BOOK REVIEW: After the Fall by Nicole Gelinas
Back in 2002, in the aftermath of the 2000-01 Internet-stock collapse, the New York Post ran a fabulous opinion piece titled "Bearmarket.sued". The op-ed questioned the thinking of investors who, unhappy with the near wipeout of some of their investments in formerly high-flying Internet companies, sought redress for their foolish decisions in the courts.
The author of the aforementioned piece was Nicole Gelinas. Gelinas decried the litigious ways of an investor class that seemingly wanted it both ways: stupendous gains during periods of market frivolity, downside protection when markets were stressed. For taking this courageous stand, Gelinas no doubt caught a great deal of flak from readers conditioned by the late ‘90s boom to expect only positive returns.
Fast forward nearly eight years, Gelinas remains a prolific writer, and her columns for the Manhattan Institute's City Journal, the Wall Street Journal and the New York Post remain a must read for anyone interested in what's truly happening in municipal and private finance. And now, after impressive amounts of painstaking research, Gelinas has written After the Fall, a book that drives a dagger into the heart of the unfortunate but ubiquitous term, "Too Big to Fail."
Having long ago taken on certain small investors unwilling to accept their own mistakes, in After the Fall Gelinas boldly takes on the U.S. financial system's trouble with bankruptcy in strongly suggesting throughout that "Bad companies, including big, bad financial companies, must be allowed to fail, so that their bad ideas can have a chance of dying with them." Indeed, as Gelinas details skillfully, the problem up until now is that Washington has given "the world of finance a terrible privilege: freedom from failure."
Gelinas traces the unfortunate insertion of "Too Big to Fail" into our economic dialogue back to Ronald Reagan's supposedly free-market presidency. It was then that banking giant Continental Illinois ran into trouble. While the FDIC was already in place to insure the funds of the bank's individual depositors, the Reagan administration felt that the externalities of Continental's collapse were "unthinkable", after which it crafted full relief for the bank's institutional lenders and bondholders who "wouldn't lose a penny, either."
Thus began a new era of finance to some degree characterized by a pyramid-like banking structure in which the largest financial institutions were seen as "protected." Comptroller of the Currency head C. Todd Conover observed that Continental's bankruptcy would have led to "a national, if not international, financial crisis." Two months after the rescue, Gelinas writes that Conover "told Congress that none of the nation's top eleven banks would be allowed to fail."
Gelinas takes the reader in frequently gripping fashion from Continental's decline, to the New York Fed's intervention in the collapse of hedge fund giant LTCM, to the 2008 fall of minor bulge-bracket investment bank, Bear Stearns. Her point in navigating the reader through the various banking crises is to show not only that the problematic notion of "Too Big to Fail" has many fathers, but that it gained steam such that when President George W. Bush was presented with collapsing banks all around him, "there were no good options." The proverbial barn door to bailouts had long been open, and by 2008, it was open wide.
In addition to offering a well-researched history of our path to moral hazard, Gelinas offers up numerous historical and policy anecdotes that the reader will enjoy. Going back to 1928 when the Federal Reserve raised interest rates to quell market and economic froth (it seems the Fed has always been interventionist), Gelinas unearthed a Wall Street Journal article which observed that "corporations and private foreign lenders...are finding a way to make their...loans through channels outside the banks." Doubtless that historical nugget will chill the monetarists in our midst.
Moving ahead to 1933, when U.S. bank failures seemingly reached their peak, Gelinas found that those failures merely swallowed up 2 percent of deposits. No doubt bank account holders expect money deposited to only grow in nominal dollar terms, but considering the willingness of most investors to lose everything on equity investments, was 2 percent really the crisis that other historians have suggested it was?
Notably, and presumably in response to the above, Gelinas writes that FDR effectively told Americans that they would be protected from bad banks or, in his words, "Let me make it clear that the banks will take care of all needs." Gelinas is mostly sanguine about the creation of the FDIC, but her impressive legwork perhaps suggests that "Too Big to Fail" began under FDR's unsteady hand. Indeed, absent the FDIC, wouldn't private insurers have happily done the FDIC's job of insuring deposits, all the while keeping a much more self-interested eye on banking activities then and now?
While Gelinas does not endorse a Glass-Steagall II whereby deposit-taking banks would be separated from investment banks, her chronicle of Sen. Charles Schumer's evolving views on the depression-era law are a lot of fun. Though then Congressman Schumer openly worried in the ‘80s about whether Glass-Steagall's growing irrelevance would "destabilize the system by allowing banks to enter the securities, insurance and real estate businesses", by the time he was Senator, his tune had changed to the point that he believed that a failure to deregulate banks would drive finance overseas.
Regarding the alleged "weapon of financial destruction" that is mark-to-market accounting, Gelinas unabashedly notes that "the new accounting did not create" the crisis, "but only measured it." Amen to that, and when it's remembered how alone Gelinas was in making this argument amid the financial carnage of 2008, quite courageous.
Most important to those of us still trying to make sense of what remains recent history, Gelinas helpfully takes the reader through the events of 2008-09 during which the financial system was allegedly in danger of collapse. No one in Washington or on Wall Street emerges unscathed from her account, and with good reason. As Gelinas notes, the awful events from not long ago were the sad result of a Washington/Wall Street consensus that some financial institutions quite simply could not be allowed to die.
As Gelinas sees it, the bailouts that resulted from this unfortunate mindset ensure more bailouts in the future. This is problematic, because as she makes plain to varying degrees throughout After the Fall, "Government money has created a risk that failed institutions will survive into the future, sucking capital and talent from the vital parts of the economy." So true, but so infrequently stated amid the Bush and Obama administrations' feverish efforts to cushion nearly every commercial mistake.
Perhaps paradoxically, Gelinas's brilliant expose of the awful nature of "Too Big to Fail" raises objections from this reviewer as to some of her suggestions and conclusions in the book. In its introduction she asks for proper rules and regulations "so that financial markets can then rationally manage the private distribution of capital, funding good businesses that power the economy."
Maybe, but isn't this the point of no regulation at all? Don't rules and regulations merely empower Washington while giving investors a false sense of security? Without them, wouldn't investors themselves do the work of regulators in starving business failures of capital, all the while funding quality ideas? Gelinas decries the SEC's decision to abolish the "uptick rule" on short sales, but it's short sellers who serve markets gallantly for curbing "irrational exuberance", and who in the process ensure that bad managers will no longer have capital to destroy.
About the rush to housing which Gelinas sees as one driver of the subsequent banking crisis, and which she argues was to some degree a function of a low rates set by the Fed and easy lending practices by banks, consider what George Gilder once observed about housing, that "What happened was that citizens speculated on their homes...Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders." What's interesting here is that the Gilder quote is from 1981, and is an account of the late ‘70s housing boom when the Fed funds rate was skyrocketing, and lending rules far more stringent.
This speaks to a subject that arguably didn't receive enough attention in After the Fall: the dollar's collapse this decade against every major foreign currency, along with gold. As evidenced by what happened in the U.S. and England in the ‘70s, and in Germany in the aftermath of World War I, wildly frothy housing booms are hardly new, and most of them occurred amid rising, not falling rates of interest; a debased currency always and everywhere in the picture. The analysis within After the Fall would have been bolstered by this historical reality, not to mention that Gelinas is surprisingly sanguine about depression-era market reforms that allegedly brought relative quietude to a formerly volatile, crisis-laden financial system.
It says here that the 1930s interventionist model which turned what should have been a short economic decline into a long recession is hardly something to elevate, not to mention that some would argue those reforms were a sideshow compared to the good wrought by a post-WWII Bretton Woods dollar that made Austrian "malinvestment" less prevalent until President Nixon's 1971 decision to sever the dollar's gold link. With the dollar having no anchor these last 39 years, weren't these crises to some degree inevitable?
Throughout After the Fall, Gelinas pays varying degrees of lip service to a point made early on that when "financial markets are too free, they will eventually destroy themselves and damage everything around them." The problems here are many, not least of which Gelinas's oft-stated view also in the book that the federal government has consistently distorted the natural workings of markets, most problematically with its allegiance to "Too Big to Fail." Just how free have the U.S.'s supposedly free markets ever been?
Gelinas often suggests that if correctly imposed, wise regulations would have averted all manner of financial crises in the last twenty-five years. But as her own research too often brings to light, the regulators empowered to supposedly manage the world of finance rarely measured up to their counterparts in the private sector. This revealed itself through failed regulatory attempts to curb derivatives' speculation, through the failure of housing/banking regulators to see in advance that something was amiss in the property market, and through the repeal (a good idea in my mind) of the uptick rule which Gelinas sees as a bad idea. It should also be noted that in chronicling LTCM's decline, Gelinas observed that thanks to its shareholders losing everything, "it would turn out that unregulated hedge funds would act more conservatively than their regulated brethren." Isn't that an essential point? Even if imposed by the most skillful of minds (perhaps an oxymoron when it comes to federal bureaucrats), the harsh regulation of the marketplace itself will always trump whatever the salarymen in Washington can come up with.
Another viewpoint that is made explicit throughout is the notion that the failure of a big bank in today's "Too Big to Fail" world could jeopardize "the entire financial system." But as Gelinas makes plain, we've never allowed a major bank failure, which means the very suggestion is pure conjecture. Anecdotally, and based on Gelinas's own thinking, the idea of a financial system collapse is quite fanciful. Indeed, failure in Gelinas's words is the happy process whereby "bad ideas die", meaning failure is in a sense a good thing for it cleansing the financial system of non-economic practices. Furthermore, if Japan and much of Western Europe could powerfully bounce back from the utter decimation of World War II, is it really true that one or many bank failures could destroy our financial system, let alone our economy? Not only is "Too Big to Fail" bad policy, it's a policy based on a presumption of financial Armageddon that doesn't pass the most basic of smell tests.
To avert future crises, one of Gelinas's main solutions is to make more stringent the capital requirements imposed on financial institutions. The problem there, and Gelinas alludes to this in the book, is that with finance global in nature, capital requirements will at best be a minor nuisance to banks as they move offshore some of their more risky activities, while at worst, finance as we know it will move overseas. "Systemic risk" will simply find a new, foreign address.
More broadly, Gelinas concludes better regulation in the future is the answer, but if disagreements about its past effectiveness can be set aside for now, where might we find these regulators in possession of the skills necessary to outsmart Wall Street? Better yet, After the Fall is to a high degree an account of government failure in overseeing the financial system, government distortion of it, and broad government mistakes that led to financial crises. Why empower this same government to fix what Gelinas deems crucial?
It seems that the better answer to the financial system's woes could be derived from a statement that Gelinas used in the book by Charles Mitchell, of National City Bank. Testifying before the Pecora Commission 75 years ago, Mitchell said "there are so many factors over which the men in finance have no control...We are human, we are filled with error, and it does not matter how good our intention may be, we are going to make mistakes."
Truer words have rarely been spoken, and just as the men and women of finance are fallible, so are the men and women who populate Washington. Given the basic truth that private and public error will never be abolished, arguably the best regulation of all is the simplest one: Let them fail. Gelinas wrote an excellent book, one that in my eyes would have been even better had the conclusion centered on this most simple of regulations.