In the 1990s, the Clinton Administration amassed a great deal of experience fighting financial crises around the world.
Some of the U.S. Treasury’s specific advice was controversial – e.g., pressing Korea to open its capital markets to foreign investors at the height of the crisis – but the broad approach made sense: Fix failing financial systems up-front, because this is the best opportunity to address the underlying problems that helped produce the crisis (e.g., banks taking excessive risks). If you delay attempts to reform until economic recovery is underway, the banks and other key players are powerful again, real change is harder, and future difficulties await.
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: http://www.jstor.org/pss/117183)
Now, of course, Summers heads the White House National Economic Council and is the Obama administration’s economic guru-in-chief. He is surrounded by experienced staffers from the 1990s, including Tim Geithner (then Assistant Secretary at Treasury, heavily involved in the details of the Asian financial crisis; now Treasury Secretary) and David Lipton (then Undersecretary for International Affairs; now at the National Economic Council and National Security Council). (Paul Blustein’s The Chastening is the best available account of the personalities and policies in the 1997-98 “emerging market” crises.)
If we look back over the past 12 months, has this crack team of crisis fighters applied what they learned from the 1990s?
They pushed early and hard for a fiscal stimulus – and this has played the same role in stabilizing spending in the US economy as properly scaled IMF lending does for weaker economies. At this level, the Summers group drew sensible lessons from the experience of the 1990s – listening finally Joe Stiglitz (then chief economist at the World Bank and now at Columbia), who stressed the importance of easing fiscal policy in the face of a financial crisis.
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, i.e., providing money to troubled financial institutions with no strings attached – at one point deriding Madeleine Albright, then Secretary of State, for proposing such an approach to Korea (Blustein, p. 138). The Treasury philosophy was clear and tough: “a healthy financial system cannot be built on the expectation of bailouts” (Summers, 2000, p.13).
No modern economy can function without a financial system, so some form of rescue that restored confidence in our banks was necessary – just as it was in Thailand, Indonesia, and Korea in 1997. But in any rescue, the governments with deep pockets (i.e., the economic strategists deciding how to deploy US fiscal resources now and in the 1990s) choose the strings to attach – and the approach adopted for the U.S. has been one of the least conditional and softest ever on troubled banks.
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, both in absolute terms and relative to the economy. In 2007 the combined balance sheets of these entities were just under 60 percent of Gross Domestic Product, while through the 3rd quarter of this year they stood at 63.5 percent of GDP (source: 13 Bankers, forthcoming 2010).
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.
By Simon Johnson
An edited version appeared this morning on NYT’s Economix; it is used here with permission. If you would like to republish the entire post, please contact the New York Times.