17
NEVER AGAIN: LEGACIES OF THE CRISIS
History doesn’t repeat itself, but it does rhyme.
—ATTRIBUTED TO MARK TWAIN
America has been through a lot since 2007, enough to keep heads spinning, to keep scowls on people’s faces, and to fill sixteen chapters of this book. But it isn’t over yet. This chapter marks the end of the book, not the end of the story. Our economy is still limping along, and Washington is still gridlocked, with a new Congress recently installed. Most of the long-awaited “exit” decisions remain in front of us. They will affect our future profoundly.
THE POLICY AGENDA
It’s the Economy, Stupid
A logical place to start is with the state of the national economy, which may be the worst legacy of the crisis. More than four years after Lehman Brothers went under, policy makers are still nursing a frail economy back to health. Having the national unemployment rate near 8 percent is a lot better than having it near 10 percent. But it is far from good. An unemployment rate more like 5 percent to 5.5 percent should be our goal; anything higher is unwarranted defeatism. The Federal Reserve seems to agree, having posted an official target range of 5.2 percent to 6 percent unemployment. But we are not getting there quickly.
The epic hawk-dove battle within the Federal Open Market Committee still rages. The Fed’s hawks seem more worried about the inflation we might get than about the high unemployment we still have. I’m rooting for the doves. Chairman Bernanke’s ammunition depot is no longer well stocked, but it is not quite empty, and he seems prepared to fire off more. That’s the good news.
Fiscal Policy and the Budget
The bad news is that fiscal policy looks paralyzed, both by the specter of trillion-dollar-plus budget deficits—themselves largely a legacy of the crisis—and by the partisan dysfunction in Congress. The 2012 election left essentially the same partisan split in Congress and did not, by itself, reduce the deficit by a single penny. We’ll see. But hope is not a policy—you must enact laws. America’s budget mess is starting to look Kafkaesque because the outline of a solution is so clear: We need modest fiscal stimulus today coupled with massive deficit reduction for the future. Some of that will take the form of higher taxes—sorry, Republicans. Most of it will be lower spending—sorry, Democrats.
If you view the world through sufficiently rose-colored glasses, you can perhaps see the two parties inching in that direction. But “inching” isn’t good enough. There is plenty of room for partisan bickering over the details, but we need to adopt the Nike solution—Just do it!—as soon as possible. The Simpson-Bowles plan points the way, and I imagine that some distant cousin of Simpson-Bowles will be adopted someday. Someday. But not today.
The Fed’s Bloated Balance Sheet
Meanwhile, the Federal Reserve is sitting with nearly $3 trillion worth of assets on its books, an uncomfortable legacy of its prodigious efforts to fight the financial crisis and shorten the Great Recession. Before the crisis, it had about $900 billion. The Fed wants to shrink its bloated balance sheet eventually. It also wants to normalize interest rates. Chairman Bernanke has sketched the central bank’s exit strategy, more or less telling us that the Fed will start raising interest rates well before its balance sheet has been whittled down to size. But they are watching and waiting for either a buoyant economy or signs of inflation before they head for the exits. Neither seems imminent.
The Ghost of Moral Hazard Past
One of the least desirable legacies of the emergency measures of 2008 and 2009 is the creation of moral hazard everywhere. Bailouts, rescues, guarantees, and the like succeeded in saving many investors, companies, and even some executives and traders from oblivion. The moral hazard ayatollahs notwithstanding, doing so was not a mistake. Had we stood firmly on the anti-moral–hazard high ground, our principles would have emerged unscathed but our economy would not have. Necessity mothered pragmatism.
But moral hazard is now an undesirable feature of the financial landscape. One important aspect of Never Again is convincing financial markets that the government will not rescue them from future mistakes. The game of “heads you win, tails the taxpayer loses” is not one we want to keep playing. But innocence has been lost—if, indeed, we ever had it. Investors have seen what the U.S. government did in a dire emergency. Should similar circumstances arise in the future, they’ll expect similar treatment.
In that respect, the moral hazard ayatollahs are right. We must convince markets that emergencies are one thing, normal times quite another. Dodd-Frank tries to do that, partly by insisting that dying financial institutions be laid to rest peacefully, not resuscitated at public expense. Remember the law’s key phrase: “Taxpayers shall bear no losses.” We’ll see how that works out in practice.
Festering Foreclosures
Perhaps the saddest legacy of the financial crisis is the tsunami of foreclosures that continues to wash over us. Many aspects of the crisis caught policy makers by surprise. This one did not. Waves of foreclosures were foreseen well in advance, but we didn’t stop them. One foreclosure-mitigation program after another failed, largely because we pinched pennies and made things far too complicated. In February 2012, the U.S. government and state attorneys general reached yet another “historic” settlement with the nation’s largest banks. This one was over the disgraceful number of legal and procedural irregularities in handling foreclosures. To get off the hook, the banks kicked in $26 billion to help underwater homeowners, which is a drop in the proverbial bucket. Even so, news reports in May 2012 revealed that many state governments were intercepting the money before it reached homeowners. Ironically, the biggest near-term effect of the settlement was to allow many foreclosures, previously bottled up by legal wrangling, to proceed. The overhang of foreclosures continues to weigh on our economy.
Is There a Mortgage in Your Future?
As journalist David Frum aptly put it, “The shapers of the American mortgage system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.” Now that system is gone, swept away by the crisis. Fannie Mae and Freddie Mac limp on as what amount to branches of the U.S. Treasury. No one wants to maintain that arrangement indefinitely. Re-creating a viable system of mortgage finance, one that is safer than the one we had, ranks high on the national agenda. After all, Americans still want to buy houses—and presumably not for cash. The housing market, which was moribund for years, finally seems to be showing some signs of life. Maybe this is a good time to turn some serious attention to reestablishing a mortgage system we can live with.
A New Rule Book for Finance
One final legacy of the financial catastrophe is the 2,319-page Dodd-Frank Act, which rewrote the financial regulatory rulebook. Implementing Dodd-Frank is a huge task that has barely begun. It needs to happen. As I have emphasized, first you write the laws, then you write detailed rules and regulations, then you watch what happens in practice—and make adjustments. The lawmaking phase ended in July 2010, although some Republicans still want to dismantle Dodd-Frank. The rulemaking phase is in progress, and it resembles trench warfare—with neither Dodd nor Frank around to defend it. The practical application phase is in its early stages. More than just the regulatory framework needs to change in the wake of the crisis, so does the way banks and other financial institutions do business. Let’s not forget that it was shameful business practices, coupled with regulatory neglect, that got us into this mess.
THE TEN FINANCIAL COMMANDMENTS
So, what are some of the key principles for finance going forward? According to an old joke, there are three secrets to designing a safe and sound financial system—the problem is that nobody knows what they are. Let me instead try to encapsulate the major financial lessons from the crisis into ten commandments for the future of finance.
1. Thou Shalt Remember That People Forget
Looking back, Tim Geithner attributed the crisis, in part, to collective amnesia: “There was no memory of extreme crisis, no memory of what can happen when a nation allows huge amounts of risk to build up.” Evidence of forgetting is all around us: in markets, in Congress, and in our nation’s vaunted financial institutions. Hyman Minsky, the renegade economist who argued against market efficiency, taught us, or rather should have taught us, that it is normal for speculative markets to go to extremes. That’s what they do. One key reason, according to Minsky, is that, unlike elephants, people forget. When the good times roll, investors expect them to roll indefinitely. But they don’t. And when bubbles burst, investors are always surprised. We should remember our Minsky: Markets and people forget.
2. Thou Shalt Not Rely on Self-Regulation
Self-regulation in financial markets is an oxymoron, maybe even a cruel deception. We need real regulation, zookeepers watching over the animals. Governments cannot and should not outsource this function to market discipline (another oxymoron) or to rating agencies, which are in business to make a profit. It’s the government’s job, and it needs to be done better. And while, yes, there is a danger of over-regulation, I’m not too worried about that now, given where we’ve just been. Generally speaking, Dodd-Frank reflects these attitudes pretty well, though we will surely discover flaws as time goes by.
3. Thou Shalt Honor Thy Shareholders
If you are a director of a public corporation, you should remember that corporate boards are supposed to understand and monitor the behavior of top executives—who are, in turn, employees of the company, not kings and queens—and to protect the interests of shareholders. Too often, directors were asleep at the wheel and did neither. Both their companies and the broader public suffered from the malign neglect. Board members need to pay more attention. We’ve tried to make them do so before—for example, with the Sarbanes-Oxley Act of 2002—but with only modest success. We need to keep trying.
4. Thou Shalt Elevate the Importance of Risk Management
It turns out that what you don’t know can hurt you. When heads of business lines are allowed to ride roughshod over risk managers, which is the traditional norm, companies wind up driven too much by greed and not enough by fear. Top executives, boards of directors, and—thanks to Dodd-Frank—regulators all share responsibility for ensuring that financial companies’ risk-management systems are up to snuff. Don’t trust, verify. Even JP Morgan Chase, long praised for its fine risk management, was caught off guard by London trading losses in 2012. Everyone has to do better.
5. Thou Shalt Use Less Leverage
Thomas Edison, who should know, said, “Genius is one percent inspiration, ninety-nine percent perspiration.” There is a lot less genius—and a lot more salesmanship—in the investment world than our overpaid Masters of the Universe would like you to believe. High returns are often illusory, the product of applying high leverage to ordinary investments. (Houses are a good example.) We learn in financial kindergarten that systematically higher returns come only from taking more risk. It’s a shame that so many people forget that lesson by the time they reach financial graduate school. Bingeing on leverage is a lot like bingeing on alcohol. Many new postcrisis regulations, not to mention the near-death experiences of many of our leading financial institutions, are now pushing us in the direction of lower leverage. We’ll see what happens as people forget.
6. Thou Shalt Keep It Simple, Stupid
Modern finance thrives on complexity; indeed, you might say that the central idea of financial engineering is complexity. But ask yourself whether all those fancy financial instruments actually do the economy any good. Or are they perhaps designed to enrich their designers? Economists are accustomed to thinking of innovation as unambiguously good; it raises standards of living. But is that always true in finance? Is it even usually true? I do not mean to imply that all financial innovations are harmful; as Paul Volcker pointed out, the ATM did a lot of good. So, most likely, did mutual funds, money market funds, and plain-vanilla mortgage pools. But who needed CDO-squared? What did those monstrosities contribute to the betterment of mankind? Of course, simplicity and complexity are in the eye of the beholder. They can’t be legislated, probably not even regulated. So we may have to rely on good judgment, transparency, and—here comes that phrase again—market discipline. If there is any.
7. Thou Shalt Standardize Derivatives and Trade Them on Organized Exchanges
Derivatives acquired a bad name in the crisis. Did I say acquired? Actually, they had a bad name long before. But not all derivatives are financial WMD. When derivatives are straightforward, transparent, well collateralized, traded in reasonably liquid markets by well-capitalized counterparties, and properly regulated, they can both hedge risks and reallocate remaining risks to those most willing to bear them—just as their proponents claim. But watch out for customized, opaque, over-the-counter (OTC) derivatives. Those are the dangerous ones, more likely to serve the interests of broker-dealers than those of customers. Dodd-Frank goes some way toward pushing derivatives into greater standardization and more exchange trading, but not nearly far enough. Industry pushback is fierce. They covet the highly profitable, customized, OTC stuff.
8. Thou Shalt Keep Things on the Balance Sheet
Some important financial activities, and even entire financial entities, were taken off banks’ balance sheets in order to avoid regulatory capital charges—that is, to boost leverage, contrary to the Fifth Financial Commandment. Sometimes there were other reasons, too. But, to paraphrase the old tune, when you fool the people you seek, you may fool yourself as well. The financial crisis exposed an embarrassing fact: Many CEOs were only dimly aware of all the SIVs, conduits, and other off-balance-sheet entities their companies had. Masters of the Universe? They weren’t even masters of their own companies. Dodd-Frank Section 165 specifies that “the computation of capital for purposes of meeting capital requirements shall take into account any off-balance-sheet activities of the company.” Good. It’s a step toward making off-balance-sheet entities safe, legal, and rare. Now let’s make it work.
9. Thou Shalt Fix Perverse Compensation Systems
Dysfunctional compensation systems create incentives for dysfunction. In particular, offering traders monumental rewards for investment success, but mere slaps on the wrist for failure, and offering mortgage brokers commissions based on volume, not on loan performance, invite them to take excessive risks. By which I mean more risk than shareholders—or, if the government stands behind the firm, taxpayers—want them to take. This commandment ought to be enforced by CEOs and corporate boards; but if they won’t do the job, we may need the heavy hand of government.
10. Thou Shalt Watch Out for Ordinary Consumer-Citizens
This last Financial Commandment comes pretty close to the eighth of the real Ten Commandments: Thou shalt not steal. We have long known that the meek won’t inherit their fair share of the earth if they are constantly being fleeced. We have also long known that morality needs enforcement. What we learned in the crisis is that failure to protect unsophisticated consumers from predatory financial practices can actually undermine the entire economy. That surprising lesson is one we shouldn’t forget. The new Consumer Financial Protection Bureau should help.
A SEVEN-STEP REHAB PROGRAM FOR POLICY MAKERS
Perhaps the supreme irony of the entire sorry episode is this: Free and innovative financial markets, inadequately regulated, almost sent us reeling into Great Depression 2.0. The federal government then swooped in to stop the bleeding and clean up the mess. Though far from flawless, its efforts succeeded amazingly well; the worst did not happen. Yet the body politic wound up mad as hell at the government. No one rushed to pin medals on the chests of Ben Bernanke, Hank Paulson, and Tim Geithner—and certainly not on Barack Obama, who has been branded both a socialist for intervening too much and a failure for doing too little. He prevailed in the November 2012 election, but his edge in the popular vote was hardly a vote of confidence.
The stunning combination of policy success and political failure may be the strangest legacy of the financial crisis, and it carries important lessons for the future. What should policy makers do differently the next time the music stops, even if the particular tune is quite different from what we had in 2007 and 2008? Here’s my Seven-Step Rehab Program for wayward (or exhausted) policy makers. They should take the prescribed course of treatment posthaste, before the nation has to do something big again.
Step 1: Don’t Try to Do Too Many Things at Once
America has a constitutional problem, a partisanship problem, and a bandwidth problem—all of which call for shorter, more focused policy agendas than the one President Obama pursued. The constitutional and bandwidth problems are incurable. The partisanship problem may be curable, but not anytime soon.
The Constitutional Problem
James Madison and his friends deliberately designed a small-government form of government. With all those checks and balances, it is hard for the federal government to get anything done. If you then augment Madison’s original design with rabid partisanship (which he knew about), the sixty-vote rule in the Senate (which is not in the Constitution), and other obstructionist tactics (mostly in the Senate), you have a generic recipe for extreme logjam. Logjams can be burst by applying enough political force. But it’s not easy. And it’s especially hard if you’re trying to burst through in multiple locations at once. That’s why I argued that President Obama should have “focused like a laser beam on the economy.”
The Partisanship Problem
The era of good feeling ended long ago. At least since Newt Gingrich’s days in the House of Representatives, if not before, American politics has become a blood sport. You don’t just oppose the other party’s policies, you try to “take out” their leaders—as Gingrich did to the Democratic Speaker of the House in 1989, and tried to do to Bill Clinton in 1998. When Gingrich was asked why House Republicans were trying to impeach Clinton over a sex scandal, his answer was remarkable: “Because we can.” That’s quite a reason. Similar thinking, I suppose, led Senate Minority Leader Mitch McConnell (R-KY) to declare in October 2010 that “the single most important thing we want to achieve is for President Obama to be a one-term president.” How about digging the U.S. economy out of the ditch? Or ending the war in Afghanistan? When partisanship runs that high, you’re lucky to accomplish one important thing, never mind twenty-five.
The Bandwidth Problem
Citizens are bombarded by information. Lost in information overload, they are highly vulnerable to deliberate distortions, even to outright lies. And with so many messages to absorb, or to filter out, we the people have limited capacity for deep dives into complicated public policy issues. This behavior is not irrational. After all, who believes that his vote, e-mail, or letter will change national policy? Judging by sound bites is much easier than keeping abreast of complicated issues. Sober policy messages have a hard time penetrating the din.
Step 2: Explain Yourself to the People
Getting anything done in American democracy is devilishly difficult unless the people are behind you. In parliamentary systems, the prime minister often can push anything he wants through the legislature. Britain, for example, is sometimes called a dictatorship interrupted by occasional elections. In our congressional system, by contrast, the president proposes and Congress disposes—often literally. But Congress follows the polling results. So if, in Geithner’s phrase, you lose the public, you may lose everything—including your policy initiatives and the next election.
The Obama administration should have trumpeted a consistent four-part message from the get-go:
1. Here is how we got into this mess.
2. This is what we propose to do to fix the problems.
3. We have a coherent plan, and here is why it makes sense.
4. This is going to take time, so please bear with us.
I will never understand why President Obama, who we thought was such a great communicator in 2008, failed to convey this message to the electorate time and time again. But his communication problem went well beyond economic policy. A frustrated New York Times columnist, Thomas Friedman, put it this way in 2012: “Barack Obama is a great orator, but he is the worst president I have ever seen when it comes to explaining his achievements, putting them in context, connecting with people on a gut level through repetition and thereby defining how the public views an issue.”
Step 3: Say It in Language That Ordinary People Can Understand
Very few people are policy wonks. If you speak wonk-talk, you will probably annoy more people than you enlighten. But Americans have horse sense. If you have a good case, and you make it clearly and concisely, you have a fighting chance of winning in the court of public opinion. Doing so may require the use of clever analogies, slogans, or gimmicks. It will almost certainly require metaphors, for people relate better to stories than to syllogisms. If you want to know what I mean, listen to any explanation by Bill Clinton. He’s the master.
Step 4: Repeat Steps 2 and 3
Do it over and over again. Especially when a message is complicated, you can never say it too many times. So repeat, repeat, repeat. President Obama, sadly, didn’t.
Step 5: Set Expectations Low
Easy problems are, well, easy to solve. It’s the hard ones that matter. Often the government can do little more than practice damage control. For example, once Lehman fell, there was nothing either the Bush or Obama administration could do to prevent a serious recession. Especially when your ability to control events is limited, you don’t want to overpromise. When in doubt, underpromise, for at least two reasons:
One is that progress will probably come slowly. Economic problems rarely disappear overnight. They dissipate slowly, like a dense fog. For a long while, the people will see little or no progress. The public needs to be conditioned to expect that, and not to look for quick fixes. Otherwise, their naturally short attention spans will dominate public discourse.
The other is that there is no political punishment for doing better than you indicated, but lots for doing worse, as Team Obama learned the hard way. Republicans latched on to the forecasting error made in late 2008 and used it to club the Democrats, even offering it as “proof” that fiscal stimulus failed, despite the fact that unemployment was over 8 percent even before the 2009 stimulus bill passed! Amazingly, that same overoptimistic forecast was still used against President Obama and his policies four years later during the 2012 election. Unemployment did go above 8 percent, didn’t it?
Step 6: Pay Close Attention to People’s Attitudes, Prejudices, and Misconceptions
In politics, as in retailing, the customer is always right. They aren’t, really, but a wise retailer treats them that way. So should a wise politician. This is one reason careful explanations are so critical. (See Step 2.) People’s basic attitudes are hard to change. Try, for example, to convince a true conservative that redistribution of income from rich to poor is good for society. (I have; it doesn’t work.) But misconceptions can sometimes be overcome by facts—provided the facts are simple, credible, and believed. It’s not easy, but it’s possible—at least for some of the people some of the time. And did I mention Step 4? Say it over and over again.
Step 7: Pay Rapt Attention to Fairness
There is a difference between close attention and rapt attention. People’s sense of fairness demands and deserves the higher-order, drop-everything kind. Because fairness normally matters more than anything else, it should be an obsession with policy makers. If people feel they are being treated fairly, they may go the extra mile with you. Or at least support you in spirit. But if they feel they are being screwed—as they certainly did during the financial crisis, and with good reason—you’ll almost certainly lose them, even if you follow Steps 1 through 6 assiduously.
Citizens who feel alienated or mistreated may adopt a “plague on all your houses” attitude, venting their anger indiscriminately at the president, Congress, Democrats, Republicans, the lot—and throw in the Federal Reserve for good measure. Just say no may become their answer to everything. Which is not good for policy debates, for policy outcomes, or for our nation’s politics. But it seems to encapsulate what happened after the crisis.
RAHM EMANUEL’S QUESTION
I close more or less where I began, with a question derived from the Emanuel Principle: Did we waste the financial crisis or use it well? Nations, like people, learn from their experiences. Or do they? Hegel famously wrote, “What experience and history teaches us is that people and governments have never learned anything from history.” But I think they do learn. It’s just that they forget, often quickly. (Remember the First Financial Commandment.)
The experience in the United States in the years since the bubbles burst has been tremendously costly; the heavy price we paid was certainly too high for whatever we learned. But we did learn something. And we need to remember those lessons the next time big financial ructions strike. Sadly, the forgetting has already begun. Unrepentant financiers, eager to return to the status quo ante, are whining about excessive regulation. Recalcitrant politicians are bemoaning big government and itching to return to laissez-faire. The public has turned its attention elsewhere.
But there’s still work ahead. Bubbles will be back. So will high leverage, sloppy risk management, shady business practices, and lax regulation. We need to put in place durable institutional changes that will at least make financial disruptions less damaging the next time the music stops. History really does rhyme. We need to pick up the meter.