Editor’s note: Last month, noted economist Robert Genetski explained how top policymakers’ erroneous assumptions led to actions that contributed to the start of the economic crisis. This month he analyzes the moves that deepened the crisis.
By Robert Genetski
Former U.S. Treasury Secretary Hank Paulson’s book On the Brink (Business Plus, Grand Central Publishing, 2010) describes how the financial climate continued to deteriorate in spite of the fiscal stimulus of 2008.
As each new problem emerges, the book reveals Paulson and Federal Reserve Chairman Ben Bernanke focused on the need to boost consumer confidence. This emphasis on confidence as a cause of economic activity instead of a consequence of economic conditions seems to have prevented them from identifying the role Fed policy was playing in restraining money and liquidity.
In Bernanke’s account, he, Paulson, , and Tim Geithner (then president of the New York Federal Reserve) address each new problem as it develops—from the failure of investment bank Bear Sterns to the deterioration of Lehman Bros. and on to the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. They attempt to devise a specific solution for each new emerging crisis. As the economy continues to deteriorate, each specific problem becomes worse, and new problems emerge.
Fannie, Freddie Bailouts
Fannie Mae and Freddie Mac were among the more seriously troubled financial institutions. They had hundreds of billions of dollars in debt and were losing billions of dollars each quarter. These agencies were created, sponsored, and regulated by the U.S. government, but were privately owned. Common stock was owned by the public, but the preferred stock was owned mostly by banks. Bank regulators had encouraged banks to buy preferred stock in these enterprises. In response, banks reportedly owned $30 billion to $36 billion of preferred stock in Fannie and Freddie.
In July 2008, amid massive losses at the GSEs, Paulson sought and received Congressional approval for Treasury to bail out the GSEs.
“The legislation gave us broad discretion to provide financial support to the GSEs as we saw fit. . . . The legislation did not impose any limitations on the amount of that support, except that it would not be exempt from the debt ceiling … it was perhaps the most expansive power to commit funds ever given to a Treasury secretary” (Paulson, p. 155).
Astute financial experts knew the U.S. Treasury had a difficult problem resolving the GSEs’ preferred stock problem. In late August, one analyst described the problem:
“Now that Fannie and Freddie are in trouble, the government is in a bind. After encouraging banks to buy FNM/FRE preferred by loosening regulations, they cannot easily make the banking sector take $36 billion of writedowns on securities that banks only invested in because of strong government incentives.…
“We are curious to see how the government will get out of that quagmire. Taking too steep a haircut on the preferred is out of the question due to the risk of further credit contraction. $36 billion of writedowns decreases banks’ lending capacity by at least $450 billion” (Kirchner, Lawrence, “Seeking Alpha,” August 28, 2008).
With Treasury’s unlimited authority to deal with this problem, Paulson (with help from Bernanke, Geithner, and others) did what Kirchner and others believed was out of the question.
Financial Panic’s Trigger
On September 5, Treasury announced its solution to the “quagmire.” Treasury would guarantee all the GSEs’ hundreds of billions of dollars in debt. However, it would place Treasury in a senior position above preferred stockholders. This meant if any money were ever recovered from the GSEs it would go first to the U.S. Treasury. Given the huge cost of bailing out the GSEs’ debt, this meant the preferred stock would be essentially worthless. In effect, Treasury had overnight eliminated well over $20 billion in bank equity, which supported well over $200 billion in loans and investments.
Those following the Fannie-Freddie fiasco were stunned. They could not imagine a move that would trigger a major shortfall in liquidity in the midst of a financial crisis. In spite of highly detailed descriptions surrounding many of his decisions, Paulson says nothing about this fateful one.
The decision produces an immediate collapse in financial markets. Within a week, a struggling Lehman declares bankruptcy, AIG follows, and problems quickly spread not only to the entire banking system but also to money market funds.
Shocked by Consequences
Less than two weeks after this decision, Paulson was apparently shocked to discover that “… all hell broke loose” (Paulson, p. 228), and “Liquidity was evaporating all over the place” (Paulson, p. 231).
With the financial system imploding, Paulson opted for a second bailout.
Treasury had committed most of what at the time was an $800 billion source of funds to bail out the GSEs. Since the situation was now worse, Paulson told President Bush he would need another $700 billion to shore up the financial system.
When the President and Vice President pressed the Fed for alternatives, Bernanke insisted that, legally, there was nothing more the Fed could do. The central bank had already strained its resources and pushed the limits of its powers. The situation called for fiscal policy, and Congress had to make that judgment. Bush pushed him, but Bernanke held firm.
“We are past the point of what the Fed and Treasury can do on their own,” Bernanke said (Paulson, p. 257).
That was untrue. The Fed has unlimited authority to create bank reserves and restore liquidity to the banking system. That, in fact, was the reason the Fed was created. There is no limit on the amount of securities it can buy. The Fed can also reduce reserve requirements to restore liquidity.
However, the Fed had spent the previous three years doing just the opposite, taking reserves out of the banking system and contributing to the lack of liquidity.
Bernanke had fallen into the Keynesian trap. He apparently assumed low interest rates meant the Fed had supplied sufficient liquidity to the banking system. He may also have relied on certain distorted measures of money that showed rapid growth.
During periods of great stress, bank deposits can increase dramatically as people seek the safety of government insurance for their money assets. Shifts in assets from one type of money asset to another can distort some of the more conventional money supply numbers. Whatever the excuse, Bernanke’s advice was simply wrong. This would have been apparent to any policymaker familiar with the classical economic perspective. Unfortunately, all key policy positions were filled with those following the Keynesian perspective.
From a Keynesian economic perspective, the government’s bailout funds would add to total spending and therefore help stabilize the financial system. From a classical economic perspective, government assistance means taking funds from where the market determines those funds are most needed. Every dollar of funds intended to help the banks, auto companies, or anyone else is at the expense of others who no longer have access to that credit.
The temporary exception to this classical economic perspective of a closed system occurs when the Federal Reserve uses its tools to add or subtract money and liquidity. Unfortunately, instead of restoring liquidity, the Fed inadvertently reduced it in the midst of the financial meltdown.
The reduction came in October 2008, when the Fed began paying banks to keep their reserves with the Fed. Although the Fed offered to pay only ¼ percent for the funds, the rate was attractive given existing financial conditions. So long as banks choose to keep reserves with the Fed instead of using them for loans and investments, the reserves cannot increase liquidity. It is similar to the Fed raising reserve requirements. The only distinction is that raising reserve requirements makes it mandatory to keep reserves out of the economy. Paying banks interest to keep reserves out of the economy makes the decision voluntary.
In October 2008 the amount of bank reserves used for loans and investments dropped to $79 billion from $99 billion in September. Under the assumption of a ten-to-one leverage ratio, this $20 billion bank reserve reduction was equivalent to removing $200 billion in liquidity from the banking system.
Instead of flooding the system with liquidity, the Fed’s policy removed 20 percent of the banking system’s reserves in the face of the worst financial crisis since the 1930s. The following month the Fed began restoring bank reserves. Within two months the worst of the crisis had passed.
Sees Importance of Reserves
Paulson hints he may have, or at least should have, recognized the impact of destroying bank capital. Here’s what he says about his thinking in early October 2008, a month after the fateful decision regarding the GSEs’ preferred stock:
“From the start of the credit crisis, I had been focused on bank capital, encouraging CEOs to raise equity to strengthen their balance sheets….
“Initially, when we sought legislative flexibility to inject capital, I thought we might need it to save a systemically important failing institution.… [N]ow I realized two crucial things: the market was deteriorating so quickly that the asset-buying program could not get under way fast enough to help.… We knew the money would stretch much further if it were injected as capital that the banks could leverage. To oversimplify: assuming banks had a ten-to-one leverage ratio, injecting $70 billion in equity would give us as much impact as buying $700 billion in assets” (Paulson, pp. 336-337).
Paulson’s book gives keen insight into how he, Bernanke, and Treasury Secretary Tim Geithner were belatedly concerned about restoring bank capital only after their decision a month earlier which had the effect of dramatically reducing bank capital.
Paulson says he Bernanke and Geithner continually assured President Bush and Vice President Cheney the Fed had done everything it could to increase liquidity. The Fed’s data on bank reserves indicate this was not the case.
President Bush apparently relied on Paulson, Bernanke, and Geithner to guide his decisions. According to Paulson, “the president said he had a simple test for making a decision on this: ‘If Hank Paulson and Ben Bernanke say it’s going to work and help stabilize the financial system we are for it'” (Paulson, p. 296)
Paulson provides several hints certain foreign officials had a better grasp of events than U.S. officials. For example, Chinese officials (who are familiar with the classical economic framework) are seen to be consistently more accurate in their assessment of U.S. financial problems than our own officials. There is also a telling conversation in October 2008 between President Bush and France’s President Sarkozy, who wants to discuss detailed financial reforms.
“That’s not for us,” President Bush said. “We’re going to have our experts do that.”
The French leader came right back at him. “These experts are the ones that got us in trouble in the first place” (Paulson, p.375).
Lessons Yet to Be Learned?
Looking back at the challenges and decisions surrounding the financial meltdown of 2008, several things are readily apparent.
- Key policymakers all used the Keynesian economic perspective to assess what was wrong and formulate policies intended to promote financial stability.
- Policymakers were continually surprised to find that after implementing their proposed solutions, the financial situation became worse instead of better.
- By relying on interest rates instead of assessing bank reserves and the existence of financial leverage, the Fed often ended up with a monetary policy opposite to what it intended.
The recent financial crisis provides important lessons of how the Keynesian economic perspective produced a series of policy mistakes that created the worst financial collapse in modern times. As long as policymakers continue to use the Keynesian framework in developing economic policies, the potential for another financial crisis is uncomfortably high.