Five Economics Pieces Worth Reading: December 31, 2009
Were It Not for the Fact that the BLS UI Claims Seasonal Adjustment Factor Has Been Overoptimistic the Last Two Christmases...

1998 and 2008: A Comment on Simon Johnson

Simon Johnson believes that the Obama administration is much more powerful than I do:

Lessons Learned From The 1990s: In the 1990s, the Clinton Administration amassed a great deal of experience fighting financial crises around the world.... In a major retrospective speech to the American Economic Association in 2000, Larry Summers – the primary crisis-fighting strategist – put it this way:

Prompt action needs to be taken to maintain financial stability, by moving quickly to support healthy institutions.  The loss of confidence in the financial system and episodes of bank panics were not caused by early and necessary interventions in insolvent institutions.  Rather, these problems were exacerbated by (a) a delay in intervening to address the problems of mounting nonperforming loans; (b) implicit bailout guarantees that led to an attempt to “gamble for redemption”; (c) a system of implicit, rather than explicit and incentive-compatible, deposit guarantees at a time when there was not a credible amount of fiscal resources available to back such guarantees; and (d) political distortions and interferences in the way interventions were carried out... (“International Financial Crises: Causes, Prevention, and Cures,” American Economic Review, May 2000, p.12; no free version is available, unfortunately:

Now, of course, Summers heads the White House National Economic Council.... [H]as this crack team of crisis fighters applied what they learned from the 1990s? They pushed early and hard for a fiscal stimulus... the Summers group drew sensible lessons from the experience of the 1990s.... But in terms of their handling of the financial system, the Summers-Geithner-Lipton approach this time around is at odds with their views and actions a decade ago. In the 1990s, they were completely opposed to unconditional bailouts.... No modern economy can function without a financial system, so some form of rescue that restored confidence in our banks was necessary.... In the 1990s, the US – working closely with the IMF – insisted that crisis countries fundamentally restructure their financial systems, which involved forcing out top bank executives. In the US during 2009, we not only kept our largest and most troubled banks intact (while on life support), but allowed the biggest six financial conglomerates to become larger than they were before the crisis.... We are still waiting for a full explanation of why the management of major troubled US banks were treated so gently – given their self-inflicted problems and desperate circumstances; if you doubt that these banks were close to failing, read some of the leading blow-by-blow accounts. Rick Waggoner, the head of GM, was forced out earlier this year, but the administration has not pressed major bank chief executives hard.

Presumably, this time around, the Summers-Geithner-Lipton group will argue there was no way to restore financial market confidence other than through the kind of unconditional and implicit bailout guarantees they opposed in the 1990s. If true, this has a terrible implication.  The structure of our financial system has not changed in any way that will reduce reckless risk-taking by banks that are large enough to cause massive damage when they threaten to fail.  The logic and 1990s experience of Summers and his colleagues suggest serious problems lie in our future. The reform legislation they have placed before Congress could still address “too big to fail” issues in principle, but attempts to limit the power of – and danger posed by – our largest banks have bogged down in heavy lobbying.  Postponing reform attempts until the banks were out of intensive care was a mistake – and just what today’s economic leadership used to warn against.

My view has always been that the Fed and the Treasury should have taken majority equity positions in all the "too big to fail" institutions in 2008 1998 as part of the price for the government support that they were given: when institutions are illiquid, you lend at a penalty rate; when you fear that lending at a penalty rate will make them insolvent, you take equity ownership--or explicitly nationalize. Had this been done, we would be having a very different financial reform conversation right now. But with Henry Paulson as Secretary of the Treasury there was no way that that was going to happen in 2008. And so when 2009 rolls around Obama has to play the cards that Paulson has left him.