Deconstructing the Fall

David Wessel, economics editor at the Wall Street Journal picks apart the layers of the economic collapse and what might have been. This series was made possible by the Charles G. Koch Charitable Foundation.
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TRANSCRIPT

Question: ARNOLD KLING, ECONLOG: To what extent was this a liquidity crisis and to what extent was it a solvency crisis?

David Wessel: A liquidity crisis is when you have a lot of financial institutions that are in good shape, but they’re just kind of short of cash and they need somebody like the Federal Reserve to tide them over until they can get back on their feet, but they basically have made good loans.  A solvency crisis is when the loans at a bank are made is so lousy that even if it could collect them all on the day of the crisis, they wouldn’t get enough money to pay off their depositors. 

Clearly this crisis began as a liquidity crisis, and that’s how the Fed treated it.  But eventually it became a solvency crisis.  That’s when, in the end, the Federal Government put a lot of tax payer capital into the banks.  That’s how you rebuild the foundations.  The problem is that, it’s not always clear when you’re crossing the line from liquidity to solvency and it’s certainly not always clear at the moment you have to make a judgment. 

Question: ARNOLD KLING, ECONLOG: What do you say to those who think it’s a liquidity crisis?

David Wessel: Well, I don’t agree with the premise. I mean, the reason that Bernanke joined Paulson in going to Congress to ask for $700 billion of taxpayer money was that he knew it was a solvency crisis.  The reason Lehman Brothers went down was not liquidity, it was solvency.  So, I think there was a political tactic decision about, at what point do you go to the ramparts and shout, “We need taxpayer money.  The banks are bust.”  And how do you do that so you get the money, but you don’t frighten people into cowering under their dining room tables?”  But I don’t think there was a problem of analysis here. 

Now, I do think there is a problem of sometimes the people in the room look at their clients as the financial institutions and that’s particularly true of people who have spent their life in the financial industry, Hank Paulson at the Treasury.  Bernanke has tried to explain this when he went on 60-Minutes, he said, “I did not set out to save Wall Street.  I set out to save Main Street.  In order to save Main Street I had to save Wall Street.”  I think that’s a coherent view.  He believes that finance is crucial to the well functioning of the economy where most of us live and work.  But it turns out to be such a complicated sentence that most Americans can’t follow it.

Question: DAN INDIVIGLIO, THE ATLANTIC BUSINESS CHANNEL: Would reducing the power of the Fed, or increasing its transparency have helped?

David Wessel: This is one that really requires hitting the rewind button and then changing the plot and then hitting the fast forward button and seeing what the ending is.  It’s kind of an impossible question to answer.  Surely it would have been better if somebody in the government was charged with having an overarching responsibility for this financial system and had both the mandate and the capacity to say, “You know, there’s just an awful lot of bad mortgage loans being made and we should make less of them.”  Or to say that, securitization, turning loans into securities, is causing problems because the people who make the loans just pass the hot potato to the security holder who buys them and they don’t have any skin in the game, so as a result they are making a lot of lousy loans.  So, surely they would have made a lot of difference. 

I don’t think that the stuff about Fed transparency, the Fed providing more information really would have made much difference before the crisis.  Most of what people are upset about is not what happened before the crisis, but the lending that the Fed did during the crisis.  And so, I think that’s an issue. And I think that also having a system where there are so many bank regulators and there’s so much turf battle going on was clearly not helpful, and it’s unfortunately that it doesn’t look like the pending legislation will consolidate that very much. 

The government could have been much clearer about what it was doing.  There was a lot of confusion about what the Paulson, Bernanke, Geithner program was.  I think that you can never set out a perfect set of principles that say this is how to respond in this circumstance, but they should have done more of that.  It would have been better if the government had more authority going into the crisis to deal with the collapse of a financial institution other than a bank so that they would have had a choice in September 2008, that was better than bankruptcy, Lehman Brothers, or bailed out AIG.  It would have been better if there were some fund that the Treasury Secretary and the Fed Chairman and the head of the FDIC could tap in an emergency that didn’t require going to congress.  Something that had maybe a lot of locks on it, but at least some body would have the key so that the government could fire back when the country was attacked by a financial virus instead of twiddling its thumbs and doing all of these jury-rigged programs until Congress got around to giving them the money.  So, I think those are a few things.

Question: FELIX SALMON, REUTERS FINANCE: Do you believe the Fed’s claim that it tried to impose a haircut on AIG’s creditors?

David Wessel: I think this is a question that we don’t yet know enough to answer.  But clearly, they did not impose a haircut on the counterparties to AIG.  Clearly those counterparties, the big banks, Goldman Sachs, Deutsche Bank, the rest of them, had a strong interest in the system and it would have been – I would have liked know just how hard did the Fed try to tell them, look, everybody’s got to take 98 cents on the dollar, or 87 cents on the dollar.  We’re not bailing anybody out 100%.  But there were a lot of problems, one was, this was an international company and it’s one thing for the Fed and the Treasury to lean on J. P. Morgan and Goldman Sachs and Morgan Stanley.  The French banks might be a lot less susceptible to the charms of Ben Bernanke and Hank Paulson, and you could have a really bad international dispute over this.  But most importantly, this was happening with a lot of other things going on.  It was kind of a busy week there.  First they marry Bank of America and Merrill Lynch.  Then they had this problem with Lehman Brothers, and then right behind, literally hours later, they’re dealing with AIG.  So, I don’t think you can look at any one of these things in isolations.  Sure, it they had six months to think about it, they probably would have done a better job.  In retrospect, should they have done something more to force a haircut on the counterparties of AIG, I think the answer to that is, yes.  Could they have done it with the power they had in the circumstances they were confronting, I honestly don’t know. 

Question: RYAN AVENT, FREE EXCHANGE/THE BELLOWS: Is the Fed’s focus on regulatory reform distracting from its primary mission?

David Wessel: I don’t.  Because I don’t think that you can have full employment and price stability and ignore the financial system and ignore asset bubbles.  My gosh, if there’s anything we’ve learned in the last five years is that employment has a lot to do with what goes on in asset bubbles.  We have 10.2% unemployment today and it’s not because of conventional monetary policy, raising interest rates because there was an increase in the consumer price index.  It’s the result of a finance bubble.  So, I don’t think the Fed can do its job without looking at that stuff.  That doesn’t mean that the Fed has to have the authority to supervise every bank in America and there’s an honest debate that goes on among people.  Many of them allies of the Fed about whether the Fed should or shouldn’t have that direct authority.  But I don’t think asset bubbles are a distraction, I think asset bubbles are a key part of their mission. 

Question: RYAN AVENT, FREE EXCHANGE, THE BELLOWS: Should the Fed be expanding or contracting its credit using operations?

David Wessel: Well, Ben Bernanke has a really hard task.  He has to decide when is the right moment to contract credit and raise interest rates.  If he does it too soon, we’ll get a relapse in to recession.  That’s what happened in 1937 when the Great Depression was extended because the Fed was too tight at the wrong time.

On the other hand, if he waits too long, we'll get an outbreak of inflation greater than he thinks is prudent.  So I don't think anybody thinks the moment is to tighten is today.  The argument is over how soon should the Fed do that; some of that depends on how the economy performs and I think that it's a tricky balance.  It takes a great deal of technical skill.  This is not like any recession we've seen in our lifetime and that means that we can't be sure the economy is going to react in the same ways.  It takes a great deal of luck because you just got to get it right and sometimes you have to make a guess.  You don't have the luxury of waiting for to see how the play's going to end before you decide what role you're going to play in the third act.

Finally, it's going to take a lot of political courage on Bernanke's part.  The Fed is under attack by the public, by the Congress, and he is undoubtedly going to have to raise interest rates and drain credit for the system before everybody thinks the economy's back to normal and he's going to have to do that at a moment when the Congress is looking at the powers of the Fed and the law that governs it.  So it's not going to be popular and it's going to be tricky.  So we all can only hope that he has the technical skill, the luck, and the political guts to do it at the right time because if it does it at the wrong time we'll have a much worse economy than if he does it at the right time.

Question: What personalities does Bernanke have to contend with in order to achieve this in Washington and Wall Street?

David Wessel:  His first constituency is his own colleagues at the Fed.  I think he's got them pretty much in line; although, there are some people who are outspokenly critical of him inside the Fed.  The second constituency is the American people because Congress is hostile to the Fed because they sense that the people are hostile.  The Gallup Poll did a survey in the summer of 2009 and they found that fewer people think the Fed is doing a good than any other federal agency that they mentioned including the IRS.  The Fed has become a lightning rod for all the anger about the sense that Wall Street got bailed out and Main Street didn't.  Like Greenspan and like Volcker before him, the Congress is an important constituency for the Fed and its Chairman.

I call the Fed the fourth branch of government in the subtitle of my book and that's a way to express just how much clout and independence they had during this crisis but the fact is it's not enshrined in the Constitution and Congress could change the law and it could change the law in ways that would make it harder for the Fed to do its job, particularly harder to raise interest rates or lower them when they think it's appropriate.  So that means courting a lot of members of Congress.  Not only the powerful ones like Barney Frank and Chris Dodd the Chairman of the two relevant committees in the House and Senate but also the rank in file members who have to vote on things  A lot of them think the Fed is a bunch of bank protecting nitwits and they're hostile.

Then finally, they do have a constituency on Wall Street in markets.  We, in this country, rely on the willingness of lots of people with money around the world to lend it to us at very cheap rates.  That's the only reason why we could have this big stimulus package, it's the only reason why the Federal government could be running such a big deficit, and to some extent Ben Bernanke and his colleagues at the Fed are the custodians of the US dollar and if people think we're going to have a lot of inflation here or a lot of bank failures or a lot of other problems, they're not going to be willing to hold so many dollars.  That means that we'll have to pay more to borrow.  So he can't ignore the markets but they are not his only constituency.

Recorded on November 20, 2009