The Paulson Legacy

With the footsteps of a new Treasury Secretary audible around the corner, Henry Paulson’s days running the country are essentially at an end. The best he can do now is delay whatever changes the Obama administration will make.

Looking back over the last two months, Paulson’s record (and that of the rest of the Bush administration) in combating the greatest financial crisis of our lifetimes is poor, though not catastrophic. The one thing that can be said in his favor is that the financial system did not completely collapse and Ben Bernanke’s supposed warning in the dark hours of September 18 that “we may not have an economy on Monday” did not come to pass. We have said on this site that stabilizing the financial system was job one, and the patient is stable.

But weighed against that success is an array of failures. The many years of deregulation that helped bring on the crisis, to be fair, predated Paulson’s tenure, and extended back into the Clinton administration. But the insistence that everything was fundamentally sound through the first half of September covered for a failure to do anything about highly visible problems with subprime loans, Alt-A loans, bond insurers, selected hedge funds, and some investment banks. The handling of Lehman and AIG have been widely credited with triggering the acute phase of the crisis, when no one would lend money to any bank. The initial bailout proposal was autocratic in conception and poorly designed, and the way it was pitched to Congress and to the American people triggered a wave of panic that has yet to subside and that in itself did significant damage to the economy. The delay in taking the steps that many people (including us) called for and that ultimately broke the fever gripping the financial sector – such as expanded deposit insurance, loan guarantees, and explicitly bank recapitalization – let the panic continue for weeks longer than necessary.

While the patient was saved, he is still far from health. While major banks are no longer failing on a weekly basis, lending to the real economy remains minimal, and the administration’s strategy amounts to encouraging banks to lend money. There has still been nothing done on housing (rumor is that Treasury is fighting against Sheila Bair’s mortgage modification proposal). Treasury has yet to buy a single mortgage-backed security, but is still pressing ahead with the original plan that few people believe is still necessary (given that banks now have unlimited deposit insurance, loan guarantees, and government capital). Apart from the swap lines extended to a limited set of central banks by the Fed, the government has been conspicuously silent on the ever-deepening emerging markets crisis.

Some people have wondered why Paulson was so set on the original plan to buy mortgage-backed securities instead of what he ended up with, which was bank recapitalization. I think the answer is pretty simple. The economic ideology of the Bush administration was that free markets are always best. When the markets failed, the idea was to surgically correct a flaw in the market for mortgage-backed securities. They believed the underlying problem was the lack of buyers for MBS, and that if the government stepped in as a buyer the market would correct and the problem would solve itself. This belief that markets ultimately work themselves out, and therefore only need small nudges in the right direction, is why the administration’s actions have been a step behind and two sizes too small throughout this crisis.

We’re still seeing this today in President Bush’s resistance to a new stimulus proposal and insistence that we just need to let the “aggressive and decisive measures” already taken to have their full effect. The next administration, while believers in the virtues of free markets, are likely to be less convinced that free markets are always the solution and more willing to flex the muscles of government when necessary. And they are more necessary than they have been in decades.

11 thoughts on “The Paulson Legacy

  1. James,

    I’d love to hear more about the “many years of deregulation that brought about the crisis.” So far, no one has adequately fleshed this statement out beyond an Obama sound bite.

    More please.

  2. I would add that there’s an excellent chance that Paulson has inked a whole batch of secret ^H^H^H^H^H ‘undisclosed’ contracts committing the federal government to paying out vast sums of money in the future – and I mean vast by $700 billion bailout standards. Under the sort of terms which a cynical realist would expect when outgoing Bush Republican administration lawyers sat down with financial elites.

    It’d be very Bushian, and the sort of thing that a Wall St CEO wouldn’t be above.

  3. Is there a record of this behavior in past administrations?:

    The best he can do now is delay whatever changes the Obama administration will make.

    Or are we (you) just adopting the Bush mindset? [just like this!]

    How about this somewhat dramatized line with this somewhat epileptic metaphor:

    “We have said on this site that stabilizing the financial system was job one, and the patient is stable.”

    Have there been financial systems in the past that were good on Friday but gone on Monday?

    And this:
    “The many years of deregulation that helped bring on the crisis, to be fair, predated Paulson’s tenure,” To be even fairer didn’t Hank amass his fortune on those “many years of deregulation”…wazinit this bum who just prior to The Sinking wanted even less regulation (hard to imagine, now …and even harder to go back and dig out the nitty gritty) less ~”the financial center of the world move to London”?

    What year here:
    “But the insistence that everything was fundamentally sound through the first half of September”… For some of us the flag went up with the construct of TAF in late 07, you?

    This looks like I missed my anti-combative meds James and I am mostly just thrashing about to find you.

    “While the patient was saved, he is still far from health.”

    I am tiring of these metaphors (we are all patients now…some of us need saving from..this very descriptor, you know?) [Desperate humor: the patients are impatient.]

    Last irritable thing:
    “The economic ideology of the Bush administration was that free markets are always best.”

    In my warped, angry, impatient but legacy-free opinion, to ascribe to anyone an “ideology”, let alone some particular variant (The economic ideology), presupposes some weighty sophistication both on the part of the ascribee and the ascriber. Lets skip right to it: GWB’s sophistication and the barbarian’s is a match. Return to O’Neill and see if ain’t so.

  4. “Deregulation is the prime suspect”

    Sadly, as usual, we’re getting the cause wrong, so how can we ensure we’ll get the fix right?

    A commission needs to be set up to thoroughly consider the causes of our current state of affairs.
    Otherwise, we’ll just live for decades in a myth as we did after the Great Depression, where we told ourselves that the crash was somehow caused by the economic growth of the 1920s. Today, we accept it was a monetary rather than a fiscal event, but it took a long time to figure this out.

  5. DCLawyer: The Economist article actually agrees you; its point is that deregulation on balance has done more good than harm. I agree that over the long run, deregulation has had many positive effects. I happen to think that a little less deregulation would have been even better. Here are a few problems:
    1. The lack of regulation of derivatives, particularly credit default swaps – and in particular the explicit rejection of regulation in 2000.
    2. The failure of state regulators to rein in the predatory lending practices of the last several years.
    3. The failure of bank regulators to monitor the health of banks.
    4. Basel II and the idea of letting banks use their own models to determine their capital requirements.
    5. The failure to adjust capital requirements to account for off-balance sheet exposures.

    It was not so much an issue of regulations being explicitly repealed, of regulators failing to keep pace with innovation in financial products.

  6. James,

    Thanks much for that rundown. I’d note that many of the items you list are actually non-regulation or failed regulation rather than de-regulation, i.e. it’s not that we changed something that had been right before. This includes financial derivatives, which were exempted from regulation when similar markets were regulated in the late 1990s. I make the distinction because I am concerned that some wish to scapegoat certain measures that actually proved very beneficial, e.g. Gramm-Leach-Bliley.

    I don’t want to say that we don’t need better regulation and in some cases more regulation. Some past decisions not to regulate have also been problematic.

  7. What do we really expect? Congress gave Paulson authority the authority to do as he decides is important. Congress has failed us again just like they did during the run up to war. As usual they are PASSING THE BUCK.

  8. DCLawyer: I agree with you. See the testimony by Albert Lo that I linked to in a recent post. Deregulation, meaning the dismantling of existing regulation, has probably been less of a factor than the failure of regulation to keep up with change in the financial system – notably new types of products and new ways of moving exposures off your balance sheet.

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