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.