David Wessel ’75 (left) and Tim Taylor ’82
Inside the Economic Crisis
Timothy Taylor When did you start thinking about writing the book? What was the economy like at that time and what story were you expecting to tell?
David Wessel After the Federal Reserve pulled the emergency cord and used powers that it hadn't used since the Great Depression to subsidize the purchase of Bear Stearns by JPMorgan Chase in March 2008, I thought: “It's never going to get more interesting for a Fed reporter.” I started the book. Little did I know how much bigger the story would get.
Timothy Taylor Your discussions of the Fed have lots of interesting details. Ben Bernanke has trail mix on his secretary's desk and diet Dr. Pepper in his office refrigerator. The New York Fed has $195 billion in gold in the basement, 50 feet below sea level. What sort of research did you have to do to get the details and background?
David Wessel Well, I've been covering the Fed for a long time so I've actually been to that gold vault at the New York Fed. As for the other stuff, I wanted to write a book that ordinary people would find interesting and understandable. When a reporter sets out to tell a story, he or she looks -- struggles to find, actually -- those great details. On Bernanke's frig? I was talking to him and went to it to get a Dr. Pepper.
Timothy Taylor I sometimes cast my mind back to when Alan Greenspan left the Fed. He was feted as perhaps the greatest central banker ever--a rock star in the financial community. How tarnished is his reputation by the events that have followed?
David Wessel Very tarnished. It's amazing. In February 2006, George W. Bush declared Greenspan to be a "rock star." Now, he is blamed for all sorts of things, some for which he is responsible and some that isn't. I think Greenspan made three mistakes. With the benefit of hindsight, he kept interest rates too low too long and sparked an orgy of speculation and borrowing. He didn't use the regulatory powers that the Fed had. And he sponsored a view in Washington -- which became very widespread -- that when in doubt, let financial markets innovate and stay out of the way
Timothy Taylor I'm actually quite sympathetic to Greenspan in a lot of ways. I sometimes think that we want our economic policy-makers to be like that pilot who safely landed the airplane in the Hudson River back in January '09--that is, we want them to have near-magical powers to fix crises in real time. But the U.S. economy can't be steered in that way. Ben Bernanke started off to be the anti-Greenspan, as you discuss. That is, he wanted the Fed chairman to be first among collegial equals, in an institution guided by fairly clear rules rather than seat-of-the-pants judgments. Obviously it turned out differently. But was his vision of the Fed chairman's role ever really realistic?
David Wessel Yes, Greenspan got too much credit for good times and too much blame for bad times -- though he didn't exactly exude humility. The Fed wasn't the only institution in our society that failed to check the excesses of the financial markets; it was one of several. In fact, I'm struck by how many checks failed -- the bank risk management committees, the rating agencies, the mortgage lenders and securitizers, the borrowers, the press.... As for Bernanke's vision that he could be the un-Greenspan, it was simply naive. And he figured that out. And now's he's on Sixty Minutes and PBS News Hour defending the Fed (and running what turned out to be a successful campaign for reelection.)
Timothy Taylor The financial crisis seemed to evolve in two waves: one wave in late summer and fall 2007, then a period by mid-2008 where it looked as if we might skate by with only a mild recession, and then a disastrous fourth quarter 2008 and first quarter 2009. I sometimes think that by mid-2008, the die was cast. There were huge losses out there in complex financial instruments based on subprime mortgages, and there was no real chance for a soft landing. But I wonder if economic policymakers could have done something in late 2007 or the first half of 2008 that would have ameliorated the later crash.
David Wessel That's a very good question. You must have been a sharp economics students in college. Here's my take. Bernanke & Co. were slow to realize in late 2007 what was happening. Bernanke and Paulson saw a housing mess and declared it to be "contained." It wasn't. Bernanke cut rates sharply in January 2008 when he realized how weak the economy was, how much worse than he had anticipated. Then comes Bear Stearns, a shock. Now some argue that had the Fed let Bear Stearns go under, the crisis would have happened sooner and might have been less severe. I’m not sure of that. But where I think Bernanke and Paulson did err is in the months following Bear Stearns. They didn't do enough to prepare for the next institution to get in trouble. They did deal with Fannie Mae and Freddie Mac, of course, but they didn't go to Congress for money or authority to deal with the next Bear Stearns nor were they adequately prepared themselves to deal with the situation.
Timothy Taylor So by fall 2008 we get to the Lehman bankruptcy. Some onlookers treat that as the crucial policy misstep that brought on panic. Maybe bailing out institutions is bad, but changing your mind and not bailing them out in a crisis situation may be worse. On the other side, there's a view which holds that at some point, something big needed to go broke. If it hadn't been Lehman, it would have been something else. In this view, Lehman going broke showed the seriousness of the situation and galvanized real responses. What do you think?
David Wessel This is one of the toughest questions in the whole episode. Bernanke, Paulson and Geithner faced formidable challenges that weekend. They hoped to sell Lehman to Barclay's, just as they had sold Bear to JPMorganChase.They rallied other Wall Street firms to help subsidize the purchase and were -- though they didn't admit it -- prepared to put some Fed money on the table. But the deal didn't come together, and they had no Plan B. They had three things in mind: (1) everyone knew Lehman was in trouble, they thought, (2) failure is essential part of capitalism, and (3) Lehman was so broke it didn't have enough collateral or security to offer the Fed in exchange for a loan big enough to save the firm. After the fact, arguments (1) and (2) vanish, and they emphasize (3) the lack of legal authority. But when the WSJ surveyed three dozen economists and asked if they believe that case, they said “no” by a 3-to-1 margin. Most people conclude that had there been a will to save Lehman, there would have been a way. Now, should Lehman have been saved? Many views on that: (1) We needed a crisis to get Congress to do what was necessary. Could be. But I don't accept that. It's too gloomy a view of what politicians will do in an emergency. (2) Had Lehman be saved, we would have had a much less severe financial panic. Hard to say, but Lehman's collapse certainly didn't help. (3) If not Lehman, then something else would have triggered the panic and collapse because the underlying problems were so deep and the economy was slowing so precipitously at the time. A lot to be said for this view. (4) It wasn't Lehman that provoked the mess, it was the messy government response (a view pushed by John Taylor of Stanford.) I don't buy this one.
Timothy Taylor I'm somewhat persuaded by the work of Ken Rogoff and Carmen Reinhart, who argue that during a financial crisis, you need to save the biggest of the big (no matter how distasteful), but it's also common to let a large mid-range firm go broke at some point. As we said back in French class, "pour encourager les autres."
David Wessel Perhaps. We should know the history, but not be slaves to it. Bernanke, for his part, understood how disruptive and damaging the collapse of financial institutions can be. That's what his work on the Great Depression showed. He says, by the way, that had Congress approved the $700-billion TARP fund earlier, he would have used it to save Lehman. (Of course, he and Paulson hadn't asked for the money at that point.)
Timothy Taylor The subtitle of your book refers to the Federal Reserve as the "fourth branch of government." I've been trying to think about whether that is literally true. Along with the executive, judicial and legislative branches, is the Fed the branch of "macroeconomic stability and financial crisis management"? If the Fed works as a fourth branch of government, do we need to think more about checks and balances for the Fed?
David Wessel It is not LITERALLY true. The Fed was created by Congress in 1913, and Congress could change the law. It emphasizes, though, the enormous power that the Fed has and that it exercised in this crisis. Were the U.S. attacked by missiles, the president of the U.S. could fire back. But when this crisis attacked, the president and Treasury secretary were powerless. Only the Fed could supply the dollars needed (until Congress acted in Oct. 2008, of course.) When Bernanke took office, the Fed had $800 billion of loans and securities. Today it has $2.1 trillion -- and no one in Congress or the White House or the Treasury had to sign off on that. The Fed -- as our conversations about Lehman and Bear Stearns illustrate -- had the power to decide which institutions lived, and which died. Pretty significant power. Now the Fed is independent for good reason...because in this, as in nearly all capitalist democracies, the politicians decided they couldn't be trusted to set interest rates; they knew that, with an eye to the next election, they'd tend to favor more growth now and too much inflation later. They insulate the Fed from political pressure, as a result. For the Fed to maintain that, it has to be “accountable” and “transparent,” to pick a couple of buzz words out of the Washington debate. It isn't always so. And when the Fed makes decisions that might properly belong to political authorities -- making them because no one else could -- then the Fed may find its independence questioned. Indeed, it is now. The Fed can lend to nearly anyone in circumstances that it deems "unusual and exigent." Obama has proposed that in the future, the Treasury Secretary should have to sign off on such loans. That seems prudent to me.
Timothy Taylor Several generations of Haverford students learned in their intro macro class that the Fed moved interest rates up to fight inflation and down to fight recession, using open market operations, the discount rate, and the reserve requirement. Clearly the Fed actions since late 2007 go WAY beyond that mandate. I'm by-and-large supportive of the need to take large and unconventional actions in the situation in which we found ourselves, but it's a little spooky to have policy responses depending on whether those like Bernanke who find themselves in a position of authority can invent new mechanisms and new kinds of bailouts on the fly.
David Wessel The view of the textbooks was always too simple. The Fed's role in maintaining financial stability and regulating the banking system has always been important, particularly in a crisis, such the Mexican debt mess of the mid-1990s or the savings and loan mess in the 1980s. But you're right: It is spooky. It's a good thing, in my view, we had someone like Bernanke at the helm, but risky to count on one man being in the right place at the right time. It suggests that we need a lot more contingency planning and scenario-making at the Fed -- and to contemplate catastrophic events. After 9/11, they prepared for the physical disruption of the banking system. After this, well, one hopes they've learned a lesson or two. It would be helpful if more academics were doing good work on how financial markets and financial institutions actually work in practice. I suspect the crisis will prompt a lot of thinking and research in this sphere.
Timothy Taylor You mentioned Bernanke's academic work on the Great Depression. As you note in the book, this work seems to have imbued him with a "whatever it takes" philosophy. No one will say that Bernanke just sat on his hands during the last couple of years. But has he gone too far? For example, should we fear a resurgence of inflation in the next few years?
David Wessel Bernanke has a couple of big challenges now -- especially the one to which you refer. He has to raise interest rates and drain some of the huge sums of money he has pumped into the system at just the right time. Do it too soon, and he'll provoke another recession. (See 1937.) Do it too late, and we'll get inflation. He knows that, but whether he has the forecasting skill, luck and political courage to act at the right moment remains to be seen. The huge federal budget deficit adds to concerns that -- once the current weakness in the economy passes -- we're doomed to have a surge in inflation. Rogoff, the Harvard economist you mentioned, sees it as almost inevitable. I don' t think it's inevitable, but I do think it's a substantial risk.
Timothy Taylor When I lived in northern California a few years back, we had a severe earthquake. As we all stood out on a patio, away from building that might collapse, the person next to me said: "I just want to know if it's over, or if that was only the beginning of something worse." My own sense is that we're through the worst of the economic situation. The panic seems to be behind us. I'm a lousy economic forecaster, but my best guess at the moment is for a slow recovery that will often feel disappointing and inadequate. This is what they call the U-shaped scenario. But I also see predictions out there for a V-shaped rapid economic recovery, or for a W-shaped additional recession. What's your best guess?
David Wessel I like the words "best guess." I think we are in for a couple of tough years of sluggish growth that isn't fast enough to bring down unemployment very rapidly. Recoveries after recessions provoked by financial problems usually are weak, and I'll bet this one is too. A Wall Street Journal survey of economists says it'll be 2013 before jobless rate is below 6% (http://online.wsj.com/public/page/economic-forecasting.html). What worries me is that the economy is so fragile that something bad -- an oil price surge, an unanticipated collapse in some financial institution, a sharp downward turn in the dollar -- could push us back into recession.
Timothy Taylor The history of this financial crisis and recession is going to be written and rewritten many times in the next couple of decades. But when people wonder what happened, who was involved, and how it was seen at the time, I think your book is going to be one of the primary sources. Writing the first draft of history is a real accomplishment. Congratulations.
David Wessel Thanks, Tim. This book is very much in the spirit of the Journal of Economic Perspectives, which you edit so ably. The economy is too important to be left to economists. We all have a stake in understanding it. I have enjoyed this. Your questions are better than those posed on the average radio talk show. For more on the book, see www.infedwetrust.com.