It is a remarkable political irony that the man who thirty years ago led the successful battle against global inflation, which in turn laid the groundwork for a quarter-century of world-wide economic growth, was still on hand last week to galvanize efforts to stem the crisis that has turned out to be the climax of the long boom.
Paul Volcker, 81, went public, first in a speech Monday in Naples, Florida; then, along with Nicholas Brady, 78, and Eugene Ludwig, 62, in a joint op-ed article in The Wall Street Journal Wednesday. Volcker was chair of the Federal Reserve Board, 1979-87. Brady was Secretary of the Treasury, 1988-1993. Ludwig held the key job in bank regulation as Comptroller of the Currency, 1993-98.
The headline: “Resurrect the Resolution Trust Corp,” meaning the temporary government agency that fifteen years ago resolved America’s savings and loan crisis, gradually and expensively.
The punchline: do it quickly, or prepare to endure “the mother of all credit contractions.”
Thirty-six hours later, the proposal had become national policy — a plan for the government to purchase bad mortgage-backed assets from financial companies in order to re-price and re-sell them. The Treasury Department called its plan “Balance Sheet Relief.” Markets soared on the news.
With the sudden agreement to write an enormous government check, despite the highly-charged political atmosphere on Capitol Hill, the possibility that the end of the fifteen-month-long emergency might finally come into view. Congress has a week or two to act before in adjourns. Doubtless the bargaining will be hard, but the deal seems unlikely to fall apart. Next, attention will turn to assessing the harm the financial crisis has done to the broader economy.
Were Volcker, Brady and Ludwig crucial in precipitating the unexpected consensus? Probably not – though it is not without significance that the WSJ editorial page seconded the plan the day after Volcker broached it. The idea of a government bailout itself is hardly novel. As Gillian Tett wrote Saturday in the Financial Times, “Every analyst worth their salt (sic) knows the Resolution Trust Corp. helped drag America out of the savings and loan crisis almost two decade ago, while the Home Owners Loan Corp. performed a similar service in the 1930s.” By Wednesday the need for something of the sort was obvious to anyone with a Bloomberg terminal.
True, there are big differences between the present situation and the savings and loan bailout; then, the statutes and insurance regulations that left government holding the bag were already on the books. Treasury Secretary Henry “Hank” Paulson apparently hopes to keep the new entity within the Treasury Department in the present situation, instead of creating a quasi-independent agency like the RTC. The dramatic daily story of push and shove behind the scenes will continue for at least another week. Then we’ll have to wait for the insider accounts of the events of the last few weeks to know much about what happened and why. (And even then, perhaps especially then, a heightened skepticism will be required.)
But the collective gravitas of the trio who wrote Wednesday in the WSJ that “absent bold action, matters could well get worse” can hardly be overstated. Volcker and Brady in particular share unmatched reputations for resourcefulness and perpendicularity in the public interest. And, clearly, their timing was impeccable. For Wednesday was the day that things got worse.
The problem all along has been much as former Treasury Secretary Paul O’Neill (2001-03) described it last spring: “If you have 10 bottles of water, and one bottle had poison in it, and you didn’t know which one, you probably wouldn’t drink out of any of the 10 bottles; that’s basically what we’ve got ….”
But then the sub-prime mortgage-backed securities in question aren‘t bottles of water; they are exotic new synthetic derivative instruments, hard to describe, hard to understand, even harder to value. Piled on top of one another through extraordinarily high degrees of leverage, they are anything but transparent.
That the situation has dragged on for more than a year before deteriorating owes to a high-stakes Alphonse/Gaston act. Big institutions, most conspicuously Bear, Stearns and Lehman Brothers, but many other firms as well, were reluctant to write down these illiquid assets on their books, each hoping to ride out the period of distress with no nominal loss of value. By the middle of last week, however, as scrutiny grew and failures mounted, mistrust had become acute. Desperate action was required.
The basic mechanism of the remedy is simple enough. Government acquires bad assets in an emergency and spreads the cost among the taxpayers, either selling or altogether writing off the assets eventually, permitting the system to function in the meantime. The rescue operation could have been structured slightly differently, in the manner of the “Brady bonds,” which enabled US bankers to get non-performing loans to emerging countries off their books in 1989. Paulson had various plans that could been proposed at any time over the past year.
The reason that Balance Sheet Relief was not officially broached until now is that such a rescue operation will be hugely expensive. Estimates last week generally started at $500 billion and ran as high as twice that. Saturday the Bush administration asked Congress to appropriate $700 billion to buy up troubled securities. “It’s a big-picture package, because it’s a big problem,” President Bush said.
The measure ends a long standoff between the Republican and Democratic parties, each maneuvering for advantage. As recently as Monday, Sen. Barack Obama (who numbers Volcker among his advisors) told Bloomberg Television that such a measure “probably could not get through Congress until we have a new Congress and new president.” As late as Thursday morning, the editors of the WSJ editorial page confided, “We’re told that Treasury has a proposal ready to send to Congress, but that the members have told Mr. Paulson that they don’t want to see it until after Election Day.” By that very afternoon, however, a green light had been given all around and details of a plan were being hammered out.
What had changed? Only that the first steps to the “mother of all credit contractions” had been taken Wednesday. For months, insiders understood some concatenation of events was possible that would lead to desperate trouble; that’s what the language of “the most serious financial crisis since the Great Depression” was all about.
The rush to the exits had finally begun — the prospect of a crash so damaging to confidence that it would prove hard to quickly reverse loomed directly ahead. Banks had ceased lending to one another. A run on money market mutual funds had commenced. Paralysis threatened to spread to the broader economy, which so for had been insulated fairly well. There was the specter of empty office buildings, shuttered factories and, presumably, even breadlines.
So Thursday afternoon Federal Reserve chairman Ben Bernanke and Paulson, neither of them a long-term Bush loyalist, met first with the president to describe their plan, then traveled to Capitol Hill to brief Congressional leaders of both parties in the offices of House Speaker Nancy Pelosi. It was a symbolic indication of some of the characteristics that make the US profoundly different from Japan., where the reluctance to break a similar bad-lending logjam lasted through a decade of stagnation.
Here is where it is necessary to pull back from the tight focus on the leaders gathered in Washington to ask, in a nation engaged in a hotly-contested presidential election: who has the authority to countersign a check for a trillion dollars? That is where Volcker, Brady and Ludwig come in. They represent what in the 1950s was confidently called the Establishment, a shadowy and shifting alliance of long-term stakeholders in American society whose demise has regularly – and misleadingly – been reported over the years.
The authority that Volcker, Brady and Ludwig possess derives from their successful service in the administrations of Presidents Carter, Reagan, George H. W. Bush and Clinton. They are viewed as being above the partisan battle. The inclusion of Ludwig to represent the Clinton Treasury is especially interesting – a sign, if one were needed, that former Clinton Treasury Secretaries Robert Rubin or Lawrence Summers remain actively engaged in politics.
Volcker in particular represents a kind of civic virtue that has been found in Washington over the years in denominations large and small, but recently in rather short supply. Gen. George Catlett Marshall comes to mind, as do the six American friends whose influence in the years after World War II was so convincingly described by Walter Isaacson and Evan Thomas in their book The Wise Men: Robert Lovett, John McCloy, Averell Harriman, Charles Bohlen, George Kennan and Dean Acheson.
Volcker’s biography is well known, thanks mainly to William Neikirk’s extremely readable first rough draft of history in 1987, Volcker: Portrait of the Money Man. His father was a civil engineer who had been hired as city manager of Teaneck, N.J., to extricate the suburb from its Depression crisis – a $5 million deficit. Thus young “Bud” Volcker grew up in an atmosphere of fiscal rectitude, with a taste for public service. After his undergraduate years at Princeton University, his first job was as a research assistant at the Federal Reserve Bank of New York, in 1949. Between government jobs, he spent some years at the Chase Manhattan bank before joining the Treasury Department for the first time, in 1962, during the Kennedy administration; and again in 1969, when Richard Nixon was president.
Vocker was president of the New York Fed in 1979 when, amid crisis, Jimmy Carter appointed him chairman of the Federal Reserve Board. He promptly began his major phase, initiating a grueling bout of tight money that would provoke a deep W-shaped recession, helped cost Carter re-election, and last until 1982. Reagan backed him throughout and reappointed him in 1983. He gave way to Alan Greenspan in 1987 and remained mostly on the sidelines as a spokesman for professional government service until he broke with tradition by endorsing Obama earlier this year. Did he galvanize the dramatic events of last week? Legitimize them? Or simply lend his prestige? It hardly matters. Of all the players who have strutted the stage of US government finance during the last fifty years, it is Volcker who will cast the longest shadow in the history books.
The 25-year Reagan boom didn’t have to end this way. George W. Bush is likely to go into history as the $2 trillion man – $1 trillion for the war in Iraq and its trail of claims, another $1 trillion for the sub-prime bailout. And this at a time when the US is facing huge pressures on its Social Security and health insurance systems.
What about Alan Greenspan? Deft as he was, Greenspan was more swept along by the decisions taken by presidents Clinton and Bush than culpable for mismanagement on his own. The judgment of history is likely to be that something went very wrong at the White House in the last eight years.