Brad DeLong: Thank you. I remember, back when I was working for the Treasury, after one White House meeting Joseph Stiglitz—then one of the members of the President's Council of Economic Advisors—turned to me and said:
Brad, not every question is best answered with a 10 minute economic history lecture.
But most are.
So let us start in the 1860s with the industrialization of America and the rise of the large scale business enterprise. There is then a law of bankruptcy: when a company does not pay you, and when you cannot work out terms, you go to a judge. The judge bangs his gave. The sheriff then auctions off the company's assets on the sidewalk and the company shuts down.
By the 1890s the judges in New York are saying: "Wait a minute! This makes no sense. Even though it is bankrupt, the New York Central Railroad is much more valuable as a going concern than if we simply pulled the individual rail segments off the roadbed and sold them off as ornamental ironwork. Moreover, there are lots of other stakeholders who rely on the operations of the New York Central--and even though they are not parties, there is a public interest in not having them suffer economic harm." So the judges change the law: they decide that when a large business enterprise goes bankrupt, we the judges will freeze its finances but let its operations continue while people negotiate and design and we approve a plan to restructure its debt and equity so that it can continue to operate. After judges took the lead legislators followed, and so we developed our current law of bankruptcy: when a company declares bankruptcy; we minimize the economic disruption by freezing and then sorting out its finances but letting its operations continue.
This system works pretty well in dealing with the bankruptcies of operating companies. Finances are frozen, debtor-in-possession financing is arranged, operations continue, the lawyers maneuver, and eventually a new financial superstructure is negotiated and plopped down on top of the operating company.
The problem is financial companies. They have no operations. They are all finance. When you freeze the finances the thing dies instantly.
Come the 1930s we face the waves of bank bankruptcies which make the Depression Great. The unemployment rate spikes to a peak non-farm level of 28%. We get the New Deal. The New Deal establishes the FDIC—which exists, among other things, to handle bank failures. When a bank fails the FDIC will go in, pay off its insured deposits, take over its assets and other liabilities, hopefully find a solvent and sound bank to take over the good-bank parts, and eat the remaining losses. This serves as an financial-sector analogue of Chapter 11. The hope was that with the FDIC we will never get into another situation like 1931 in which applying bankruptcy law to failing financial institutions produces general economic disaster.
Then comes the fall of 2008. The Federal Reserve and the Paulson Treasury look at the situation—with nearly every investment and commercial bank in the United States on or over the brink of bankruptcy because of incredibly, incredibly bad risk management by the top and lots of people actually trading assets who don't care what happens to their positions or their firm in the long run as long as the mark-to-model valuation of their position on December 31 generates a huge bonus for them. The Federal Reserve and the Paulson Treasury realized: Wait a minute. These aren’t just commercial banks. They are investment banks too. If we use the FDIC we can keep half the operations going, but the FDIC will have to shut down the investment banking operations, the shadow banking operations. And Henry Paulson and Ben Bernanke decide that they just cannot risk doing that. The shadow banking operations of the major overleveraged New York financial institutions are just too big to fail—or rather, too big for us to risk failing without an adequate reorganization net beneath them, and we did not have that reorganization net
That is why Bush Treasury Secretary Henry Paulson went to the Congress and asked to borrow $700 billion for the TARP on the faith and credit of the United States and lend it out to recapitalize financial institutions during the crisis—hoping to get all of it or most of it back after the crisis ebbs.
But then question is: how do you recapitalize the banks so that they don't fail and have to shut down their financial operations immediately? Last month I was at a conference with one of Paulson's Assistant Secretaries, Phil Swagel. Phil said that at the time the Treasury and Federal Reserve believed that they had two choices. They could give the money out to all the banks—even those that weren’t over the edge of but only on the immediate brink of bankruptcy—and accept that the banks are going to make money on the rescue, because neither the Treasury nor the Federal Reserve had any legal authority to force a recapitalization and could only do so by making the terms sufficiently attractive that all the banks would take the money voluntarily. Or they could sit back and wait until banks over the edge of bankruptcy came crawling in and were willing to accept any terms at all—in which case the government could take the options, take the equity, take the executive compensation, take some of the short-term debt, and make a big profit on the TARP by selling off its large equity ownership stake in the bank over the crisis was over.
Phil said that at the time the conclusion of the Treasury and the Federal Reserve was that the second strategy was too risky. You needed to calm the crisis immediately, and waiting for the banks to come in begging for help on any terms at all would not do that. As then Vice-Chair of the Federal Reserve Don Kohn said: the choice was between rescuing the jobs and millions of Americans if you did the first, and teaching a few thousand financiers a well-deserved lesson by taking their fortunes if you did the second.
Now Phil said that he still believes that the Treasury and the Federal Reserve made the right decision in the fall of 2008, but that this question can be debated—would it economically have been better if the princes of Wall Street and the investors in overleveraged New York financial institutions had lost their fortunes even if the recession had been deeper as a result? Perhaps: it is important that moral hazard be limited, and that financiers whose actions cause systemic risk not emerge with their fortunes intact and augmented—as they have. Is that avoiding the enabling of moral hazard more important than reducing the rise in unemployment? Perhaps. Politically, the Federal Reserve and the Treasury have burned their capital with the public and the Congress because of the correct perception that they rescued Wall Street. Would it have been better to have had a larger rise in unemployment and spectacular personal bankruptcies of most of the princes of Wall Street if that had preserved the Federal Reserve's and the Treasury's credit with the Congress and the public so that they could take more aggressive stimulative action down the road, like now? Perhaps.
What is clear is that the absence of a Chapter 11 or FDIC analogue for investment banks and shadow banks gave Paulson and Bernanke no truly good options in the fall of 2008. And that is what Dodd-Frank is supposed to fix. I do think it’s a significant improvement: the next time a Paulson is caught in a similar situation he will have the authority to do for mixed investment and commercial banks, for investment banks, and for shadow banks what the FDIC has done for commercial banks since the 1930s and what U.S. bankruptcy law has done for operating companies since the 1890s.
That is a very good thing.
Brad DeLong: This will be another history lesson—less than 10 minutes this time. I remember talking to the late Ned Gramlich, first a University of Michigan professor and then a Clinton-appointed Governor of the Federal Reserve—sometime in the early 2000 about why it was that the Federal Reserve was being so... unaggressive at regulating mortgage finance. Ned—who was then in favor of the Fed being much more aggressive—made several points.
First, the people who tend to be attracted to jobs at the Federal Reserve and who like to be Governors of the Federal Reserve are people who like bankers and like banks. They are not people who focus on restricting bank freedom of action, but rather on empowering banks to do what bankers want to do.
Second, then Federal Reserve Chair Allan Greenspan was a Randite: one of those right-wingers who sees enormously value in individual freedom. If you tell him that unless finance is more tightly regulated that consumers will make mistakes, he will say: they are adults, and we do adults no long-run favors by treating them like children. If you tell him banks will make mistakes, he will say: they are adults too, and we do adults no long-run favors by treating them like children.
Third, Ned said: can you imagine Greenspan up there on Capitol Hill, with the Republican members asking him why he won't let the mortgage lenders make the loans they want to make and the Democratic members asking him why he won't let the American people buy the houses they want to buy that the mortgage lenders want to finance? Denouncing him as an incompetent national nanny? Saying: I know the lenders want to lend and the borrowers want to borrow and buy these houses, but I am the Federal Reserve and I know better? That is not something that the Federal Reserve can do.
But this is, I hope, a role that a Consumer Financial Protection Commission can take on—even as it is, housed in some strange way I do not understand inside the Federal Reserve Board. It is substantially independent. Its explicit mission to serve as a check on lenders' ability to trick borrowers into borrowing on terms they they not. It is going to make it much stronger and a much better regulator than we have had over the last two decades. For the consensus has to be that over the past two decades the regulators have not done a very good job at all.