It is time, finally, to return to the crisis of 2008, to the conference at Jackson Hole, August 21-23, where we began. We know now that the policy makers who stayed home, in Washington, New York, London. Frankfurt and Basel, had been seeking for a year to defuse the situation behind the scenes. We know, too, that policy-makers had little idea how dangerous the situation would become, and conference-goers still less. After all, the crisis hadn’t happened yet.
Three weeks later Lehman Brothers filed for bankruptcy. An all-out financial panic ensued, and for the next three weeks global markets tottered on the edge of a precipice.
By October 13, the worst was over.
You can see this much from the chart below. It’s a picture of the most commonly-used barometer of banking-system stress – the difference between the overnight index swap rate and the one-month interest rate that banks pay to borrow money from one another. It is the portion of the vig due to credit risk. I’ve taken it from the climactic chapter of the US Congress’s Financial Crisis Inquiry Report.
It depicts clearly the entire history of the crisis – from the first sub-prime hedge fund failures in June 2007, through the extremely anxious year of August ’07-08, to the panic. During those four week s, Federal Reserve chairman Ben Bernanke later told the Inquiry Commission,
If you look at the firms that came under pressure in that period… only one … was not at serious risk of failure. … So out of the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a week or two.
This was a month when anything could have happened. If Morgan Stanley had been allowed to fail, or Citigroup, Deutsche Bank, UBS, or General Electric — if the White House and leaders of both parties in Congress had failed to agree on emergency lending measures of historic proportions — the result would have been what Bernanke called Depression 2.0.
Auto factories shuttered, businesses snapped up by wealthy foreigners and lucky misers at fire-sale prices, ATM machines switched off, layoffs ordered, unemployment arcing towards 25 percent. That’s what they call a “counterfactual” – a story that didn’t happen
In November ’08, Queen Elizabeth visited the London School of Economics to open a new building. She clearly understood that Britain had dodged a very near disaster. Famously she asked economist Luis Garicano, “Why did nobody see it coming?” The answer turns out to depend crucially on the meaning of “it.”
The Queen meant the panic, of course. The rest – the aftermath and the workout – hadn’t happened yet.
The panic is the key to understanding what happened in 2008, and what has changed since then. It has received very little attention for the reasons given in this long serial. We don’t see banking panics because, since Adam Smith, they have been systematically excluded from the account of formal economics, out OF the conviction that banks are like any other competitive business – the more the merrier, no special oversight required.
Central bankers knew better. Protocols for dealing with systemic runs evolved throughout the nineteenth century. In 1912, the Federal Reserve System was established to serve as “lender of last resort.” But in the consternation over the Great Depression, the US banking system was tightly partitioned. In the excitement over Keynesian economics, the emergency playbook was lost – until Milton Friedman and Anna Schwartz called attention to the price that had been paid for ignoring standard operating procedure in 1930.
After that, a schism developed among macroeconomists. Some were preoccupied with getting into great depressions , others with getting out. With that division of the house in mind, let’s go back over the events of the crisis.
. The Year of Living Dangerously
Bernanke, who took over the job in Februry2006, made something of a slow start. As late as March 2007, he told Congress that the impact of subprime- lending problems “seemed likely to be contained.” By June it had become clear that this hope was unrealistic, and the Fed began devising safety nets: an auction facility designed to let cash-strapped banks borrow without being stigmatized; dollar swaps with the European, Swiss, British and Japanese central banks, to facilitate – to disguise – their lending to needy domestic banks that couldn’t otherwise borrow from the Fed; the Term Securities Lending Facility and the Primary Dealer Credit Facility in March 2008, to mitigate the effects of the forced sale of Bear Stearns. Bernanke will surely describe all this in The Courage to Act: A Memoir of Crisis and Its Aftermath, scheduled to appear in October.
Treasury Secretary Henry Paulson was less successful. He attempted in the fall of 2007 to persuade financial institutions to pool their troubled assets in a “Super SIV” (a structured investment while). It failed completely, when only the weakest institutions agreed to participate. In the spring, Paulson commissioned aides to prepare a “Break the Glass” Bank Recapitalization Plan, a hodgepodge of measures some of which would be proposed in the fall. Federal Reserve Bank of New York President Timothy Geithner, who the next year would replace Paulson, later recalled, “Ben and I had been telling Hank for months that ultimately there would have to be a comprehensive legislative solution, authorizing the government to take a lot more risk.” When at one point Michael Boskin, who had been chief economic adviser to George H.W. Bush, told Paulson the same thing, “He looked at me as if I were crazy.”
A wary auditor of the proceedings was former Treasury Secretary Lawrence Summers, anticipating a job in a possible Democratic administration in 2009. In his regular columns in the Financial Times, but especially in a speech at Stanford just before the forced sale of Bear Steans, Summers warned of a “vicious liquidation cycle” threatening major financial institutions. The fiscal stakes were not small, he added: “Past financial crises have, in the end, been resolved at costs of several percent of GNP.” James Poterba, president of the National Bureau of Economic Research, later remembered the talk as eerily prescient.
That there was a housing bubble that summer was obvious to all with eyes to see. Particularly striking was a photo essay about a Lehman Brothers project near Bakersfield, California. with text by Allan Sloan, in Fortune magazine. The McAllister Ranch development had been “envisioned as a 6,000-home, multibillion-dollar recreational community built around a Greg Norman-designed golf course, boating and fishing waters and a beach club,” wrote Sloan. “Now McAllister is three-square miles of fenced-off, almost lunar landscape punctuated by a half-finished clubhouse and a golf course gone to weeds.” He continued,
We’re not predicting that Lehman will fail – it won’t because of the Federal Reserve Board, which has let it be known that it will lend Lehman (and any other investment bank it deems worthy) enough money to avoid collapsing, the way Bear Stearns did…. Lehman will ultimately end up owned, once again, by a much larger institution.
Bernanke may have had hopes as late as August that the situation could be defused without damage to broader markets – as the dot.com bubble had been seven years before, or the Russian financial crisis of 1998. But it was about then that Geithner staged a contest among his aides at the New York Fed to identify the best metaphor for the situation: Wheels coming off the bus? Engines falling off the plane? Rivets popping on the submarine? Hundred-year flood? Cancer? Contagion?
US taxpayers learned they were about to get involved from an op-ed article by Paul Volcker and Nicholas Brady in The Wall Street Journal on Wednesday, September 17: “Resurrect the Resolution Trust Corp,” Volcker, former chairman of the Fed, and Brady, 78, Treasury Secretary 1988-93, had been around the US savings and loan crisisof the late ’80 and early ’90s. They knew something about how to save threatened banks.
To that point, the news that Lehman Brothers had filed for bankruptcy seemed no more than the latest episode in a continuing saga. Behind the scenes it was already clear that Lehman’s failure would cripple the giant insurance company AIG – its Financial Products division had insured many of Lehman’s trades. AIG lost half its value in the first hour of trading. Short-sellers had gone to work
Tuesday evening Bernanke and Paulson had persuade President Bush that they had no alternative but to take over AIG in exchange for an $85 billion loan to keep it afloat. Morgan Stanley was under attack by short-sellers, speculators who sought to gain by driving down the prices of its stock. A run on money market funds had begun. General Electric was having trouble rolling over its short-term commercial paper. Bidding goodnight to his Treasury Secretary and Fed chairman, as they left to explain to stern Congressional leaders on Capitol Hill the Fed’s decision to save AIG, President Bush said, “Someday you guys are going to have to tell me how we ended up with a system like this and what we need to do to fix it.”
By Wednesday it was clear that Congress would have to become involved; the Fed had reached the limits of its authority. Bernanke again told Paulson that the president would have to ask for an enormous appropriation. Paulson didn’t reply. Bernanke consulted his staff that evening and steeled himself to say the same again the next morning, more bluntly than ever before. But by then Paulson at last had relented: taxpayer money would be required after all. Bush cancelled the political fund-raising trip he had planned to make. The two told him that they would have to ask Congress for $500 billion or more. For what? To buy toxic assets from endangered banks, they explained. That evening Paulson and Bernanke made another trip to Capitol Hill. Friday morning Paulson made a short bleak statement in the White House Rose Garden, Bush at his side.
Looking back, the drama can be divided into four distinct acts, each testing the limits of human endurance and each lasting about a week. Week I had seen the beginning of the panic and the Bush administration squaring away to meet it. Week II was about the presidential election, now less than two months away. John McCain suspended his campaign to return to Washington, perhaps to declare against what he had begun calling “the bailout.”
After McCain requested a White House meeting, the president had no choice but to grant it; so he invited Democratic presidential candidate Barack Obama as well, and went ahead the night before.with the evening speech to the nation on the urgency of the situation. Obama, who had Lawrence Summers as his chief economic adviser the Sunday that Lehman filed for bankruptcy, dominated the meeting before it dissolved in a plasma of voices, with Bush walking out of the room. Markets continued to collapse: a run on Washington Mutual one day, on Wachovia the next. McCain was persuaded to support the Troubled Asset Relief Program, the TARP, as it had become known.
Week III began on Monday, September 29, with financial institutions under siege in Europe and the defeat in the House of the three-page Emergency Economic Stabilization Act, Republicans voting solidly against it. The Dow Jones Industrial Average fell 778 points, or 7 percent that day. The Jewish holiday of Rosh Hashanah intervened and Congress recessed for the day. By now the administration had realized that buying assets wouldn’t work; they were too hard to find. The Treasury would have to inject capital into the banks instead, in the form of loans, to render them proof against runs. Arms were twisted, deals were made, the cost of the measure increased. The Senate passed the Stabilization Act Wednesday evening; the House followed suit, by a comfortable margin, Friday afternoon.
Week IV, concern shifted to Europe, where a weekend summit hosted by French president Nicholas Sarkozy had ended in disarray. The government of Ireland had guaranteed the debt of all its banks; German chancellor Angela Merkel had said as much for her nation’s banks, but stopped short of a formal proclamation. On Wednesday the LIBOR-IOS spread hit 325 basis points, its greatest of the panic; Morgan Stanley and Merrill Lynch were still under attack; Bank of America and Citicorp had entered the danger zone. Then six central banks, led by the Fed, announced coordinated rate cuts. Finance ministers of the G-7 nations were arriving in Washington for their annual meeting. Over the weekends they pledged to take “all necessary steps to end the crisis” – meaning spend whatever it took – to end the crisis.
The next day, Columbus Day, Monday, October 13, Paulson summoned the chief executives of the nine biggest banks to the Treasury Department to tell them how much of the TARP funds each was to borrow to insure there would be no further doubts about the solvency of their institutions. The relief plan had been successful redesigned. Many details remained. But except for an aftershock in mid-November – when Citigroup tottered on the brink of failure until the TARP executive, the Federal Deposit Insurance Corporation and the Fed agreed on a lending program and Obama designated Geithner as his Treasury Secretary – the panic was over.
In the first-person Paulson and Geithner accounts – and Bernanke’s book coming next month – there is enough material for half a dozen television miniseries. I skate over these events in order to show that, whatever else, they bear absolutely no resemblance to Jimmy Stewart lecturing an angry mob in the film It’s a Wonderful Life. A more illuminating cinematic metaphor is the one I suggested in the second episode of this serial – the scene in Howard Hawks’ Red River in which John Wayne, Montgomery Clift and a dozen trail-hands succeed in stemming a stampede of the five thousand cattle they are driving to market. I defy you to read the first-person accounts of those weeks by Bernanke, Geithner or Paulson and not be moved by the heroism that the financial regulators and their staffs displayed.
. The Swedes Take a Hand
That same Columbus Day brought news of a Nobel Prize for economist Paul Krugman, formerly of MIT, by then teaching at Princeton’s Woodrow Wilson School of Public and International Affairs. No one was surprised that Krugman was so honored. That it should have been a singleton award could be (and was) argued either way. But that the award came in the crisis year raised eyebrows.
Krugman had been the first to argue in the ’70s and ’80s that innovation and scale conferred important advantages in international trade, overturning an emphasis on simple geography that had preoccupied economists since the time of David Ricardo. Many others had been involved in a major rethinking of the reasons for observed patterns of trade, but it seemed likely for decades that Krugman would eventually at least share a Nobel Prize. The likelihood freed him to gradually leave research economics for journalism. In 2001 he had joined The New York Times as one of its marquee op-ed columnists.
The question arose almost immediately, among students of the prize, had Krugman been a late starter that year? The calendar is clear: a committee of the Swedish Academy of Sciences solicits nominations in September. It meets in February to choose a prospective slate or slates. Letters go out seeking further opinions and appraisals. A choice is made in May; a nomination is prepared over the summer and, signed by all members of the committee, is forwarded to the 600 or so members of the academy. The economics section meets twice to discuss the selection before a vote is taken in October by the larger group and the award announced the same day.
There was expectation in the spring and summer of 2008 that the committee was thinking of a prize for another skein of work, based on letters that went out to various experts. Campaigns within particular scientific communities have been a regular feature of life practically since the Nobel Prizes were first voted in 1901.Was a campaign mounted for an award to Krugman in the crisis year? The only scrap of evidence I know is lost.
When Krugman was honored at the annual dinner, at the Allied Social Science Association meeting in New Orleans, of Economists for Peace and Security, in January 2008, Nobel laureates Paul Samuelson and Robert Solow sent extraordinarily encomiums, emphasizing his acuity on the growing crisis of the present day, which were read to the crowd by presiding officer James K. Galbraith, of the University of Texas. Galbraith told me via email last week: “I turned around at the end of the dinner and found that the cleanup crew had rolled [the texts] up with the tablecloths. It was infuriating, when you consider that of all the economists in all the world, only Paul and Bob would send things that were not otherwise preserved on a computer.” Did copies of the laureates’ remarks somehow make their way to Stockholm? We won’t know before 2058. Committee proceedings are sealed for fifty years.
What we do know is that Krugman went right to work. In 1999, he had published a book about the various crises of the 1990s, The Return of Depression Economics, in which he argued that “the world has become a much more dangerous placer than we imagined” and plumped for a variety of capital restraints. In a matter of days in October 2008, he completed two new chapters which he added to the book when he republished it on December 1 as The Return of Depression Economics and the Crisis of 2008.
The chapter on the panic – “Banking in the Shadows” – shows Krugman at his best – and worst. There is a lucid history of conventional banking, including an account of how the Panic of 1907 led to the creation of the Fed and what happened next: “There’s more or less unanimous agreement among economic historians that the banking crisis [of 1930, 1931 and 1933] is what turned a nasty recession into the Great Depression.” There’s a clear, brief explanation of shadow banking, couched in terms of a simple illustration – the market for auction-rate securities, invented by Lehman Brothers in 1984, which collapsed in early 2008. And, finally, there is the seemingly inevitable thumb on the scale. Krugman’s book has nothing to say about the events of those four weeks in September and early October. How could it? They had only just transpired. Even when Krugman revisited the story in End This Depression Now, in 2012, the two chapters devoted to the panic – “The Minsky Moment” and “Bankers Gone Wild” – give only a perfunctory account of what had happened in the autumn of 2008, and then only in the service of his argument that deregulation had turned moral hazard into an industry – that the crisis was the result of “bankers gone wild.”
Instead, in the 2008 book, Krugman directed his ire at Robert Lucas, the Chicago economist who knocked MIT from its perch. He escalated matters in lectures in London, and with a controversial article in The New York Times Magazine in September 2009. He thus reignited a controversy about inside economics that continues to the present day: Keynesians vs. everyone else. Krugman routinely establishes important truths – energy companies really did cheat in the California power auctions a few years ago; real business cycle theory really was a thirty year dead-end; conservative claims that that the 1977 Community Reinvestment Act led ineluctably to the crisis really are a Big Lie. He has become as good a newspaper columnist as he was an economist – one of the best in the world. Just don’t count on him for the other side of the story.
. Obama is Elected and the Depression Narrative Takes Hold
Four days after Lehman filed for bankruptcy, the same day the Bush administration agreed to go to Congress for TARP, Barack Obama hired Summers as his principal economic adviser, supplanting but not replacing the economists who had toiled with Obama throughout the campaign. A week later it was Summers who saw him through the White House meeting at which he bested McCain. To that point the campaign had been a close-run thing. It is probably not too much to say that Summers helped secure Obama victory in November.
By then, the economy itself seemed on the verge of cardiac arrest. The recession that had quietly begun in December 2007 had finally been recognized for what it was; unemployment claims were soaring; hiring had ceased. Trade figures were especially alarming. The flow of goods and services across borders had all but stopped in the panic. The Obama team recruited Christina Romer, of the University of California at Berkeley, a leading expert on the Great Depression, to be chairwoman of the Council of Economic Advisers. Summers began jockeying for the Treasury job. When Geithner got it instead, he signed on as National Economic Adviser, with an office in the White House, hoping to replace Bernanke at the Fed in Year Two of the new administration.
In a 57-page memo dated December 15, 2008, obtained in 2012 by Ryan Lizza, of The New Yorker, Summers outlined the situation for the president-elect. The economy had already lost 2 million jobs; without a government response, it would lose 4 million in the next year. The unemployment rate would rise to 9 percent. The deficit was already large, thanks to TARP and spending on the wars in Afghanistan and Iraq. Summers sketched four alternative stimulus plans, estimated to cost $550 billion, $665 billion, $810 billion, and $890 billion.
At a meeting the next day in Chicago, Obama pressed his advisers to add an inspiring “moon-shot” to the plan, something visionary that might command widespread support. What about a national ”smart grid,” a high-voltage transmission system designed to make the nation’s electrical system more efficient and less vulnerable to disruption? Lizza reported,
Obama, still thinking he could be a director of change, was looking for something bold and iconic – his version of the Hoover dam — but Romer and others finally had a “frank” conversation with him , explaining that big initiatives for the stimulus were not feasible. They would cost too much and not do enough good in the short term. The most effective ideas were less sexy, such as sending millions of dollars to the dozens of states that were struggling with budget crises of their own .
The stimulus bill, sold straight out of economics textbooks, and with little or no support among conservative economists, proved to be the first target when the Republican Party chose to argue that Obama was a dangerous big spender. Obamacare was next. The Republicans had suffered a stinging defeat in the election of 2008” they had lost both houses in 2006, now they had lost the White House. They were determined to regain their majority.
The battles of the first few months of the new administration still make a vivid story. The stimulus controversies; the loans to the auto companies; the internal arguments over whether to take over and restructure the banks and the decision to undertake the stress tests instead. Obama chose to use his rare majority in both houses of Congress to press ahead with a partial restructuring of the market for health insurance. The recession ended in June 2009; but despite the spending, the unemployment rate reached 10 percent in September.
One decision, in particular, stands out for purposes of our story. For all the talk of a Great Depression, Obama never described the panic of the year before – not in his inaugural address nor in his state of the union speech. The fact that the administration of George W. Bush, whatever its sins, had in the desperate hour staved off a great disaster, went almost completely unremarked in those increasingly partisan times. (Take a look back at that chart of the LIBOR-OIS spread.)
. Bernanke is Caught in the Middle
One of the first things Bernanke did once the worst was past was to take David Wessel, economics columnist of The Wall Street Journal, into his confidence. Wessel took leave to write a book. With plenty of help from Fed sources, he did a terrific job. In Fed We Trust: Ben Bernanke’s War on the Great Panic – How the Fed Became the Fourth Branch of Government (Crown) appeared in August 2009. The first book about the crisis may still be the single best. There was, however, one problem in turning the story of the courage and ingenuity the Fed had displayed into the dominant version of things events. Rupert Murdoch had bought the WSJ in 2007, and, after that, began a drought lasting until earlier during which the newspaper had failed to win a single Pulitzer Prize for its newsgathering, a pair of awards for commentary and editorial writing notwithstanding.
Thus, in 2009, though the WSJ beat the Times on the crisis story by almost any estimate except the Times’ own, neither newspaper was awarded a Pulitzer for its coverage (though both were finalists, the Times in public service and the WSJ in national reporting). Prizes went instead to the Las Vegas Sun for public service, for stories about the high death rate among construction workers in Las Vegas; to the St. Petersburg Times for national reporting, for fact-checking in the presidential campaign; to the Los Angeles Times, for explanatory reporting on wildfires in the west; to the New York Times, for breaking news in the Gov. Eliot Spitzer scandal. The award for a general non-fiction book went to Slavery by Another Name: The Re-Enslavement of Black Americans from the Civil War to World War II, by Douglas A. Blackmon (Doubleday) This, after a year that saw the greatest economic crisis in seventy-five years, makes you wonder what the Pulitzer Board was thinking. The use of the phrase “the Great Panic,” so conspicuous in Wessel’s book, dropped out of use altogether.
Bernanke had to be careful about what he said, especially in his Congressional testimony in the first months of 2009, out of concern for the central bank’s independence. The forces of populism, left and right, already had begun to grumble about the Fed’s relatively untrammeled power; the clamor had only increased since. (Because it earns interest on the bonds it holds in its enormous portfolio, the Fed requires no Congressional appropriation; indeed, it turns billions of dollars back to the Treasury every year.) Bernanke’s first public mention of the panic of 2008, and linking of it to the Panic of 1907, came at the Jackson Hole meeting in August 2009 . Since then, he has been increasingly more forthcoming. It will be interesting to see what he writes in The Courage to Act. But so far, the man who understood the crisis best has been reluctant to forcefully explain how he and the others at the Fed understood events at the time.
. Politics Trumps All
The second year of the Obama administration was less exciting that the first. Obamacare was signed into law. The Tea Party went to work to protest it, and the November election returned Republican to power in the House. The tactic of shutting down government over deficit issues began. The European sovereign-debt crisis was discovered. In August 2009, Obama reappointed Bernanke to a second four-year term. In January 2011, Summers went home.