How Do You Protect Finance Without Rewarding Error?
All during the 2008-09 financial crisis, Americans were told that the government was saving Wall Street not to protect overpaid bankers but to help Main Street avoid a second Great Depression. It was a hard case to make. However valid the logic, it was overwhelmed by infuriating realities — government was pouring tens of billions into the financial system while 500,000 or more Americans were losing their jobs every month. Naturally, people felt bitter and betrayed.
Ten years after the financial crisis, the first responders — Henry Paulson, treasury secretary under President George W. Bush; Tim Geithner, treasury secretary under President Obama; and Ben Bernanke, former chairman of the Federal Reserve Board — are confessing that this political and public relations failure was their greatest setback.
The result, said Geithner on the radio program "Marketplace," has been a "huge loss of confidence in public institutions." Echoed Paulson: "What we did was so unpopular. ... I was never able to make the connection between what ... this financial system (and our policies do) for the average American. ... We weren't doing this for Wall Street." Bernanke agreed: "We didn't make that case," though they tried through speeches, congressional testimony and TV interviews.
They repeated the message recently at a conference sponsored by the Brookings Institution, a think tank. The danger — then and in the future — is that efforts to stop a financial panic will falter on political objections from the White House, Congress or regulatory agencies. Halting the panic requires propping up Wall Street, the purveyors of credit, in some form. Although everyone wants to end the panic, no one wants to be seen helping the institutions that caused or aggravated the crisis.
A paper delivered by Bernanke at the conference illustrates the dilemma. Following other economists, Bernanke identifies two main channels through which the financial crisis weakened the "real" economy of jobs and production: first, a buildup of household debt, used to finance homebuying and consumer goods and services; and second, widespread financial speculation by banks, investment banks, hedge funds and the like.
The housing boom was fated to implode. Home buyers had paid too much on the (false) assumption that prices would rise indefinitely. As real estate valuations crested in 2006, homeowners had to divert more of their income to repaying their mortgages and home-equity loans. Other consumer spending suffered. By itself, this might have triggered a recession, possibly a severe one. But Bernanke and others believe that the popping of the housing bubble by itself would not have caused a recession as destructive as what actually occurred.
The difference, they argue, reflects the side effects of financial speculation: reliance of banks and others on short-term funding and the proliferation of arcane securities. What might have been a serious recession turned into an almost-depression. Panic seized many financial markets. Securities were dumped; their prices fell. "The severity of the recession cannot be explained by a deterioration in housing and consumer finances alone," Bernanke recently wrote on his blog.
The implications are unavoidable. Amazing though it seems, most economic forecasting models — including the Fed's model — did not include "much role for credit factors," Bernanke wrote in the Brookings paper. Most models "focused on explaining the behavior of the postwar U.S. economy, a period that until 2007 had been without a major financial crisis." Not surprisingly, in August 2008 the Fed staff forecast the unemployment rate would peak at about 6%; the actual figure was 10%.
The models must change, Bernanke says. True. But gains in control may be modest. Forecasting models have repeatedly missed major economic turns, for better or worse. In the 1970s, inflation was underestimated; in the early 1980s, unemployment was overestimated. Major productivity shifts, up or down, have constantly surprised. The models are always playing catch-up.
The larger issue is whether policymakers can respond quickly enough to pre-empt another financial crisis. The answer is hardly preordained. Interestingly, Bernanke's research as a young economist — a 1983 study established him as an academic heavyweight — focused on the breakdown of the credit-creation process in the 1930s. The result, the study suggested, was that the Great Depression had been extended and deepened.
It is not surprising that Geithner, Paulson and Bernanke feel vindicated that — in Bernanke's words — "policymakers' aggressive actions to end the financial panic on Wall Street were crucial in preventing an even more devastating blow to Main Street." This may be, but the dilemma remains. How do you protect the system without seeming to reward the guilty?
