a policy of targeting inflation stabilized the economy more effectively than one that targeted bubbles. The presentation got a mixed reception. Henry Kaufman, a well-known Wall Street economist, said that it would be irresponsible for the Fed to ignore rampant speculation. Rudi Dornbusch, an M.I.T. professor (who has since died), pointed out that Bernanke and Gertler had overlooked the possibility that credit could dry up after a bubble burst, and that such a development could have serious effects on the economy. But Greenspan was more supportive. “He didn’t say anything during the session,” Gertler recalled. “But after it was over he walked by and said, as quietly as he could, ‘You know, I agree with you.’ That had us in seventh heaven.”
In December, 1996, Greenspan had warned that investors could fall victim to “irrational exuberance.” Subsequently, though, he had adopted a policy of benign neglect toward the stock market, ignoring warnings that a bubble in technology and Internet stocks had developed. The paper by Bernanke and Gertler provided theoretical support for Greenspan’s stance, and it received a good deal of publicity, something neither of its authors had previously experienced. “Ben was a bit taken aback by the public attention,” Gertler said. “The Economist attacked us viciously.”
In 2002, when the Bush Administration was looking to fill two vacant governorships at the Fed—there are seven in all—Glenn Hubbard, who is the dean of Columbia Business School and who was then the chairman of the White House Council of Economic Advisers, proposed Bernanke. “We needed a strong economist who understood the financial markets, and Ben had expertise in that area,” Hubbard recalled. “He is also an extremely nice person. In terms of getting on with people, he is very affable, and I thought that would help him, too.”
Although the Fed is an independent agency, it is subject to congressional oversight, and Presidents typically appoint people who are sympathetic to their world view. Hubbard knew little about Bernanke’s politics. “I was aware he was an economic conservative, but I didn’t know whether he was a Republican,” Hubbard said. Robert Frank, a liberally inclined economist at Cornell and Bernanke’s co-author on “Principles of Economics,” believed that Bernanke was a Democrat. When the White House announced that it was nominating Bernanke to be a Fed governor, Frank was shocked. “I asked Ben, ‘Why is Bush appointing a Democrat?’ ” Frank told me. “He said, ‘Well, I’m not a Democrat.’ ’’ In writing their book, Frank was impressed not only by Bernanke’s openness to opposing views but also by his wry humor and his lack of ego. “In most situations, he is the smartest guy in the room, but he doesn’t seem too eager to show that,” Frank said.
When Bernanke joined the Fed, it was struggling to revive the economy after the Nasdaq collapse of 2000-01 and the terrorist attacks of September 11, 2001. Between September, 2001, and June, 2003, Greenspan and his colleagues cut the federal funds rate—the key interest rate under the Fed’s control—from 3.5 per cent to one per cent, its lowest level since the nineteen-fifties. Cutting interest rates during an economic downturn is standard policy at the Fed; lower borrowing costs encourage households and businesses to spend more. But Greenspan’s rate reductions were unusual in both their scale and their longevity. The Fed didn’t reverse course until the summer of 2004, and even then it moved slowly, raising the federal funds rate in quarter-point increments.
With cheap financing readily available, a housing boom developed. Families bought homes they couldn’t have afforded at higher interest rates; speculators bought properties to flip; people with modest incomes or poor credit took out mortgages designed for marginal buyers, such as subprime loans, interest-only loans, and “Alt-A” loans. On Wall Street, a huge market evolved in subprime mortgage bonds—securities backed by payment streams from dozens or hundreds of individual subprime mortgages. Banks and other mortgage lenders relaxed their credit standards, knowing that many of the loans they issued would be bundled into mortgage securities and sold to investors.
“The Fed’s easy-money policy put a lot of the wind at the back of some of the transactions in the housing market and elsewhere that we are now suffering from,” Glenn Hubbard told me. Before leaving government, in 2003, Hubbard argued in White House meetings that the Fed needed to start raising rates. “It was particularly striking for the Fed to maintain an accommodative policy after the 2003 tax cut, which gave another boost to the economy,” Hubbard said. “That was a significant error.”
Greenspan dominated the Federal Open Market Committee (F.O.M.C.), which sets the federal funds rate, but Bernanke explained and defended the Fed’s actions to other economists and to the public. In October, 2002, a few months after joining the Fed, he gave a speech to the National Association for Business Economics, in which he said, “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.” In other words, it is difficult to distinguish a rise in asset prices that is justified by a strong economy from one based merely on speculation, and raising rates in order to puncture a bubble can bring on a recession. Greenspan had made essentially this argument during the dot-com era and reiterated it during the real-estate boom. (As late as 2004, Greenspan said that a national housing bubble was unlikely.)
As house prices soared, many Americans took out home-equity loans to finance their spending. The personal savings rate dipped below zero, and the trade deficit, which the United States financed by borrowing heavily from abroad, expanded greatly. Some experts warned that the economy was on an unsustainable course; Bernanke disagreed. In a much discussed speech in March, 2005, he argued that the main source of imbalance in the global economy was not excess spending at home but, rather, excess saving in China and other developing countries, where consumption was artificially low. Lax American policy was helping to mop up a “global savings glut.”
“Bernanke provided the intellectual justification for the Fed’s hands-off approach to asset bubbles,” Stephen S. Roach, the chairman of Morgan Stanley Asia, who was among the economists urging the Fed to adjust its policy, told me. “He also played a key role in the development of the ‘global savings glut’ theory, which the Fed used as a very convenient excuse to say we are doing the world a big favor in maintaining demand. In retrospect, we didn’t have a global savings glut—we had an American consumption glut. In both of those cases, Bernanke was complicit in massive policy blunders on the part of the Fed.”
Another expert who dissented from the Greenspan-Bernanke line was William White, the former economics adviser at the Bank for International Settlements, a publicly funded organization based in Basel, Switzerland, which serves as a central bank for central banks. In 2003, White and a colleague, Claudio Borio, attended the annual conference in Jackson Hole, where they argued that policymakers needed to take greater account of asset prices and credit expansion in setting interest rates, and that if a bubble appeared to be developing they ought to “lean against the wind”—raise rates. The audience, which included Greenspan and Bernanke, responded coolly. “Ben Bernanke really believes that it is impossible to lean against the wind on the way up and that it is possible to clean up the mess afterwards,” White told me recently. “Both of these propositions are unproven.”
Between 2004 and 2007, White and his colleagues continued to warn about the global credit boom, but they were largely ignored in the United States. “In the field of economics, American academics have such a large reputation that they sweep all before them,” White said. “If you add to that the personal reputation of the Maestro”—Greenspan—“it was very difficult for anybody else to come in and say there are problems building.”
After years of theorizing about the economy, Bernanke revelled in the opportunity to participate in policy decisions, though he rarely challenged Greenspan. “He wouldn’t have gotten into that club if he didn’t go along,” Douglas Cliggott, the chief investment officer at Dover Investment Management, a mutual-fund firm, told me. “Mr. Greenspan ran a tight ship, and he didn’t fancy people spouting off with their own views.” In January, 2005, Bernanke gave a speech at the annual meeting of the American Economic Association, in which he reflected on his transition from teaching: “The biggest downside of my current job is that I have to wear a suit to work. Wearing uncomfortable clothes on purpose is an example of what former Princeton hockey player and Nobel Prize winner Michael Spence taught economists to call ‘signalling.’ You have to do it to show that you take your official responsibilities seriously. My proposal that Fed governors should signal their commitment to public service by wearing Hawaiian shirts and Bermuda shorts has so far gone unheeded.”
A month later, Greg Mankiw, the chairman of the Council of Economic Advisers, announced that he was returning to Harvard, and recommended Bernanke as his replacement. Al Hubbard, an Indiana businessman who headed the National Economic Council, which advises the President on economic policy, wasn’t convinced that Bernanke was the right choice. “When you meet him, he comes over as incredibly quiet,” Hubbard told me. “I wanted to make sure he was somebody who wouldn’t be reluctant to engage in the economic arguments.” After talking with Bernanke, Hubbard changed his mind. “He’s actually very self-confident, and he’s not intimidated by anybody,” Hubbard said. “You could always count on him to speak up and give his opinion from an economic perspective.”
In June, 2005, Bernanke was sworn in at the Eisenhower Executive Office Building. One of his first tasks was to deliver a monthly economics briefing to the President and the Vice-President. After he and Hubbard sat down in the Oval Office, President Bush noticed that Bernanke was wearing light-tan socks under his dark suit. “Where did you get those socks, Ben?” he asked. “They don’t match.” Bernanke didn’t falter. “I bought them at the Gap—three pairs for seven dollars,” he replied. During the briefing, which lasted about forty-five minutes, the President mentioned the socks several times.
The following month, Hubbard’s deputy, Keith Hennessey, suggested that the entire economics team wear tan socks to the briefing. Hubbard agreed to call Vice-President Cheney and ask him to wear tan socks, too. “So, a little later, we all go into the Oval Office, and we all show up in tan socks,” Hubbard recalled. “The President looks at us and sees we are all wearing tan socks, and he says in a cool voice, ‘Oh, very, very funny.’ He turns to the Vice-President and says, ‘Mr. Vice-President, what do you think of these guys in their tan socks?’ Then the Vice-President shows him that he’s wearing them, too. The President broke up.”
As chairman of the Council of Economic Advisers, Bernanke was expected to act as a public spokesman on economic matters. In August, 2005, after briefing President Bush at his ranch in Crawford, Texas, he met with the White House press corps. “Did the housing bubble come up at your meeting?” a reporter asked. “And how concerned are you about it?”
Bernanke affirmed that it had and said, “I think it is important to point out that house prices are being supported in very large part by very strong fundamentals. . . . We have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas. And those supply-and-demand factors are a big reason why house prices have risen as much as they have.”
By this time, the President’s ambitious plans to partly privatize Social Security had been stymied by congressional opposition, and his plans to simplify the tax system appeared likely to meet a similar fate. Nevertheless, the White House economics team was searching for market-friendly policy proposals, and Bernanke was happy to contribute. On the flight from Crawford to Washington, D.C., he and Hennessey discussed replacing tax subsidies to employer-based health-insurance plans with a fixed tax credit or deduction that families could use to buy their own coverage. In Washington, they continued to develop the idea, which proved popular with economic conservatives, though some experts have said it would lead to a dramatic drop in employer-provided health plans. “It’s what we proposed, and it’s what John McCain proposed,” Al Hubbard said. “If we can keep health care in the private sector, it is what eventually will happen. Ben and Keith are the guys who came up with it.”
From the moment Bernanke went to work for Bush, he was seen as a likely successor to Greenspan, who was due to retire in January, 2006. Shortly after Labor Day, 2005, at Bush’s request, Al Hubbard and Liza Wright, the White House personnel director, compiled a list of eight or ten candidates for the Fed chairmanship and interviewed several of them. The selection committee eventually settled on Bernanke. “An important part of the Fed job is bringing people along with you, on the F.O.M.C. and so on,” Hubbard told me. “He had the right personality to do that. Plus, Ben is a very powerful thinker. We were impressed with his theories of the world and the way he thinks. He believes in free markets.”
Some press reports have suggested that the public controversy over the abortive nomination to the Supreme Court of Harriet Miers, the White House counsel, helped Bernanke’s chances, because it put pressure on the Administration to appoint a nonpartisan figure to the Fed. “That was never even discussed,” Hubbard insisted to me. “We didn’t take account of Harriet Miers or anything else. There was no politics involved.” On October 24, 2005, President Bush nominated Bernanke as the fourteenth chairman of the Fed, saying, “He commands deep respect in the global financial community.” After thanking the President, Bernanke said that if the Senate confirmed him his first priority would be “to maintain continuity with the policies and policy strategies established during the Greenspan years.”
F or more than a year, Bernanke kept his word. In the first half of 2006, the F.O.M.C. raised the federal funds rate in three quarter-point increments, to 5.25 per cent, and kept it there for the rest of the year. But cheap money was only part of Greenspan’s legacy. He had also championed financial deregulation, resisting calls for tighter government oversight of burgeoning financial products, such as over-the-counter derivatives, and applauded the growth of subprime mortgages. “Where once more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risks posed by individual applicants and to price that risk appropriately,” Greenspan said in a 2005 speech.
Bernanke hadn’t said much about regulation before being nominated as the Fed chairman. Once in office, he generally adhered to Greenspan’s laissez-faire approach. In May, 2006, he rejected calls for direct regulation of hedge funds, saying that such a move would “stifle innovation.” The following month, in a speech on bank supervision, he expressed support for allowing banks, rather than government officials, to determine how much risk they could take on, using complicated mathematical models of their own devising—a policy that had been in place for a number of years. “The ongoing work on this framework has already led large, complex banking organizations to improve their systems for identifying, measuring, and managing their risks,” Bernanke said.
It is now evident that self-regulation failed. By extending mortgages to unqualified lenders and accumulating large inventories of subprime securities, banks and other financial institutions took on enormous risks, often without realizing it. Their mathematical models failed to alert them to potential perils. Regulators—including successive Fed chairmen—failed, too. “That was largely Greenspan, but Bernanke clearly shared an ideology of taking a hands-off approach,” Stephen Roach, of Morgan Stanley Asia, said. “In retrospect, it is unconscionable that the Fed didn’t really care about regulation, or didn’t show any interest in it.”
Bernanke was more concerned about inflation and unemployment, the Fed’s traditional areas of focus, than he was about the growth of mortgage securities. “The U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding years to a more sustainable, average pace of growth,” he told the Senate banking committee in February, 2007. By then, home prices in many parts of the country had begun to drop. At least two prominent economists—Nouriel Roubini, at N.Y.U., and Joseph Stiglitz, at Columbia—had warned that a nationwide housing slump could trigger a recession, but Bernanke and his colleagues thought this was unlikely. “You could think about Texas in the nineteen-eighties, when oil prices went down, or California in the nineteen-nineties, when the peace dividend hit the defense industry, but these were regional things,” one Fed policymaker told me. “A national decline in house prices hadn’t occurred since the nineteen-thirties.”
On February 28, 2007, Bernanke told the House budget committee that he didn’t consider the housing downturn “as being a broad financial concern or a major factor in assessing the state of the economy.” He maintained an upbeat tone over the next several months, during which two large subprime lenders, New Century Financial Corp. and American Home Mortgage, filed for bankruptcy, and the damage spread to Wall Street firms that had invested in subprime securities. On August 3rd, the day after American Home Mortgage announced that it was shutting down, the Dow fell almost three hundred points, and CNBC’s Jim Cramer, in a four-minute rant that is still playing on YouTube, accused the Fed of being “asleep.”
“Bernanke is being an academic,” Cramer bellowed. “He has no idea how bad it is out there! . . . My people have been in this game for twenty-five years, and they are losing their jobs, and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing!”
Four days later, the F.O.M.C. met, but left the federal funds rate unchanged. In a statement, the committee acknowledged the housing “correction” but said that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.” Looking back on this period, Bernanke told me, “I and others were mistaken early on in saying that the subprime crisis would be contained. The causal relationship between the housing problem and the broad financial system was very complex and difficult to predict.” Relative to the fourteen trillion dollars in mortgage debt outstanding in the United States, the two-trillion-dollar subprime market seemed trivial. Moreover, internal Fed estimates of the total losses likely to be suffered on subprime mortgages were roughly equivalent to a single day’s movement in the stock market, hardly enough to spark a financial conflagration.
One of the supposed advantages of securitizing mortgages was that it allowed the risk of homeowners’ defaulting on their mortgages to be transferred from banks to investors. However, as the market for mortgage securities deteriorated, many banks ended up accumulating big inventories of these assets, some of which they parked in off-balance-sheet vehicles called conduits. “We knew that banks were creating conduits,” Don Kohn, the Fed’s vice-chairman, told me. “I don’t think we could have recognized the extent to which that could come back onto the banks’ balance sheets when confidence in the underlying securities—the subprime loans—began to erode.”
On August 9, 2007, the crisis escalated significantly after BNP Paribas, a major French bank, temporarily suspended withdrawals from three of its investment funds that had holdings of subprime securities, citing a “complete evaporation of liquidity in certain market segments of the U.S. securitization market.” In other words, trading in the mortgage securities market had ceased, leaving many financial institutions short of cash and saddled with assets that they couldn’t sell at any price. Stocks fell sharply on both sides of the Atlantic, and the following day Bernanke held a conference call with members of the F.O.M.C., during which they discussed reducing the interest rate at which the Fed lends to commercial banks—the “discount rate.” Since the Fed was founded, it has had a “discount window,” from which commercial banks may borrow as needed. In recent years, however, most banks had stopped using the window, because they could raise money more cheaply from investors and other banks.
The Fed decided to keep the discount rate at 6.25 per cent but issued a statement reminding banks that the discount window was open if they needed money. Seven days later, however, after more wild swings in the markets, the Fed voted to cut the discount rate by half a point, to 5.75 per cent. It declared that it was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”
Bernanke now realized that the subprime crisis posed a grave threat to some of the country’s biggest financial institutions and that Greenspan-era policies were insufficient to contain it. In the third week of August, he made his second visit as head of the Fed to Jackson Hole, where he invited some of his senior colleagues to join him in a brainstorming session. “What’s going on and what do we need to do?” he asked. “What tools have we got and what tools do we need?”
The participants included Don Kohn; Kevin Warsh; Brian Madigan, the head of monetary affairs at the Fed; Tim Geithner, the head of the New York Fed; and Bill Dudley, who runs the markets desk at the New York Fed. The men agreed that the financial system was facing what is known as a “liquidity crisis.” Banks, fearful of lending money to financial institutions that might turn out to be in trouble, were starting to hoard their capital. If this situation persisted, businesses and consumers might be unable to obtain the loans they needed in order to spend money and keep the economy afloat.
Bernanke and his colleagues settled on a two-part approach to the crisis. (Geithner later dubbed it “the Bernanke doctrine.”) First, to prevent the economy from stalling, the Fed would lower the federal funds rate modestly—by half a point in September and by a quarter point in October, to 4.5 per cent. This was standard Fed policy—trimming rates to head off an economic decline—but it didn’t directly address the crisis of confidence afflicting the financial system. If banks wouldn’t extend credit to one another, the Fed would have to act as a “lender of last resort”—a role it was authorized to perform under the 1913 Federal Reserve Act. However, borrowing from the Fed’s discount window, its main tool for supplying banks with cash, not only meant paying a hefty interest rate but also signalled to competitors that the lender was having difficulty raising money. Moreover, many of the banks that had bought subprime securities and needed to lend dollars weren’t in the United States.
Kohn proposed a potential solution. Before the turn of the millennium, he recalled, worries about widespread computer failures had prompted many financial institutions to hoard capital. The Fed, determined to keep money flowing in the event of a crisis, had developed several ideas, including auctioning Fed loans and setting up currency swaps with central banks abroad, to enable cash-strapped foreign banks to lend in dollars. Y2K had transpired without incident, and none of the ideas had been tested. Kohn suggested that the Fed revisit them now.
Versions of the Y2K proposals became the second part of the Bernanke doctrine—its most radical component. Over fifteen months, beginning in August, 2007, the Fed, through various novel programs known by their initials, such as T.A.F., T.S.L.F., and P.D.C.F., lent more than a trillion dollars to dozens of institutions. One program, T.A.F., allowed banks and investment firms to compete in auctions for fixed amounts of Fed funding, while T.S.L.F. enabled firms to swap bad mortgage securities for safe Treasury bonds. The programs, which have received little public attention, were supposed to be temporary, but they have been greatly expanded and remain in effect. “It’s a completely new set of liquidity tools that fit the new needs, given the turmoil in the financial markets,” Kevin Warsh, the Fed governor, said. “We have basically substituted our balance sheet for the balance sheet of financial institutions, large and small, troubled and healthy, for a time. Without these credit facilities, things would have been a lot worse. We’d have a lot more banks needing to be resolved, unwound, or rescued, and we would have run out of buyers before we ran out of sellers.”
Richard Fisher, the head of the Dallas Fed, told me that the lending programs would be Bernanke’s main legacy. He likened what the Fed has done to replacing a broken sprinkler system. “If the pipes are blocked up, the sprinkler heads don’t receive any water, and the lawn turns brown and dies,” he said. “In this case, the piping system had been broken and clogged. Just turning the faucet of the federal funds rate was insufficient to the challenges the Fed faced.”
Although many people at the Fed worked on the details of the lending programs, Bernanke provided the impetus for their development. One of his first acts on taking office was to establish a financial-stability working group, which brought together economists, finance specialists, bank supervisors, and lawyers from different departments at the Fed to devise solutions to potential problems. As the subprime crisis unfolded, Bernanke met with the task force frequently to discuss the Fed’s response, including how, in seeking to expand the scope of its activities, it could exploit obscure laws from the nineteen-thirties. “Ben is very good at making decisions—none of this waiting for the definitive academic paper before acting,” said Geithner, who last week was reported to have been selected as Treasury Secretary by President-elect Barack Obama. “We’ve done some incredibly controversial, consequential things in a remarkably short period of time, and it’s because he was willing to act quickly, with force and creativity.”
Despite the rate cuts and lending programs, months passed without discernible improvements in the credit markets. During the summer and fall of 2007, the drop in house prices accelerated and the number of subprime delinquencies increased. In October, at a meeting in Washington of central bankers, executives, and economists, Allen Sinai, the chief economist at Decision Economics, Inc., asked Bernanke how he thought a central bank should manage the economic risks posed by a housing bubble. According to Sinai, Bernanke said that he had no way of knowing if there had been a housing bubble. “I realized then that he just didn’t realize the scale of the problem,” Sinai told me.
At F.O.M.C. meetings, some members compared the subprime debacle with the financial crisis of 1998, when the Fed organized a consortium of Wall Street firms to prevent the giant hedge fund Long Term Capital Management from collapsing. The markets had gyrated for a couple of months before recovering strongly, and the broader economy had been largely unaffected. “In September, it still looked good,” Frederic Mishkin, a Columbia professor and a close friend of Bernanke, who served as a Fed governor from September, 2006, until August of this year, told me. “I thought it was going to be worse than 1998, but not much worse. I thought it was going to be over in a few months.”
By the end of 2007, however, Bernanke was beginning to agree with some of the Fed’s critics that interest rates needed to come down quickly. On January 4, 2008, the Labor Department reported that the unemployment rate had jumped from 4.7 per cent to five per cent, prompting a number of economists to say that the United States was on the brink of a recession. More banks and investment banks, including Citigroup, UBS, and Morgan Stanley, were reporting big losses—a development that particularly concerned Bernanke because of its historical overtones.
In an article Bernanke published in 1983, he showed how the Fed’s failure in the early thirties to prevent banks from collapsing contributed to the depth and severity of the Great Depression—a finding that supported a theory first proposed in 1963 by the economists Milton Friedman and Anna Schwartz. In November, 2002, shortly after joining the Fed, Bernanke appeared at a conference to mark Friedman’s ninetieth birthday, and apologized for the Fed’s Depression-era policies. “I would like to say to Milton and Anna: regarding the Great Depression, you’re right; we did it,” he said. “We’re very sorry. But, thanks to you, we won’t do it again.”
On January 21, 2008, stock markets around the world fell sharply. The U.S. markets were closed for Martin Luther King Day, but at six o’clock that evening Bernanke convened a conference call of the F.O.M.C., which voted to cut the federal funds rate by three-quarters of a point, to 3.5 per cent. It was the first rate cut to occur between meetings since September, 2001, and the largest one-day reduction in the rate.
When the committee met on January 29th, it cut the federal funds rate by another half a point, to three per cent. In a month and a half, the Fed had shifted from a policy roughly balanced between fighting inflation and maintaining economic growth to one explicitly aimed at heading off a recession. To people inside the Fed, which is accustomed to moving at a stately pace, the change felt wrenching. “To move that far that fast was unprecedented,” Frederic Mishkin, the Columbia professor and former Fed governor, said. “In our context, it’s remarkable how fast we reacted.” Some economists who worry about inflation were outraged by the rate cuts. “They’re doing the same stupid things they did in the nineteen-seventies,” Allan Meltzer, an economist at Carnegie Mellon, who has written a history of the Fed, told the Times. “They were always saying then that we’re not going to let inflation get out of hand, that we’re going to tackle it once the economy starts growing, but they never did.”
Bernanke was frustrated by the attacks on his policies, especially when they came from academics whose work he respected. If he moved slowly, people on Wall Street accused him of timidity. If he brought rates down sharply, academic economists accused him of going soft on inflation.
As the financial crisis worsened, Bernanke worked more closely with Paulson, who, after becoming Treasury Secretary, in June, 2006, had established considerable autonomy in determining the Bush Administration’s economic policy. The men appeared to have little in common. Bernanke was scholarly and reserved; Paulson, an English major who played offensive tackle for Dartmouth in the seventies, where he was known as the Hammer, was gregarious. Both, however, were political moderates who liked baseball. On his desk, Paulson, a Cubs fan, kept a copy of Bill James’s “Historical Baseball Abstract,” given to him by Bernanke, a former Red Sox fan who, since moving to the capital, had adopted the Washington Nationals.
Paulson and Bernanke met for breakfast every week and saw each other often at meetings of the President’s Working Group on Financial Markets, which was led by Paulson and included senior officials from the Securities and Exchange Commission and the Commodity Futures Trading Commission. Paulson frequently solicited Bernanke’s advice. “I’ve been impressed with his pragmatism and how intellectually curious he is,” Paulson told me in September. “He’s willing to consider all ideas—conventional and non-conventional—and he doesn’t easily accept things that the bureaucracy comes up with.”
In early March, 2008, stock in Bear Stearns, the investment bank and a major underwriter of subprime securities, fell steeply amid rumors that the firm was having trouble raising money in the overnight markets, on which, like all Wall Street firms, it depended to finance its huge trading positions. Many of the bank’s clients began to withdraw their money, and many of its creditors demanded more collateral for their loans. In accommodating these requests, Bear was forced to draw on its cash reserves. By the afternoon of Thursday, March 13th, it reportedly had just two billion dollars left, not nearly enough to meet its obligations on Friday morning.
The Bernanke doctrine hadn’t been designed to deal with such a situation. When Bernanke and Tim Geithner, the Fed’s point man on Wall Street, first learned of Bear’s predicament, they believed that the bank should be allowed to fail. For decades, the Fed had resisted lending to Wall Street firms for fear that it would encourage them to take excessive risks—a concern that economists refer to as “moral hazard.” (The discount window is confined to commercial banks.) Bear wasn’t one of Wall Street’s biggest firms, and its demise seemed unlikely to lead to other failures. In the argot of central bankers, the bank didn’t appear to present a “systemic risk.”
By late Thursday night, after officials from the New York Fed and the S.E.C. visited Bear’s offices to review its books, the assessment had changed. The company was a major participant in the “repurchase”—or “repo”—market, a little publicized but vitally important market in which banks raise cash on a short-term basis from mutual funds, hedge funds, insurance companies, and central banks. Every night, about $2.5 trillion turns over in the repo market. Most repo contracts roll over on a daily basis, and the lender can at any time return the collateral and demand its cash. This is precisely what many of Bear’s lenders were doing—a process akin to the run by depositors on the Bailey Bros. Building & Loan in “It’s a Wonderful Life.”
Bear was also a big dealer in credit-default swaps (C.D.S.s), which are basically insurance contracts on bonds. In return for a premium, the seller of a swap promises to cover the full value of a given bond in the case of a default. Bear alone reportedly had more than five thousand institutional partners with whom it had traded C.D.S.s. If the bank were to default before the markets opened on Friday, the effect on the repo and swaps markets would be chaotic.
At two o’clock that morning, Geithner called Don Kohn and told him that he wasn’t confident that the fallout from the bankruptcy of Bear Stearns could be contained. At about 4 A.M., Geithner spoke to Bernanke, who agreed that the Fed should intervene. The central bank decided to extend a twenty-eight-day loan to J. P. Morgan, Bear’s clearing bank, which would pass the money on to Bear. In agreeing to make the loan, Bernanke relied on Section 13(3) of the Federal Reserve Act of 1932, which empowered the Fed to extend credit to financial institutions other than banks in “unusual and exigent circumstances.”
News of the Fed’s loan got Bear through trading on Friday, but Bernanke and Paulson were eager to find a permanent solution before the Asian markets opened on Sunday night. After a weekend of torturous negotiations, J. P. Morgan agreed to buy Bear Stearns for a knockdown price of two dollars a share, but only after the Fed agreed to take on Bear’s twenty-nine-billion-dollar portfolio of subprime securities. “The further we got into it, the more we said, ‘Oh, my God! We really need to address this problem,’ ” a senior Fed official recalled. “The problem wasn’t the size of Bear Stearns—it wasn’t the fact that some creditors would have borne losses. The problem was—people use the term ‘too interconnected to fail.’ That’s not totally accurate, but it’s close enough.” In the repo market, for example, Bear Stearns had borrowed heavily from money-market mutual funds. “If Bear had failed,” the senior official went on, “all these money-market mutual funds, instead of getting their money back on Monday morning, would have found themselves with all kinds of illiquid collateral, including C.D.O.s”—collateralized debt obligations—“and God knows what else. It would have caused a run on that entire market. That, in turn, would have made it impossible for other investment banks to fund themselves.”
The day the Federal Reserve announced the rescue of Bear Stearns, it also cut the discount rate by another quarter point, and said that for a time it would open the discount window to twenty Wall Street firms—an unprecedented step. Fed officials felt they had little choice but to let investment banks borrow from the Fed on the same terms as commercial banks, even if it encouraged moral hazard. “We thought that even if we were successful in getting a solution that avoided a default for Bear, what was happening in the credit markets had too much momentum,” a Fed official recalled. “We weren’t going to be able to contain the damage simply by helping avoid a failure by Bear.”
There is now wide agreement that Bernanke and his colleagues made the correct decision about Bear Stearns. If they had allowed the firm to file for bankruptcy, the financial panic that developed this fall would almost certainly have begun six months earlier. Instead, the markets settled for a while. “I think we did the right thing to try to preserve financial stability,” Bernanke said. “That’s our job. Yes, it’s moral-hazard-inducing, but the right way to address this question is not to let institutions fail and have a financial meltdown. When the economy has recovered, or is on the way to recovery, that’s the time to say, ‘How can we fix the system so it doesn’t happen again?’ You want to put the fire out first and then worry about the fire code.”
Nevertheless, after Bear Stearns’s deal with J. P. Morgan was announced, Bernanke was attacked—by the media, by conservative economists, even by former Fed officials. In an editorial titled “Pushovers at the Fed,” the Wall Street Journal declared that James Dimon, the chairman and chief executive of J. P. Morgan Chase, was “rolling over” the Fed and the Treasury. In early April, Paul Volcker, who chaired the Fed from 1979 to 1987, told the Economic Club of New York, “Sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank.” The Fed’s job is to act as “custodian of the nation’s money,” Volcker went on, not to take “many billions of uncertain assets onto its own balance sheet.”
Some of the criticisms were unfair. Bear Stearns’s stockholders lost almost everything in the deal; James Cayne, the bank’s chairman, lost almost a billion dollars. Still, even some Fed officials were uneasy about the acquisition of Bear Stearns’s mortgage securities. Bernanke was sufficiently disturbed by Volcker’s speech that he called to reassure him that the Fed’s action had been an improvised response to a crisis rather than a template for future action.
In fact, it quickly became clear that an important precedent had been set: the Bernanke doctrine now included preventing the failure of major financial institutions. Since the collapse of the mortgage-securities market on Wall Street, in the summer of 2007, mortgage securitization had been left mainly in the hands of two companies that operated under government charters to encourage home-ownership: the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Like the Wall Street firms, Fannie and Freddie had suffered big losses on their vast loan portfolios, and many Wall Street analysts believed that the companies were on the verge of insolvency—an alarming prospect for the U.S. government. In order to finance their purchases of mortgages and mortgage bonds, Fannie and Freddie had issued $5.2 trillion in debt, and although they were technically private companies, their debt traded as if the government had guaranteed it. If the companies defaulted, the creditworthiness of the entire government would be called into question.
On Sunday, July 13th, Paulson told reporters outside the Treasury Department that he would request from Congress authority to invest an unspecified amount of taxpayers’ money in Fannie and Freddie, which would remain shareholder-owned corporations. Fed officials said that until Congress agreed to Paulson’s request the central bank would insure that the mortgage companies had sufficient cash by lending them money through the discount window. “We could recognize the systemic risk here,” the Fed policymaker said. “Paulson had a plan to deal with that risk, and the system required that somebody be there while the plan was being implemented. We had the money to bridge to the new facility.”
The plan to prop up Freddie and Fannie was no more warmly received than the Bear Stearns rescue package had been. “When I picked up my newspaper yesterday, I thought I woke up in France,” Senator Jim Bunning, a Republican from Kentucky, said to Bernanke when he appeared before the Senate banking committee. “But no, it turned out it was socialism here in the United States of America.” Two prominent Democratic economists, Lawrence Summers, the former Treasury Secretary, and Joseph Stiglitz, pointed out that the highly paid managers of the mortgage companies had been left in place, with few restrictions on how they operated. David Walker, the former director of the Government Accountability Office, said the rescue was a bad deal for the taxpayers.
Bernanke couldn’t say so publicly, but he agreed with some of the critics. For years, the Fed had warned that Fannie and Freddie were squeezing out competitors and engaging in risky mortgage-lending practices. Bernanke would have liked to combine a rescue package with extensive reforms, but he realized that an overhaul of the companies was not politically feasible. Despite their financial problems, Fannie and Freddie still had many powerful allies in Congress, and Bernanke was determined that the plan be approved quickly, in order to restore confidence in the markets.
On August 21st, Bernanke departed for the annual Jackson Hole conference, which was to be devoted to the credit crunch. Over the course of three days, one speaker after another challenged aspects of the Fed’s response, and, implicitly, of Bernanke’s leadership. Allan Meltzer, of Carnegie Mellon, complained that the Fed had adopted an ad-hoc approach to bailing out troubled firms. Franklin Allen, a professor at the Wharton School, said that banks and investment firms could use the Fed’s lending facilities as a means of concealing the state of their finances, and Willem Buiter, of the London School of Economics, accused the Fed of doing the financial industry’s bidding, saying that the central bank had “internalized the fears, beliefs, and world views of Wall Street” and fallen victim to “cognitive regulatory capture.”
Alan Blinder, Bernanke’s friend and colleague from Princeton, defended him, arguing that the Fed had performed well in trying circumstances, and Martin Feldstein, a Harvard economist, said that it had “responded appropriately this year.” But Feldstein added that the financial crisis was getting worse as housing prices continued to drop and homeowners to default. Perhaps the most suggestive comments were made by Yutaka Yamaguchi, a former deputy governor of the Bank of Japan, who, during the nineties, helped manage Japan’s response to a ruinous speculative bust. The Bank of Japan began cutting interest rates in July, 1991, Yamaguchi recalled, but the financial system didn’t stabilize until after the Japanese government bailed out a number of banks, a project that took almost a decade. The main lesson of the Japanese experience, he said, was the need for an “early and large-scale recapitalization of the financial system,” using public money.
Throughout the discussion, Bernanke sat quietly and listened. He looked exhausted, and during one presentation he appeared to fall asleep. In his own speech, he defended the Fed’s actions and argued that in the future the agency should be given more power to supervise big financial firms and opaque markets such as the repo market, and that a legal framework should be established to allow the government to intervene when they got into trouble. The speech suggested that Bernanke had adopted a more favorable view of regulation, but he made no mention of using monetary policy to deflate speculative bubbles or of recapitalizing the banking system.
Bernanke still believed that his finger-in-the-dike strategy was working. After all, in the second quarter of the year the Gross Domestic Product had expanded at an annualized rate of almost three per cent—and the unemployment rate was under six per cent. Commodity prices, including oil prices, had started to fall, which would ease inflation pressures. In Washington, over Labor Day weekend, Bernanke and Paulson met to discuss Fannie and Freddie. In the five weeks since Congress had given the Bush Administration broad authority to invest in the companies, the firms had tried unsuccessfully to raise capital on their own. Paulson and Bernanke decided that a government takeover was now the best option. In addition to removing the threat that Fannie and Freddie would default on their debts, it would enable the government to expand their lending activities and help stabilize house prices. “We have worked together for nine months, recognizing that the real-estate market is at the heart of our economic problems,” Paulson told me later in September. “We said, ‘If you wanted to get at that, how would you do it?’ ”
On Sunday, September 7th, Paulson announced that the government would place Fannie and Freddie in a “conservatorship,” replacing their chief executives, taking an eighty-per-cent ownership stake in each of the companies, and providing them with access to as much as two hundred billion dollars in capital. The next day, the Dow closed up almost three hundred points. The billionaire Warren Buffett, whom Paulson had briefed on the move, said that it represented “exactly the right decision for the country.” Even the Wall Street Journal’s editorial page, which for months had criticized Paulson and Bernanke, grudgingly endorsed the plan.
At the Treasury Department and the Fed, there was little opportunity to celebrate. On Tuesday, September 9th, stock in Lehman Brothers dropped by forty-five per cent, following reports that it had failed to secure billions of dollars in capital from a Korean bank. Lehman approached several potential buyers, including Bank of America and Barclays, the British bank. But by the end of the week it was running out of cash. On Friday evening, Geithner and Paulson summoned a group of senior Wall Street executives to the New York Fed and told them that the government wanted an “industry” solution to Lehman’s problems. Talks continued through the weekend, but by Sunday afternoon both Bank of America and Barclays had bowed out, and word circulated that Lehman was preparing to file for bankruptcy.
Remarkably, once the potential bidders dropped out, Bernanke and Paulson never seriously considered mounting a government rescue of Lehman Brothers. Bernanke and other Fed officials say that they lacked the legal authority to save the bank. “There was no mechanism, there was no option, there was no set of rules, there was no funding to allow us to address that situation,” Bernanke said last month, at the Economic Club of New York. “The Federal Reserve’s ability to lend, which was used in the Bear Stearns case, for example, requires that adequate collateral be posted. . . . In this case, that was impossible—there simply wasn’t enough collateral to support the lending. . . . We worked very hard, over one of those famous weekends, with not only some potential acquirers of Lehman but we also called together many of the leading C.E.O.s of the private sector in New York to try to come to a solution. We didn’t find one.” Bernanke insisted to me, too, that there was nothing he could have done to prevent Lehman from going under. “With Bear Stearns, with all the others, there was a point when someone said, ‘Mr. Chairman, are we going to do this deal or not?’ With Lehman, we were never anywhere near that point. There wasn’t a decision to be made.”
However, Bernanke and Paulson were undoubtedly sensitive to the charge, made in the wake of their efforts to salvage Bear Stearns, Fannie Mae, and Freddie Mac, that they were bailing out greedy and irresponsible financiers. For months, the Treasury and the Fed had urged Lehman’s senior executives to raise more capital, which the bank had failed to do. Many analysts remain skeptical that the Fed couldn’t have rescued Lehman. “It’s really hard for me to accept that they couldn’t have come up with something,” Dean Baker, of the Center for Economic and Policy Research, said. “They’ve been doing things of dubious legal authority all year. Who would have sued them?”
At the time, a popular interpretation of Lehman Brothers’ demise was that Bernanke and Paulson had finally drawn a line in the sand. (“We’ve reestablished ‘moral hazard,’ ” a source involved in the Lehman discussions told the Wall Street Journal.) But less than forty-eight hours later the Fed agreed to extend up to eighty-five billion dollars to A.I.G., a firm that had possibly acted even more irresponsibly. One difference was that the Fed, in charging A.I.G. an interest rate of more than ten per cent and demanding up to eighty per cent of the company’s equity, had been able to impose tough terms in exchange for its support. “We felt we could say that this was a well-secured loan and that we were not putting fiscal resources at risk,” the senior Fed official told me.
More important, A.I.G. was a much bigger and more complex firm than Lehman Brothers was. In addition to providing life insurance and homeowners’ policies, it was a major insurer of mortgage bonds and other types of securities. If it had been allowed to default, every big financial firm in the country, and many others abroad, would have been adversely affected. But even the announcement of A.I.G.’s rescue wasn’t enough to calm the markets.
On Tuesday, September 16th, the Reserve Primary Fund, a New York-based money-market mutual fund that had bought more than seven hundred million dollars in short-term debt issued by Lehman Brothers, announced that it was suspending redemptions because its net asset value had fallen below a dollar a share. The subprime virus was infecting parts of the financial system that had appeared immune to it—including the most risk-averse institutions—and the news that the Reserve Primary Fund had “broken the buck” sparked an investor panic that by mid-October had become global, striking countries as far removed as Iceland, Hungary, and Brazil.
Bernanke accompanied Paulson to Capitol Hill to warn reluctant congressmen about the catastrophic consequences of failing to pass a bailout bill. (“When you listened to him describe it, you gulped,” Senator Chuck Schumer, the New York Democrat, said of Bernanke’s evocation of the crisis.) He helped enable Goldman Sachs and Morgan Stanley to convert to bank holding companies, and he coöperated with other regulators on the seizure of Washington Mutual and the sale of most of its operations to J. P. Morgan. He was in his office until 4 A.M. finalizing Citigroup’s takeover of Wachovia. (The government agreed to cap Citigroup’s potential losses on Wachovia’s huge mortgage portfolio.) The Fed also announced that it would spend up to a half-trillion dollars shoring up money-market mutual funds.
Often, it was clear that Bernanke and Paulson were improvising. On November 10th, the Fed and the Treasury Department announced that they would provide more money to A.I.G., raising the total amount of public funds committed to the company to a hundred and fifty billion dollars. (The Fed’s original eighty-five-billion-dollar loan, and a subsequent one, of $37.8 billion, had proved inadequate.) Two days later, Paulson abandoned the idea of buying up distressed mortgage securities—a proposal that he and Bernanke had vigorously defended—and last week, at a hearing of the House Financial Services Committee, congressmen excoriated him. “You seem to be flying a seven-hundred-billion-dollar plane by the seat of your pants,” Gary Ackerman, a Democrat from New York, scolded Paulson. Perhaps the most damning criticism came from the committee’s chairman, Barney Frank, the Massachusetts Democrat, who noted that although the bailout legislation had included specific provisions to address foreclosures, Americans continued to default on mortgages at a record rate.
The Congressman had a point. Paulson’s and Bernanke’s efforts to prop up the financial system have so far had little effect on the housing slump, which is the source of the trouble. Until that problem is addressed, the financial sector will remain under great stress.
Last week, the stock market plunged to its lowest level in eleven years, auto executives flew into Washington on their corporate jets to demand a bailout, and Wall Street analysts warned that the political vacuum between Administrations could create more turmoil. “We can’t get from here to February 1st if the current ‘who’s in charge?’ situation continues,” Robert Barbera, the chief economist at I.T.G., an investment firm, told the Times.
Bernanke, though, remains remarkably calm. (Jim Cramer would say oblivious.) He is unapologetic about the alterations to the bailout plan, arguing that changing circumstances demanded them, and he is relieved that the Treasury Department and Congress are now leading the government’s response to the crisis. Despite grim news on unemployment, retail sales, and corporate earnings, he is hopeful that an economic recovery will begin sometime next year. Until the middle of last week, there were signs that the credit crisis was easing: some banks were lending to each other again, the interest rates that they charge each other have come down, and no major financial institution has failed since the passage of the bailout bill. “It was a very important step,” Bernanke told me last week, referring to the bailout. “It greatly diminished the threat of a global financial meltdown. But, as Hank Paulson said publicly, ‘you don’t get much credit for averting a disaster.’ ”
On Wall Street, Bernanke’s reviews have improved, especially at firms that have received assistance from the Fed. “I think he has done a superb job, both in coming up with innovative solutions and in coördinating the policy response with the New York Fed, the Treasury Department, and the S.E.C.,” John Mack, of Morgan Stanley, told me. “I give him very high marks.” George Soros, the investor and philanthropist, whose firm has not benefitted from the Fed’s largesse, said, “Early on, being an academic, he didn’t realize the seriousness of the problem. But after the start of the year he got the message and he acted very decisively.” Still, Soros went on, citing renewed turbulence in the markets and speculation about the fate of Citigroup, whose stock price last Friday fell below four dollars, the crisis is far from over. “With Lehman, the system effectively broke down. It is now on life support from the Fed, but it’s really touch and go whether they can hold it together. The pressure is mounting even as we speak.” He added, “We may be on the verge of another collapse.”
Bernanke, in a search for inspiration and guidance, has been thinking about two Presidents: Franklin Delano Roosevelt and Abraham Lincoln. From the former he took the notion that what policymakers needed in a crisis was flexibility and resolve. After assuming office, in March, 1933, Roosevelt enacted bold measures aimed at reviving the moribund economy: a banking holiday, deposit insurance, expanded public works, a devaluation of the dollar, price controls, the imposition of production directives on many industries. Some of the measures worked; some may have delayed a rebound. But they gave the American people hope, because they were decisive actions.
Bernanke’s knowledge of Lincoln was more limited, but one morning the man who organizes the parking pool in the basement of the Fed’s headquarters had given him a copy of a statement Lincoln made in 1862, after he was criticized by Congress for military blunders during the Civil War: “If I were to try to read, much less answer, all the attacks made on me, this shop might as well be closed for any other business. I do the very best I know how—the very best I can; and I mean to keep doing so until the end. If the end brings me out all right, what is said against me won’t amount to anything. If the end brings me out wrong, ten angels swearing I was right will make no difference.”
Bernanke keeps the statement on his desk, so he can refer to it when necessary. ♦
Intervention Is Bold, but Has a Basis in History
By STEVE LOHR
After a week of mounting chaos in financial markets around the globe, the United States took a momentous step that shifts power in the economy toward Washington and away from Wall Street.
The government’s plan to prop up banks large and small — along with recent bailouts as well as guarantees to support business loans, money markets and bank lending — represents the most sweeping government moves into the nation’s financial markets since the Great Depression, and perhaps ever, according to economists and finance experts.
The high-stakes program is intended to halt the worst financial crisis since the 1930s. If successful, it could long be studied by historians as a textbook case of the emergency role that government can play to rescue a teetering economy.
“It is profound, and it is something of a shift back to the state,” said Adam S. Posen, an economist at the Peterson Institute for International Economics. “But is this a recasting of capitalism? I think what we’ll see is that the government acts as a silent partner and gets out as soon as it can.”
Indeed, they say, many questions remain. Is the government picking winners in a plan that initially seems tilted toward the nation’s largest banks? What strings are attached to the investment in matters like executive pay? Will the move presage a more forceful government hand to control financial markets or will it be a brief stint as capitalism’s protector?
The package does call for the government investments to be in three-year securities that the banks can repay at any time, when markets settle and conditions improve. “This is clearly a crisis measure in crisis times, but it’s a good thing there is a sunset provision that limits the length of the government’s investment,” said Richard Sylla, an economist and financial historian at the Stern School of Business at New York University.
The United States is acting in step with Europe, where governments often take a more interventionist stance in economies and the financial systems are in the hands of a comparatively small number of banks.
Britain took the lead last week, declaring its intention to take equity stakes in banks to steady them. In the last two days, France, Italy and Spain have announced rescue packages for their banks that include state shareholdings.
The government’s plan is an exceptional step, but not an unprecedented one.
The United States has a culture that celebrates laissez-faire capitalism as the economic ideal, yet the practice strays at times. Over the last century, the federal government has occasionally taken stakes in railways, coal mines and steel mills, and has even taken a controlling interest in banks when it was deemed to be in the national interest.
The corporate wards of the state typically have been returned to private hands after short, sometimes fleeting, stretches under federal stewardship.
Finance experts say that having Washington take stakes in United States banks now — like government interventions in the past — would be a promising move to address an economic emergency. The plan by the Treasury Department, they say, could supply banks with sorely needed capital and help restore confidence in financial markets.
Elsewhere, government bank-investment programs are routinely called nationalization programs. But that is not likely in the United States, where nationalization is a word to avoid, given the aversion to anything that hints of socialism.
In past times of war and national emergency, Washington has not hesitated. In 1917, the government seized the railroads to make sure goods, armaments and troops moved smoothly in the interests of national defense during World War I. After the war ended, bondholders and stockholders were compensated and railways were returned to private ownership in 1920.
During World War II, Washington seized dozens of companies, including railroads, coal mines and, briefly, the Montgomery Ward department store chain. In 1952, President Harry S. Truman seized 88 steel mills across the country, asserting that unyielding owners were determined to provoke an industrywide strike that would cripple the Korean War effort. That nationalization did not last long, though, because the Supreme Court ruled the move an unconstitutional abuse of presidential power.
In banking, the government took an 80 percent stake in the Continental Illinois Bank and Trust in 1984. Continental Illinois failed in part because of bad oil-patch loans in Oklahoma and Texas. As the nation’s seventh-largest bank, Continental Illinois was deemed “too big to fail” by federal regulators, who feared wider turmoil in the financial markets. In the end, the government lost an estimated $1 billion on the bad loans it bought as part of the takeover of Continental, which eventually became part of Bank of America.
The nearest precedent for the Treasury plan, finance experts say, are the investments made by the Reconstruction Finance Corporation in the 1930s. The agency, established in 1932, not only made loans to distressed banks, but also bought stock in 6,000 banks, at a cost of $1.3 billion, said Mr. Sylla, the N.Y.U. economist. A similar effort these days, in proportion to today’s economy, would be about $200 billion.
When the economy stabilized eventually, the government sold the stock to private investors or the banks themselves — and about broke even, Mr. Sylla estimated. The 1930s program was a good one, experts say, but the government moved too slowly to deal with the financial crisis, which precipitated and lengthened the Great Depression. The lesson of history, it seems, is for Washington to move quickly in times of economic crisis with a forceful government intervention in the marketplace. And Ben S. Bernanke, chairman of the Federal Reserve, has studied the Great Depression and the policy miscues in those years.
“The goal is to get the engine of capitalism going as productively as possible,” said Nancy Koehn, a historian at the Harvard Business School. “Ideology is a luxury good in times of crisis.”
The traditional American reluctance for government ownership is not shared in other countries. After World War II, several European countries nationalized basic industries like coal, steel and even autos, which typically remained in government hands until the 1980s, when most Western economies began paring back the state’s role in the economy.
Europe remains far more comfortable with government having a strong hand in business. So when Sweden, for example, faced a financial crisis in the early 1990s, the nationalization of much of the banking industry was welcomed. The Swedish government quickly bought stakes in banks, and sold most of them off later — a model of swift, forceful intervention in a credit crisis, financial experts say.
“In Europe, the concept of the social contract is much more social — that is, socialist — than we’ve been comfortable with in America,” said Robert F. Bruner, a finance expert at the Darden School of Business at the University of Virginia.
“The obvious danger with anything that really starts to look like the government taking ownership or control of a significant piece of an industry is, Where do you stop?” Mr. Bruner said. “The auto industry is in dire straits and the airline industry is in trouble, for example.”
“But the spillover effects from the crisis in the financial system are so great, pulling down the rest of the economy in a way that no other industry can, so that the potential cost of not doing something like this is immense,” Mr. Bruner said.