Tuesday, November 16, 2010

Financial crisis event books

These are two: David Wessel's In Fed We Trust and Henry Paulson's On the Brink. Wessel's book is a much better read but the Paulson book complements the former. For instance, Wessel claims that George Bush was largely absent during the crisis as it unfolded but in some ways Paulson's book contradicts this. Paulson also provides the political drama and backdrop that were largely absent from Wessel's book. In many ways, his book highlights the political elements that were absent in many considerations of my earlier posts on the crisis. The only thing I found unbelievable was his claim that all along he thought that TARP would be used for asset purchases and the only reason he had not proposed it was it was politically unpalatable (at least that was how I read it).

One thing that both books made extremely clear to me was that despite the fact that I thought that the Fed and Treasury had powers to take over failing banks and replace management, they clearly thought they didn't. The role of lawyers in the Fed and Treasury was emphasized at critical points. Bernanke and Paulson sought their opinions even on whether bailing out AIG by invoking a clause in the Fed charter that allowed the Fed to step in when it deemed it was absolutely necessary was legal. Mark Thoma concurs:

“Since the government didn't have resolution authority for banks in the shadow system, it only had two choices when faced with the collapse of a large bank like Bear Stearns or Lehman. Let the bank fail and risk a domino effect that brings the entire system down and potentially creates a depression, or bail out the systemically important bank -- including management and equity holders (investors). [Some claim the government did, in fact, have other choices, but I don't think the key players in the Fed and Treasury believed that they had the authority they needed to take over the large banks, remove management, and put them through traditional FDIC-like procedures that impose losses on investors.] By choosing to bail out the banks, they also bailed out those who created the mess. This left the appearance that the wealthy and well-connected get bailed out, while the middle and lower classes get the bill. Typical households really can't see what they gained from the bailout since, for many, the counterfactual where the system melts down without a bailout is either hard to imagine or not believed. They don't understand, for example, why the government helping them to pay off loans wouldn't have helped banks just as much as a direct bailout. "Where was my bailout?" they wonder.”

Wessel's book was more enjoyable perhaps because it was more economics than politics. Characters like Jeff Lacker and Charles Plosser come out looking like naysayers – crying that the the crisis was not something to be worried about. Wessel seems to think that Bernanke's consensus style was sometimes a hindrance to getting things done. He refers to it as a economics seminar approach to decision making. I don't know which economics seminars Wessel has been attending (or Bernanke for that matter) but most of the seminars I was at in Rochester were nothing short of contentious. One speaker even refused to continue talking because he kept being challenged by an attendee. For instance, here's Andrew Gelman in his tribute to statistician Arnold Zeller (emphasis mine): “No matter who the speaker was, Zeller was always interrupting, asking questions, giving his own views. Not in that aggressive econ-seminar style that we all know and hate ...

What I was looking for in both books however was severely missing and is highlighted in the Thoma's piece. Neither Bernanke nor Paulson could clearly articulate what would have happened to the economy if the investment banks (and AIG and Fannie/Freddie) were simply allowed to fail. Intoning “God help us all” if the financial system collapsed is not a scenario. So in some ways, while I appreciated more the nuances of the bailout and why they did what they did I am still far from fully convinced that the bailout was necessary.

I think that when you are a participant you are biased toward believing in your priors. There is no doubt in my mind that both Bernanke and Paulson felt that the bailout was necessary. Likewise, I believe that if there were a crisis in sociology for instance, that there is a possibility that the entire field would collapse because fewer and fewer people are becoming sociologists, the field would be crying for a bailout as well (as would makers of horse drawn buggies or automobile makers – all intoning “God help us all”).

Nor were any of the books very good at linking how the collapse of the financial system affected Main Street via the unemployment rate. Were the effects psychological? E.g. “Oh my God, the financial system is collapsing, I better lay off all my workers!” or was it direct? E.g. “Oh my God, the commercial paper market has frozen solid and I better lay of all my workers!”

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