In the days before the Lehman Brothers bankruptcy in the fall of 2008, Treasury Secretary Hank Paulson let it be known that the investment bank wouldn’t be bailed out. He told Wall Street bankers that the government wouldn’t provide any money, and his advisers leaked that there would be no more bailouts.
"I told Hank this was a huge mistake, irresponsibly damaging to confidence," Timothy Geithner, who was then president of the Federal Reserve Bank of New York, writes in his book "Stress Test: Reflections on Financial Crises." "This was not the time to tell the markets they were on their own. By committing to do nothing now, we’d end up having to do more and put more taxpayer money at risk later."
Paulson was no populist. As the former chief executive of Goldman Sachs, he knew that the crisis posed a severe threat and, in the final months of the George W. Bush administration, he was relatively insulated from political pressure. Yet even Paulson could not resist the temptation to send the message that Wall Street was immoral and shouldn't be rescued.
This is the "central paradox of financial crises" that Geithner identifies as a core theme of his book, published this month. "What feels just and fair," writes Geithner, who succeeded Paulson as Treasury secretary, "is often the opposite of what's required for a just and fair outcome." In other words, saving Wall Street, the argument goes, was necessary to save Main Street. Retribution might feel good, but in the end it hurts innocents.
The paradox is key to the disappointment some had with how the United States responded to the crisis and recession of 2007-2009. At every stage, the public rebelled against how the policymakers responded, making it harder for policymakers to do more. As the political system hardened against additional action, the economy was left vulnerable, and people on Main Street were left suffering. And all of that reinforced the perception that the dramatic, early interventions weren't worth the cost.
Inside the government's response to the crisis
In a series of colorful stories describing his life in public service, Geithner describes how he experienced this dynamic, first with the financial rescue, then with President Obama's stimulus, and even when trying to combat Europe’s financial crisis. He has clear ideas about how to combat crises, but he still struggles with that central paradox: how to win the public at the same time you're doing the unseemly task of rescuing the system. Perhaps it's insolvable.
Still, it may be the most important question to come out of the crisis, because at a conceptual level, scholars have known for many decades how to put out the fire. Walter Bagehot described the basics of how to combat a financial crisis 150 years ago when he urged central bankers to lend freely and early to solvent institutions. And from John Maynard Keynes on, we’ve long known how to fill the demand gap created by a deep recession: fiscal stimulus, government spending.
By and large, the Fed -- under Chairman Ben Bernanke and Geithner -- and two White Houses followed these principles. But while they stabilized the economy, they of course failed to generate an economic recovery that felt adequate, or fair, for the average American. The interesting historical counterfactual is whether they could have done more to lessen the pain and to counter the sense that Wall Street got away with murder. Geithner is fairly clear that more could have been done at the margin, but, by and large, he believes that he and his colleagues operated at the limits of their authority.
What else could have been done to boost the economy?
Critics no doubt will disagree. They might point out that the Fed could have done more to save Lehman Brothers – although Geithner and co. say that was legally impossible. Critics say the Fed could have done more to lend to ordinary people, though such a program was enacted in Great Britain to little effect. They might say the Fed could have adopted more aggressive monetary policy – announcing it would stimulate the economy until growth returned to its pre-crisis trend, for example – though many economists had grave concerns about that approach. They say regulators could have done far more to hold Wall Street executives accountable.
Meanwhile, the Bush administration, and more realistically the Obama administration, could have taken much more dramatic steps to help heavily indebted homeowners. This is perhaps the best argument for doing more, since Obama had access to billions of dollars to do precisely this, but how much of a difference it would have made in the overall trajectory of the economy is a matter of fierce debate.
But among most professional economists, there's great consensus that the economy would have grown faster and the unemployment rate would have come down more quickly if the government had provided more economic stimulus. Geithner agrees that the biggest failure of government in response to the crisis was providing too little support for the recovery. But he blames the public's response.
After the initial $800 billion stimulus of February 2009, Obama wasn’t able to obtain much more spending authority from Congress, certainly not enough to keep the economy growing at a healthy clip. By that fall, "'stimulus' had become a dirty word in American politics. With unemployment in double digits, this yawning gap between the perception and the reality of the [stimulus] was probably inevitable," Geithner writes. "The stimulus was a jobs bill passed at a time when jobs were vanishing; our insistence that it was preventing much worse pain, while true, was not compelling to people in acute pain."
As Geithner points out, by the end of Obama’s first year, Republicans started calling for spending cuts, Democrats were running away from stimulus, and "the public was dubious of the idea that when families and businesses were tightening their belts, those of us in government should borrow more money from China so we could loosen ours." Washington quickly hardened against more action to help the economy and instead veered into a discussion of deficit reduction: reducing government spending.
We can never know whether Obama, Geithner and their brethren could have changed this dynamic. Could they have somehow convinced the public – more precisely, reluctant lawmakers on both sides of the aisle – that more stimulus was the right approach? Geithner has a few interesting examples of how the White House squeezed a bit more out of the system -- the payroll tax cut deal of 2010, for instance – but it sounds like he thinks the White House was already operating at its political frontiers.
It’s always always possible, however, that Obama and Geithner could have managed the politics better. For one, the White House could have pushed harder and more strongly for stimulus throughout the first term.
The White House's foray into deficit reduction politics
By late 2009, Obama and Democrats had bought into the language of deficit reduction (and were also totally focused on passing the Affordable Care Act, a distraction, though a worthy one in their view.) With deficit reduction, Obama’s point was always that the country needs to contain long-term spending trends, and his team noted that doing so could buy room for more stimulus in the short term. But the distinction got lost in the debate.
By 2011, the White House itself decided that it wanted to enter negotiations with the Republicans over a fiscal compromise, the so-called grand bargain. Geithner writes that David Plouffe, one of Obama’s top advisers, argued that the White House "couldn’t ignore the public clamor for fiscal discipline." Plouffe said, "We didn’t run on a platform of permanently increasing the size of government." It wasn’t a point of universal agreement, but it won the day.
In the end, Obama was locked into eight months of negotiations with Republicans, which many White House officials regarded as a low point in the presidency. Those negotiations resulted in deep spending cuts. Later, the White House broke out of the pattern of compromise, pushing unbridled jobs legislation (they still hated the word stimulus) and successfully defeating Republican threats to default on the debt if even bigger spending cuts weren’t enacted. But it was too late for new legislation, and perhaps additional legislation had always been impossible.
Today, while the crisis and recession may have faded, the fundamentals of the economy remain weak. Incomes show little growth, economic opportunity remains low, and inequality continues to widen. With two and a half years remaining in his term, Obama still has no elixir to ease the gridlocked politics and pass legislation that could address the long-running trends that are behind today’s economic malaise.
Throughout "Stress Test," one gains a deep appreciation for the heart-pumping decisions made by Geithner and his colleagues from 2007 through 2012. And he makes a compelling case that overhwelming force is necessary in crisis, and that the measures taken by the Fed and two successive administrations prevented even more pain for ordinary Americans. He acknowledges his discomfort with the public thirst to punish bankers at the expense of rescuing the system, though he never quite reconciles how much more he might have used the bully pulpit to express the outrage of a nation at what Wall Street wrought.
It's possible that more outrage and more accountability from the nation's leaders would have stemmed the public's frustration with Washington and proved to be the key to doing even more -- the solution for Geithner's paradox. But it's hard to believe that such tactics could have led to a faster growing economy or much lower unemployment.
Geithner concludes that "the lingering public revulsion for what we did, for bailouts and stimulus and government intervention to resolve financial crises, is a serious problem for the policymakers who will stand in my shoes in the future."
The problem -- how do crisis firefighters save the system and win the public -- has yet to be solved.