Causes and Consequences of the Financial Crisis of 2007 to 2009

8/3/2019 Causes and Consequences of the Financial Crisis of 2007 to 2009

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CAUSESANDCONSEQUENCESOFTHEFINANCIALCRISISOF20072009

WILLIAMPOOLE*

Bytheearlyfallof2009,thebusinesscontractionthatbeganinDecember2007appearedtobeending,1buttheoutlook,remainedhazy.Despiteanumberofgreenshoots,asFederalReserveChairmanBenBernankelikedtoputit,2thedatawerenotdecisiveenoughtodeclaretheendofthecontraction.Employmentwasstill falling throughSeptember2009.3Although

inOctober

2009

it

certainly

seemed

that

the

economy

was

near

thebottom, itwasnot safe to say that thecrisiswashistory.4Nevertheless,much isalreadyknownabout thecausesof thefinancial crisis and government responses to it, permitting amuch more than speculative review. David Wessel has providedasuperbblowbyblowaccountofeventsduringthecrisis;5 there is no point in repeating that account here.Nevertheless,abriefchronologyof thephasesof the financialcrisisshouldhelptoorganizethediscussion.

*Senior

Fellow,

Cato

Institute;

Distinguished

Scholar

in

Residence,

University

of

Delaware.Attitudestowardthecrisisare, inevitably,shapedby theperspectiveoftheobserver.MyownperspectiveisthatofaChicagoschooleconomistwithstronglibertarianleanings.Myperspectiveisalsoshapedbymytenyears(March1998toMarch2008)aspresidentandCEOoftheFederalReserveBankofSt.Louis.

1.NATL BUREAU OF ECON. RESEARCH, DETERMINATION OF THE DECEMBER 2007PEAK INECONOMICACTIVITY(2008);BD.OFGOVERNORSOFTHEFED.RESERVESYS.,SUMMARY OF COMMENTARY ON CURRENT ECONOMIC CONDITIONS BY FEDERALRESERVEDISTRICT,OCTOBER2009,ativi(2009)[hereinafterCURRENTCONDITIONS].

2.ShobhanaChandra&MatthewBenjamin,BernankeGreenShootsMaySignalFalseSpringAmidJobLosses, BLOOMBERG.COM, Apr. 6, 2009, http://www.bloomberg.com/apps/news?pid=20601103&sid=aJa8WNMvKaxg.

3.SeePressRelease,BureauofLaborStatistics,U.S.DeptofLabor,TheEmploymentSituationFebruary2010,at1(Mar.5,2010),availableathttp://www.bls.gov/news.release/pdf/empsit.pdf.

4.

See

CURRENT

CONDITIONS,

supra

note

1,

at

i.

5.DAVID WESSEL, IN FED WE TRUST: BEN BERNANKES WAR ON THE GREATPANIC(2009).


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422 HarvardJournalofLaw&PublicPolicy [Vol.33

I. CHRONOLOGYOFTHEFINANCIALCRISISThecrisisbrokeinmidAugust2007,whenthemarketsuddenly

cutoff

funding

to

several

financial

entities.

6

The

Federal

Reserves

initial response inAugustwas to reduce thediscount ratetheinterestratetheFedchargesonloanstobanksinthehopethatbankscouldprovidefundstofirmscutoffbythemarket.7

InmidSeptember2007,theFedbegantocutitsmainpolicyinterestrate,thefederalfundsrate.Theratehadstoodat5.25%fromJune2006throughAugust2007.8AlthoughtheFedordinarilychanges its fed fundsratetarget instepsoftwentyfivebasispoints,thefirstreductioninSeptemberwasbyfiftybasispoints.9As financial strainsgrew and the economygraduallyweakened, the Fed continued to reduce its fed funds targetrate,reaching3%inlateJanuary2008.10

Inmid

March

2008,

financial

strains

intensified

as

the

market

cutoff funding toBearStearns,a largeNewYork investmentbank.11 To prevent Bear Stearns from failing, the Federal Reserveprovidedanemergencyloanandassumedthecreditriskon some Bear Stearns assets, which persuaded JP MorganChase tobuyBearStearns.12A fewdays later,theFederalReserve cut its federal funds rate target by seventyfive basispoints,down to2.25%.13TheBearStearnsbailoutmarked theendofthefirstphaseofthefinancialcrisis.

6.CONG. RESEARCH SERV., FINANCIAL CRISIS? THE LIQUIDITY CRUNCH OFAUGUST2007,at9(2007).

7.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.,FederalReserveBoardDiscount Rate Action (Aug. 17, 2007), available at http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm.

8.Fed.ReserveBankofN.Y.,HistoricalChangesof theTargetFederalFundsandDiscount Rates, http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html(lastvisitedMar.24,2010).

9.Id.10.Id.11.TurmoilinU.S.CreditMarkets:ExaminingtheRecentActionsofFederalFinancial

Regulators:HearingBefore theS.Comm. onBanking,Hous.&UrbanAffairs, 110thCong. (2008) (statementofBenS.Bernanke,Chairman,Bd.ofGovernorsof theFed.ReserveSys.).

12.

Minutes

of

the

Bd.

of

Governors

of

the

Fed.

Reserve

Sys.

(Mar.

16,

2008),

avail

ableathttp://www.federalreserve.gov/newsevents/press/other/other20080627a2.pdf.13.Fed.ReserveBankofN.Y.,supranote8.


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No.2] CausesandConsequences 423

InApril,theFedlowereditsfundsratetargetanothernotchto2%,whichithelduntilSeptember.14Duringthissecondphaseofthe crisis, the economy was drifting downward,but not at an

alarmingpace.

This

phase

ended

with

the

Lehman

crisis.

The

FeddidnotbailoutLehmanBrothers,aninvestmentbanktwicethe size of Bear Stearns, and Lehman declaredbankruptcy onSeptember 15.15 Lehmans collapse marked the beginning ofphasethreeofthecrisis,whenmarketstrainswentfromserioustocalamitous.TheFedbailedoutAmericanInternationalGroup(AIG),ahugeinsurancecompany,thedayafterLehmanfailed.16InOctober2008,theFedcutitstargetfundsrateintwostepsto1%andfurthertonearzeroinDecember.17

TheflighttosafetywassointensethatinNovemberandDecember2008themarketbidtheyieldonTreasurybillsliterallyto zero on some days.18 Credit strains were severe and eco

nomicactivity

declined

sharply.

There

is

no

particular

date

or

event to mark the end of phase three of the crisis; marketsgradually improved and the economy transitioned to phasefour,inwhichcreditconditionsbecamemoresettledandcreditbegantoflowagain.

The financial crisis was worldwide, with EuropeanbanksandmarketsasseverelyaffectedasthoseintheUnitedStates.19AsianbankswerestrongerthanU.S.andEuropeanbanks,butAsiacouldnotescapetheeffectsofthecrisis.20Outputandemploymentfellaroundtheworld.

14.Id.

15.PressRelease,LehmanBrothers,LehmanBrothersHoldingsInc.AnnouncesIt Intends to File Chapter 11 Bankruptcy Petition (Sept. 15, 2008), available athttp://www.lehman.com/press/pdf_2008/091508_lbhi_chapter11_announce.pdf.

16.Press Release, Bd. of Governors of the Fed. Reserve Sys., Federal ReserveBoard,withfullsupportof theTreasuryDepartment,authorizes theFederalReserve Bank ofNew York to lend up to $85billion to the American InternationalGroup(AIG)(Sept.16,2008),availableathttp://www.federalreserve.gov/newsevents/press/other/20080916a.htm.

17.Fed.ReserveBankofN.Y.,supranote8.

18.JohnWaggoner,Investorsrushtoearnnothing:4weekTbillssell likehotcakesat0%interest,USATODAY,Dec.10,2008,at1B.

19.OutputSlumpsAcrossEurope,EURONEWS,Oct.12,2008,http://www.euronews.net/ 2008/12/10/outputslumpsacrosseurope/.

20.BenS.Bernanke,Chairman,Bd.ofGovernorsof theFed.ReserveSys.,Ad

dressat

the

Federal

Reserve

Bank

of

San

Franciscos

Conference

on

Asia

and

the

GlobalFinancialCrisis:AsiaandtheGlobalFinancialCrisis(Oct.19,2009),availableathttp://www.federalreserve.gov/newsevents/speech/bernanke20091019a.htm.


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II. CONDITIONSLEADINGTOTHECRISIS21Afterthestockmarketpeakin2000andtoresistthe2001re

cession,the

Fed

reduced

its

target

federal

funds

rate

in

steps,

eventually reaching 1% in 2003.22With interest rates low andmemoriesofthedotcomstockcrashfresh, investorssearchedfor higher yielding investments. They thought that they hadfound the perfect vehicle in collateralized debt obligations(CDOs)backedbysubprimemortgages.TheCDOswerestructuredobligations,withseveraltranchesofdifferingriskcharacteristics. The senior tranche had first claim on the mortgageinterestandprincipalpaidby the subprimemortgages in themortgage poolbacking each CDO issue. The senior trancheswereratedtripleAbytheratingagencies.23

As the decade proceeded, underwriting standards for sub

primemortgages

deteriorated.

Mortgage

brokers,

who

origi

nated the subprime mortgages, lent to households withoutadequate incomeorassets to service the mortgages.24 Incomeand assetdocumentationwas weak or nonexistent.25 Some ofthe mortgageborrowerswere investors anticipating quick resaleofthepropertiestheypurchasedtheflippers.26Nevertheless, the market was so hungry for yield that investmentbanks found that they could easily package subprime mortgages intoCDOsandpeddle them to investors.Toomany investors, unfortunately, took the tripleA ratings at face valueandloadedtheirportfolioswiththeCDOs.

Citigroupisagood,butbynomeansunique,example.Citihad

formed

structured

investment

vehicles

(SIVs)

as

off

balance

sheet

entities to hold CDOs.27 Because mortgages return principalgradually over a period of years, these CDOs were inherentlylongtermassets for theSIVs.TheSIVs financed theirpurchases

21.Foramorecompletetreatment,seeWilliamPoole,TheCreditCrunchof200708:LessonsPrivateandPublic,44BUS.ECON.38(2009).

22.Fed.ReserveBankofN.Y.,supranote8.

23.RogerLowenstein,TripleAFailure,N.Y.TIMES,Apr.27,2008(Magazine),at36.24.KurtEggert,TheGreatCollapse:HowSecuritizationCausedtheSubprimeMelt

down,41CONN.L.REV.1257,1276(2009).

25.Id.at128182.

26.

Id.

at

128889.

27.ArthurE.Wilmarth,Jr.,TheDarkSideofUniversalBanking:FinancialConglomeratesandtheOriginsoftheSubprimeFinancialCrisis,41CONN.L.REV.963,1033(2009).


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mostly withborrowed funds, not equity.28 Moreover, theborrowed funds were often in the form of shortmaturity, assetbackedcommercialpaper.29Commercialpaperissimplyacorpo

rateIOU,

and

the

asset

backing

for

each

commercial

paper

issue

wasapackageofCDOs.Thecommercialpaperwasshort term,withmaturitiesofthirtydays,sixtydays,orevenovernight.

When the financialcrisisbroke inAugust2007,commercialpaper investors no longer rolled over their maturing paper.30Theydemanded tobepaid incash instead. In thecaseof theCitigroupSIVs,CiticouldhavelettheSIVsdefault,butinsteadbrought the assets onto itsownbalance sheetand repaid thematuring commercial paper.31 Doing so put great strain onCitigroupitself.

Thefederalgovernmentencouragedgrowthofthesubprimemortgage market in an attempt to increase the percentage of

familiesowning

their

own

homes.32

Congress

and

the

Bush

Administration pushed the giant mortgage intermediaries,Fannie Mae and Freddie Mac, to accumulate subprime mortgages.33Previously,FannieandFreddiehaddealtonlyinprimemortgageswithamaximum loantovalue ratioofeightypercent.34 The mainbusiness of these governmentsponsored enterprises (GSEs) was to securitize prime mortgages intomortgagebacked securities, someofwhich they sold into themarket and some ofwhich theyheld in their ownportfolios.Other federal policies also encouraged home ownership andgrowthofthemortgagemarket.

House construction led the way to faster economic growth

afterthe

2001

recession.35

Federal

policies

that

encouraged

28.Id.

29.Id.30.Id.31.Id.; see also INTL MONETARY FUND, GLOBAL FINANCIAL STABILITY REPORT:

CONTAINING SYSTEMIC RISKS AND RESTORING FINANCIAL SOUNDNESS 72 (2008)(explaininghowconsolidationofSIVsimpactsacompanysbalancesheet).

32.RussellRoberts,HowGovernmentStokedtheMania,WALLST.J.,Oct.3,2008,atA21.33.Id.34.U.S. GOVT ACCOUNTABILITY OFFICE, FANNIE MAE AND FREDDIE MAC:

ANALYSIS OF OPTIONS FOR REVISING THE HOUSING ENTERPRISES LONGTERM

STRUCTURES

2

n.7

(2009).

35.LawrenceH.White,FederalReservePolicyandtheHousingBubble,29CATOJ.115,119(2009).


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housingandanincreaseinhousepricesfedtheboom.36Mortgages,bothprimeandsubprime,appearedtobereasonablysafeinvestmentsbecause aborrower in distress could refinance or

sellthe

property

for

enough

to

repay

the

mortgage.

As

house

prices leveledoff in2006,andadjustableratemortgages takenoutinthelowinterestrateenvironmentof20032004begantoadjustup, themusic stopped.37Defaultsbegan to rise,and inmid2007,somefirmshadtroublefinancingtheirpositions.38

Analystscontinuetoargueabouthowmuchresponsibilityforthefinancialcrisisbelongstothefederalgovernment.Myviewis that the federalgovernment was a supporting actorbut theresponsibility rests primarily with theprivate sector. The governmentdidnotmakeorevendirectlyencourageBearStearnsto sponsor hedge funds investing in subprime CDOshedgefundsthatcollapsed inJuly2007.Citigroupwasnotcompelled

toform

its

SIVs

holding

subprime

assets.

It

did

so

in

part

to

take

assetsoffitsbalancesheettoescapebankcapitalrequirements.NordoIfaultlaxregulation.Thefundamentalproblemwas

a failure of economic analysis inboth the private sector andamongregulatoryagencies.Neithermarketparticipantsnorfederal agencies thought that a significant decline in the nationalaverageofhousepricescouldoccur.The failure tounderstandfullytherisksofsubprimemortgagesandtoforeseethedeclineinhousepricesmightbeanhonestmistakeofportfoliomanagersand federalauthoritiesalike.Buildingportfolioswith riskylongmaturityassetsfinancedwithlittleequitycapitalandshortmaturityliabilities,however,isaninexcusablemistake.Thefed

eralgovernment

pursued

policies

to

encourage

home

owner

ship, but that fact cannot justify the portfolio policies thatcrashed. The privatesector managers of firms thatbuilt suchportfoliosbeartheresponsibilityforbuildinghousesofcards.

36.Roberts,supranote32.37.SeePressRelease,S&PIndices,HomePricesContinuetoSendMixedMessages

as2009ComestoaCloseAccordingtotheS&P/CaseShillerHomePriceIndices(Feb.23,2010)(showingagraphdepictingthefallinhousingpricesin2006).

38.RandallS.Kroszner,Governor,Bd.ofGovernorsof theFed.ReserveSys.,

Addressat

the

Consumer

Bankers

Association

2007

Fair

Lending

Conference:

The

Challenges Facing Subprime Mortgage Borrowers (Nov. 5, 2007), available athttp://www.federalreserve.gov/newsevents/speech/kroszner20071105a.htm.


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III. THEFEDERALGOVERNMENTSMANAGEMENTOFTHECRISIS

Althoughthe

National

Bureau

of

Economic

Research

did

not

of

ficiallyidentifythecyclepeakinDecember2007untilayearlater,39afterAugust2007thefinancialstresswasobvious,asweresignsofaweakeninginthegeneraleconomy.TheFederalReservewasthefirstrespondertothecrisis;fiscalpolicyresponsescamelater.

Tounderstand theFedsmanagementof thecrisis, it is importanttodistinguishmonetarypolicyfromcreditpolicy.Monetarypolicyinvolvescentralbankcontroloverinterestratesandtheaggregatequantityofcentralbankfundsinthesystem.TheFedsmainmonetarypolicy instrument is the federal funds interestrate,whichistherateonovernightloansbetweenbanks.Traditionally,theFedcontrolsthisratethroughpurchasesand

salesof

government

securities

in

the

open

market.

Credit policy refers to the centralbanks efforts to providefunds toparticularborrowersorborrowing sectors.From thebeginning,theFedhadacreditorientedviewastohowtorespondtothecrisis.ItsfirstpolicyactioninAugust2007,asthecrisisbegan,wasnot toreduce its fed funds targetratebut instead to lower the discount rate, which is the rate the Fedchargeson its loans tobanks.40Thediscountratehad forsomeyearsbeenonehundredbasispointsabovethefedfundstargetrate,buttheFedcutthemargintofiftybasispointsonAugust17,2007.41Predictably,thatactionhad littleeffectbecausemostbankswerestillabletoborrowreadily inthemarketatthefed

funds

rate,

which

was

fifty

basis

points

cheaper.

ManyintheFedthoughtthatstigmaexplainedwhybanksusedthediscountwindowsosparingly.42Banks,theythought,wereunwilling toborrow from thewindowbecausedoingsowould be a sign to the market of financial weakness, eventhough theFedmaintained the confidentialityof theborrow

39.SeeNATLBUREAUOFECON.RESEARCH,supranote1.40.SeePressRelease,Bd.ofGovernorsoftheFed.ReserveSys.,supranote7.41.Fed.ReserveBankofN.Y.,supranote8.

42.Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys.,

Addressat

the

Federal

Reserve

Bank

of

Richmond

2009

Credit

Markets

Sympo

sium: The Federal Reserves Balance Sheet (Apr. 3, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090403a.htm.


8/21


ing.43TheFedsearched foranothermechanism to injectmorefundsintothebankingsystemandinDecember2007launchedtheTermAuctionFacility,orTAF.44TheTAFwasatypeofdis

countwindow

borrowing

in

which

the

Fed

auctioned

off

blocksoffundstothehighestbidders.45TheTAFdidnot,however,solvethebasicproblemthatthe

banks andbank credit markets faced. As the crisis deepened,mostbankswerereportinglargelosses;discountwindowlending,includingthatthroughtheTAF,wascollateralized.46Banksretainedthecreditriskonthecollateral.AtthetimeoftheLehmanfailureinmidSeptember2008,TAFcreditoutstandingwas$150billion,butavailabilityofTAFfundsdidnothingtomakebanks more willing to lend to Lehman or other riskyborrowers.47Thus,theTAFdidlittletoimprovebankcreditavailability.

NordidtheTAFdomuchtobringdownbanklendingratesto

creditworthyborrowers.

A

bank

borrowing

from

the

Fed,

even

at

theattractiveTAFauctionrate,couldchooseeithertomakenewloanswith the fundsor to let itsother liabilities,suchascertificatesofdeposit(CDs),runoff.Thus,themarginalcostofmakinganewcommercialloanwasstilltheCDrateandnottheTAFauction rate. Essentially, TAF provided a modest increase inbankearningsbecausetheTAFborrowingratewasbelowabankscostoffundsfromothersources,suchasfromissuingCDs.TheTAFdidnotsolvetheassetliabilitydurationmismatchproblembanksfaced. Banks held substantial longerterm loans financed withshorterterm funds.Even theninetydayTAF fundsdidnotaddressthisproblem.Atbest,theTAFwasastopgapmeasurethat

didnot

address

the

fundamentals

of

the

financial

crisis.

As TAF funds outstanding grew, and as the Fed inventedotherspecialfacilitiestoeasecreditstrainsinparticularsectorsof themarket, theFeddidnot increase the total funds itmade

43.Id.44.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.,FederalReserveand

other centralbanks announce measures designed to address elevated pressures inshorttermfundingmarkets(Dec.12,2007),availableathttp://www.federalreserve.gov/newsevents/press/monetary/20071212a.htm.

45.Id.46.Id.

47.Press Release, Bd. of Governors of the Fed. Reserve Sys., Federal Reserve

andother

central

banks

announce

further

coordinated

actions

to

expand

signifi

cantly the capacity to provide U.S. dollar liquidity (Sept. 29, 2008), available athttp://www.federalreserve.gov/newsevents/press/monetary/20080929a.htm.


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availabletothemarket.JustbeforetheLehmanfailure,totalreservebankcreditwasonly3.6%abovethefigureayearearlier,whichdidnotevidenceanexpansionarymonetarypolicy.48The

Fedhad

reduced

its

fed

funds

target

rate,

but

the

reductions

hadbarelykeptpacewiththedeclineinthedemandforfundsinthemarket.Althoughtotalreservebankcredithadgrownby$30billion over the fiftytwo weeks prior to midSeptember2008,theFedsholdingsofgovernmentsecuritieshaddeclinedby$300billion.49Duringthisphaseofthecrisis,theFed ineffectfinancedtheBearStearnsbailout,theTAF,andotherspecial credit facilities by selling government securities from itsportfolio.50Theeasiercreditpolicywasnotreinforcedbyanincreaseintheaggregatesupplyoffundstothemarket.

WhethertheFedshouldhavepursuedamoreexpansionarymonetary policybefore Lehmans collapse is not clear. In the

summerof

2008,

employment

was

not

in

afreefall

and

the

enormousincreaseinenergypricestoapeakinJulyraisedvalidinflationconcerns.51FedmonetarypolicychangeddramaticallyaftertheLehmanfailureandthebailoutofAIG.AfterLehman,theFedfinancednewcreditextensionsbyprintingnewmoney.The Fed held its government securities portfolio roughly constantandallowedtotalreservebankcredittoexplodefrom$888billionjustbeforeLehmanto$2.25trillion52attheendof2008.53Termauctioncreditroseto$450billion,andseveralothercreditprogramswereexpandedornewlyinvented.54

48.See BD. OF GOVERNORS OF THE FED. RESERVE SYS., FEDERAL RESERVE

STATISTICALRELEASE

H.4.1FACTORSAFFECTINGRESERVEBALANCESOFDEPOSITORYINSTITUTIONSANDCONDITIONSTATEMENTOFFEDERALRESERVEBANKS,SEPTEMBER11,2008(2008).

49.Id.50.Seeid.51.SeePressRelease,BureauofLaborStatistics, supranote3;seealsoTheSemi

annualMonetary Policy Report to the Congress:Hearing Before the S. Comm. onBanking,Hous.&UrbanAffairs, 110th Cong. (2008) (statement of Ben S. Bernanke,Chairman,Bd.ofGovernorsoftheFed.ReserveSys.).

52.ThisfigureisbasedontheweeklyaveragefortheweekendingDecember31.53.BD. OF GOVERNORS OF THE FED. RESERVE SYS., FEDERAL RESERVE STATISTICAL

RELEASEH.4.1FACTORSAFFECTINGRESERVEBALANCESOFDEPOSITORY INSTITUTIONSANDCONDITIONSTATEMENTOFFEDERALRESERVEBANKS,DECEMBER29,2008(2008);BD.OFGOVERNORSOFTHEFED.RESERVESYS.,FEDERALRESERVESTATISTICALRELEASEH.4.1 FACTORS AFFECTING RESERVE BALANCES OF DEPOSITORY INSTITUTIONS AND

CONDITION

STATEMENT

OF

FEDERAL

RESERVE

BANKS,

SEPTEMBER

4,

2008

(2008).

54.FED.RESERVEBANKOFN.Y.,DOMESTICOPENMARKETOPERATIONSDURING2008,at24(2009).


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The initial fiscal policy response to the crisis was the EconomicStimulusActof2008,55enactedinFebruary,whichprovided tax rebates andbusiness tax deductions to counter the

recessionthat

many

thought

might

have

begun.56

The

Congres

sional Budget Office (CBO) estimated that the legislationwouldincreasethefederaldeficitby$152billionin2008.57Thedeficit is an imperfect measure of the impact of fiscal policy,butforpresentpurposeswillserveasausefulmeasureofthesizeofthefiscalresponse.TheCBOconcludedthatthelegislationmadeamodestcontribution,raisingconsumptionin2008,but that the impact on overall economic activity disappearedbytheendofthatyear.58Thus,thisstimulusbillmadenolastingcontributiontoeconomicstability.

InFebruary2009,thenewObamaAdministrationpassedtheAmericanRecoveryandReinvestmentActof2009.59Thisfiscal

packagewas

much

larger

than

the

one

passed

ayear

earlier.

TheCBOestimated the impacton thebudgetdeficit tobeanincrease of $185billion in fiscal 2009, of $399billion in fiscal2010,andatotalof$787billionoverthetenyearbudgethorizon of 2009 to 2019.60 Economists will argue about the effectivenessofthislegislationforyearstocome.

Boththe2008and2009stimulusbillswereattemptstotemper thegeneraleconomicdownturn.Other fiscalactionsweremoredirectlyaimedat the financialcrisis. InJuly2008,at theurgingofTreasurySecretaryHenryPaulson,CongressgrantedtheTreasuryauthoritytoprovidefinancialassistancetoFannieMaeandFreddieMac.61Atthetime, thesetwonominallypri

vatefirms

had

more

total

obligations,

on

and

off

balance

sheet,

thanthepublicallyheldTreasurydebt.Theywerebroughtinto

55.Pub.L.No.110185,122Stat.613.56.Id.101103.57.CONG.BUDGETOFFICE,COSTESTIMATE:H.R.5140,ECONOMICSTIMULUSACT

OF2008,at12(2008).58.CONG.BUDGETOFFICE,DIDTHE2008TAXREBATESSTIMULATESHORTTERM

GROWTH?1(2009).59.Pub.L.No.1115,123Stat.115.60.SeeLetterfromDouglasW.Elmendorf,Dir.,Cong.BudgetOffice,toCharles

E.

Grassley,

Ranking

Member,

Comm.

on

Fin.,

U.S.

Senate

(Mar.

2,

2009).

61.JeanneSahadi,SenatePassesLandmarkHousingBill,CNNMONEY.COM,July26,2008,http://money.cnn.com/2008/07/26/news/economy/housing_bill_Senate/index.htm.


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federal conservatorship uneventfully in early September,beforearunonthemcouldcreateapanicinthemarkets.62

The Troubled Asset Relief Program63 (TARP) was designed

todeal

directly

with

the

so

called

toxic

subprime

mortgage

assets on banks books. The turmoil following the LehmanbankruptcywassogreatthattheTreasuryandtheFederalReserveagreedthatitwasnecessarytoattackthetoxicassetproblemdirectly.64Afterconsiderablepoliticalwrangling,Congresspassedthe$700billionTARPbill.TheoriginalTreasuryobjectivewithTARPwas tobuy toxicassets frombanks.The ideawassubjecttoafatalflawthatshouldhavebeenobvioustotheTreasuryfromthestart:WhatpricewouldtheTreasurypayfortoxic assets? If the Treasury paid what the assets were trulyworth, the program would not serve to assist thebanks; ifTreasuryoverpaid, the resultwouldbea taxpayergift to the

banks.After

batting

around

several

ideas,

the

Treasury

aban

donedtheideaofbuyingtoxicassets.65Instead, theTreasury usedTARP funds to strengthenbank

capital through purchases of senior preferred stock in thebanks.66 Inessence, theTreasury tooka semiownershipposition inbankswithoutdiluting common shareholders.Bybolstering bank capital, the Treasury enabled banks to resumelending to the private sector, or at least reduced pressure onbankstocontracttheirlending.ByJune2009,Treasurycapitalpurchases totaled $199billion, of which $70billion hadbeenrepaid.A totalof 591 institutions were involved. Inaddition,TARP fundswereused foravarietyofother loans, including

$55billion

in

assistance

to

automobile

firms.

67

62.CONG.RESEARCHSERV.,FANNIEMAEANDFREDDIEMACINCONSERVATORSHIP1(2008),availableathttp://fpc.state.gov/documents/organization/110097.pdf.

63.EmergencyEconomicStabilizationActof2009,Pub.L.No.110343,122Stat.3765.64.Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys.,

AddressattheNationalAssociationforBusinessEconomics50thAnnualMeeting:CurrentEconomicandFinancialConditions(Oct.7,2008),availableathttp://www.federalreserve.gov/newsevents/speech/bernanke20081007a.htm.

65.HenryM.Paulson,Jr.,Secretary,U.S.DeptoftheTreasury,RemarksonFinancial Rescue Package and Economic Update (Nov. 12, 2008), available athttp://www.financialstability.gov/latest/hp1265.html.

66.

CONG.

BUDGET

OFFICE,

THE

TROUBLED

ASSET

RELIEF

PROGRAM:

REPORT

ON

TRANSACTIONSTHROUGHJUNE17,2009,at2(2009).67.Id.


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IV. EVALUATIONOFTHEGOVERNMENTSRESPONSETOTHEFINANCIALCRISIS

TheTreasury

and

the

Federal

Reserve

were

slow

to

recog

nizethat theproblemwasmuchmorethan liquidity.Marketswerecuttingofffundingtobanksandotherfinancialfirmsbecauseinvestorsfearedthatthefirmsmightbeinsolvent.Thosefears werejustified. Two Bear Stearns hedge funds had collapsed inJuly2007,andanumberofotherentitieswereobviouslyandvisibly in shaky financialcondition.68There shouldhavebeenanearlierrecognition thathousepricesweregoingtodecline,becausepriceswereoutof linewithfundamentals.Thus, not only would subprime mortgages become increasingly troubledbut soalsowouldprimemortgages.Failure torecognizetheimplicationsofdeclininghousepriceswasnota

regulatory

failure

but

a

basic

failure

of

economic

analysis.69

Regulatorscouldenforcecapitalstandardsonbanksandcouldmonitor bank risk management policies. As ordinarily conceived, the economic analysis of house prices went beyondwhatbanksupervisorsandexaminerswereexpectedtodo.

TheTreasuryandtheFederalReservecanalsobefaultedforfailing to engage in adequate contingency planning after theBear Stearnsbailout. It is hard to read Wessels account anyother way.70 The Treasury and the Fed did not seek fundingfromCongressbecausetheyassumedthatCongresswouldnotberesponsive.71Theydidnottrytomakethepubliccase,however. After Lehman failed, they had no choice, and Congress

did

respond

with

prompt

passage

of

the

TARP

legislation.

In

contrast, the risks of failing to deal with Fannie Mae andFreddie Mac were well understood and the two firms weretakenintoconservatorshipwithoutincident.72

68.WESSEL,supranote5,at93.69.Seeid.(notingthattheFedsmainpolicyconcernasofJuly2007wastherisk

ofrisinginflationandnotthehousingbubble).70.Seeid.at17880.71.Id.at179(PaulsonandBernankeconcludedthattherewasntanypointin

asking

Congressunless

the

crisis

intensified

to

the

point

where

there

were

no

otheroptions.).72.Id.at18687.


13/21


TheTreasuryandtheFederalReservehavenotmadeastrongcaseforfinancialreform.73Largebankshavebecomelarger;theproblemof toobig to fail (TBTF) ismuchmore serious. Baker

andMcArthur

estimate

that

the

public

subsidy

to

the

big

banks,

becauseofthemarketsassumptionthatanylargebankintroublewillbebailedout, runssomewherebetween$6billionand$34billionperyear.74Theissueisnotprimarilythesubsidyarisingfromthefactthatbigbankscanborrowmorecheaplythancansmallbanks.75Instead,thesubsidypermitsthebigbankstogrowevenbigger,increasingtherisktothefinancialsectorif(orwhen) they get into trouble again. Moreover, cheap financingencouragesthebigbankstotakeriskstheymightnototherwisetake;withimpliedfederalbacking,banksneednotfearthatthemarketwillcutofffinancing.

More than eighteen months after the Bear Stearnsbailout,

thereseems

to

be

no

sense

of

urgency

in

addressing

the

TBTF

problemand in instituting reforms tomake the financial system more robust. This situation reflects a failure of politicalleadershipinWashington.Althoughbanksarecurrentlymorecautious thantheywerebefore thefinancialcrisis,underlyingconditionsand incentiveshavenotchanged.As theeconomyimprovesandmemoriesofthefinancialcrisisfade,thereisrealdangerthatanewfinancialcrisiswillbetakingshape.

V. LEGALANDGOVERNANCEISSUESDavidWesselisgenerallyverycomplimentaryofthepolicies

pursued

by

the

Federal

Reserve.

His

introductory

chapter

to

In

FedWeTrustistitledWhateverItTakes,76andherepeatsthatphrase frequently in his commentary on Fed creativity in inventingnewcreditfacilitiestodealwiththecrisis.Itwilltake

73.TheSenateisnowconsideringareformbill,andtheHousepassedabillinDecember2009.SewellChan,ReformBillAddsLayersofOversight,N.Y.TIMES,Mar.16,2010,atB1.

74.SeeDEANBAKER&TRAVISMCARTHUR,CTR.FORECON.&POLYRESEARCH,THEVALUEOFTHETOOBIGTOFAILBIGBANKSUBSIDY2(2009).

75.Id. (arguing that thementioned subsidyarisesprecisely from the fact that

banks

enjoying

protection

under

the

too

big

to

fail

concept

are

able

to

borrow

morecheaply).76.WESSEL,supranote5,at1.


14/21


someyears toaccumulate research findingsas tojusthoweffectivetheFedscreditfacilitieswere.77

Alegalissue,orgovernanceissue,surroundstheFederalRe

servesuse

of

Section

13(3)78

of

the

Federal

Reserve

Act.79

This

Section came into theAct as an amendment in 1932.80 UndertheFederalReserveAct,thebasicpoweroftheFedistomakeloanstobanksandtoconductopenmarketoperationsinobligations issuedorguaranteedby the federalgovernment.Section 13(3) provides emergency authority for the FederalReserve to lend to nonbanks when such lending is deemednecessaryinunusualandexigentcircumstances.81

TheFederalReserveinvokedSection13(3)asitslegaljustificationforseveraldifferentactions.TheFedappealedtoSection13(3)asthelegalbasisfortheemergencyfundstobailoutBearStearnsandAIG.Thesamejustificationwasoffered,however,

forsome

other

special

credit

facilities,

including

the

commer

cialpaper funding facility, illustrating the issues surroundingsuchjustificationsingeneral.Theamendmentwasinsertedlatein the legislativeprocessandwasnotsubject tocommitteeorfloordebate.Thereiscaselaw,however,indicatingwhatun

77.SeeWilliamPoole,TheBernankeQuestion,CATO.ORG,July28,2009,http://www.cato.org/pub_display.php?pub_id=10388.

78.DavidFettigprovidesusefulbackground informationonSection13(3).SeeDavidFettig,TheHistoryofaPowerfulParagraph:Section13(3)enactedFedbusinessloans76yearsago,REGION,June2008,at33;seealsoDavidFettig,LenderofMoreThanLastResort:RecallingSection13(b)andtheyearswhentheFederalReserveopeneditsdiscountwindowtobusiness,REGION,Dec.2002,at14.

79.The

Federal

Reserve

Act

of

1913,

Pub

L.

No.

63

43,

ch.

6,

13,

38

Stat.

251,

263(codifiedasamendedat12U.S.C.343(2006)).80.Pub.L.No.72302,ch.520,210,47Stat.709,715(codifiedat12U.S.C.

343(2006)).81.12U.S.C.343(2006)(Inunusualandexigentcircumstances,theBoardof

GovernorsoftheFederalReserveSystem,bytheaffirmativevoteofnotlessthanfivemembers,mayauthorizeanyFederalReservebank,duringsuchperiodsasthesaidboardmaydetermine,atratesestablishedinaccordancewiththeprovisions of section 357of this title, to discount for any individual,partnership, orcorporation,notes,drafts,andbillsofexchangewhensuchnotes,drafts,andbillsofexchangeare indorsedorotherwise secured to the satisfactionof theFederalreservebank: Provided, Thatbefore discounting any such note, draft, orbill ofexchange for an individual or a partnership or corporation the Federal reservebank shall obtain evidence that such individual, partnership, or corporation isunable to secure adequate credit accommodations from otherbanking institu

tions.All

such

discounts

for

individuals,

partnerships,

or

corporations

shall

be

subjecttosuchlimitations,restrictions,andregulationsastheBoardofGovernorsoftheFederalReserveSystemmayprescribe.).


15/21


usual and exigent circumstances most likely meant in 1932.Contemporaneouscourtsinterpretingsimilarlanguageinotherstatutesfocusedonthesuddennessandunexpectednessofca

lamitousevents

and

whether

immediate

action

was

required

to

avoiddisaster toacorporation.82 In thecontextof theFederalReserveAct,therefore,thetermunusualandexigentcircumstances likely contemplates unforeseen financial circumstances that require immediateaction or remedy, particularlywhennecessarytoensurethesurvivalofabusinessentity.

Furthermore, although the third edition ofBlacks LawDictionary, published in 1933, did not have a definition of unusual and exigent circumstances, it did have a definition ofexigencythatcorroboratesthecaselawsfocuson imminence:[d]emand,want,need,imperativeness;emergency,somethingarisingsuddenlyoutofthecurrentofevents;anyeventoroc

casionalcombination

of

circumstances,

calling

for

immediate

action or remedy; a pressing necessity; a sudden and unexpectedhappeningoranunforeseenoccurrenceorcondition.83

Finally,onerelevantpieceoflegislativehistoryconcernsSection11(r)oftheFederalReserveAct,84whichpermitstheBoardtoutilize its13(3)powers in situationswhere thereare fewerthanfivememberspresent.85Thisprovisionwaspartofalargerbill aimed at providing insurance in the event of terrorist attacks. One can thus assume the reason for it was so that theBoard could take immediate action in response to a financialcrisisasexigentasonebroughtonbya terroristattack.Congressclearlyhadsuchanextremeexigencyinmindbecauseit

providedthat

even

adelay

to

contact

other

Board

members

by

phoneorotherelectronicmeanswouldbetoolong.86

82.SeeGoodRoadsMach.Co.ofNewEng.v.UnitedStates,19F.Supp.652,653(D.Mass.1937);Carsonv.AlleganyWindowGlassCo.,189F.791,796(D.Del.1911).

83.BLACKSLAWDICTIONARY721(3rded.1933).

84.Pub.L.No.107297, tit.III,301,116Stat.2322,2340(2002)(codifiedat12U.S.C.248(r)(2006)).

85.12U.S.C.248(r).86.12U.S.C.248(r)(2)(A)(ii)(III)(requiringbeforetheBoardexercisesits13(3)

powers that itdeterminethatexigentcircumstancesexisted,thattheborrower isunable tosecurecredit throughothermeans, thataction isnecessary toprevent

seriousharm

to

the

economy

or

the

stability

of

the

U.S.

financial

system,

that

theyhavebeenunable tocontact theotherboardmembersbyanymeansavailable,andthatwaitinganyfurthertodosowouldbeimpossible).


16/21


The Feds reliance on Section 13(3) is fullyjustified in thecontextofdecisionstobailoutBearStearnsandAIG,whateverthe merits of thosebailouts, for those situations were clearly

emergencies.The

case

for

relying

on

Section

13(3)

to

justify

the

programtobuycommercialpaper,however,ismuchlessclear.The Fed announced its Commercial Paper Funding Facility(CPFF)onOctober7,2008.87The first loansweremadeaboutthreeweekslater,onOctober27.Byyearend,thisprogramhadanoutstandingbalanceof$332billion.Theprogramreachedapeakof$350billioninmidJanuary2009.88

The launch of CPFF did not reflect a weekend emergency.Thefinancialcrisiscalledforquickanddecisiveaction,butnotimmediateactiondecidedinamatterofhours.Iftherewasanemergencyatall,itwasbecauseofcongressionalunwillingnesstoact,notbecauseCongressdidnothave time toact. IfCon

gresswas

unwilling

to

act

because

of

its

concern

about

the

poli

tics of a program to provide credit to large corporations, afederal agency should not make its own decision on what isnecessary, committing hundreds ofbillions of dollars in taxpayerresources.

OnepossibleviewisthattheFedfounditselfinanunfortunateposition,butthatitdidwhatithadtodogivenOctobersfinancialturmoil.ThatseemstobeWesselsview:whateverittakes.89TheFed shouldhavemadea strongpubliccase thatCongresshadtoacttoprovidetheneededcredit.Therewouldhavebeenapublicdebateabout thewisdomof theproposedprogram.Weknownothingof the internaldebates in theFed

aboutthe

CPFF.

Essentially,

the

Fed

simply

asserted

that

the

program was necessary to reduce financial turmoil. The Federal Reserve has never explained, either in October 2008 orsince,whyassistancetotheparticularborrowerseligiblefortheCPFFwasessentialtodealingwiththefinancialcrisis,whereasassistancetootherpotentialborrowerswasnotessential.

IfCongresshadacted, theCPFFwouldhavebeenadministeredby theTreasury, insteadofby theFed,and financedbynewTreasurydebt,insteadofbymonetaryexpansion.Aswithother federal credit programs, eligibility, reporting require

87.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.(Oct.7,2008),avail

able

at

http://www.federalreserve.gov/newsevents/press/monetary/20081007c.htm.

88.WESSEL,supranote5,at22829.89.Id.at229.


17/21


ments, disclosure requirements, the interest rate, and othercredit terms would havebeen determinedby legislation, ordelegatedtotheTreasury.Governmentprogramprovisionsare

inherentlypolitical

decisions.

The

Fed

should

not

have

been

making these decisions, because doing so would inevitablydrawitintopoliticaldisputes,suchasthoseoverdisclosure.

TheFederalReservesprogram tobuymortgagebackedsecurities (MBSs) raises similar governance issues. The Fedsprogramistobuyatotalof$1.25trillionofMBSsbytheendofthefirstquarterof2010.90LiketheCPFF,thisprogramwasnota weekend emergency effort, but rather one that Congresscould have authorized. The Fed initially announced this program inapress releaseonNovember25,2008.91The firstappearanceofMBSsontheFedsbalancesheetwasnotuntiltheH.4.1releaseforJanuary15,2009.92

Thetime

between

announcement

and

execution

of

the

Feds

MBSpurchaseprogramiscomparabletothegapbetweenpassage of the TARP legislation in 2008 and the stimulusbill inFebruary2009.CongresscouldhavedebatedanMBSpurchaseprogramanddecidedwhetherthebenefitsoftheprogramoutweighedtheadditionalgovernmentdebtrequiredtofinance it,ratherthanlettinganunelectedagencyinitiatetheprogram.

Oneelementofsuchacongressionaldebatemight logicallyhavebeen whether it wouldbe a good idea to expand theamount of Treasury debt outstandingby $1.25 trillion to finance this program. Given the enormous scale of thebudgetdeficit, thatwouldhavebeenavalid issue todebate. Instead,

theFederal

Reserve

is

financing

the

program

by

creating

new

money. Another item that might havebeen debated in Congresswouldhavebeenwhethera totaloutlayof$1.25 trillionshouldallgo forpurchasingMBSs.Somemighthavearguedthat someof the funds should instead havebeen used to expandloanstosmallbusinesses.Or,perhapssomeshouldhave

90.Id.at269.

91.PressRelease,Bd.ofGovernorsoftheFed.ReserveSys.(Nov.25,2008),availableathttp://www.federalreserve.gov/newsevents/press/monetary/20081125b.htm.

92.BD.OFGOVERNORSOFTHEFED.RESERVESYS.,FEDERALRESERVESTATISTICAL

RELEASE H.4.1 FACTORS AFFECTING RESERVE BALANCES OF DEPOSITORYINSTITUTIONSANDCONDITIONSTATEMENTOFFEDERALRESERVEBANKS,JANUARY

15,2009,tbl.1(2009).


18/21


beenusedtobuybondsfromhardpressedstategovernments,ortoexpandmortgagereliefforborrowersnearforeclosure.

Thepointisnottoargueherethemeritsofalternativeusesof

$1.25trillion

but

to

emphasize

that

decisions

on

credit

pro

gramshavehistoricallybeen left toCongress.Once the financialcrisisisfullyresolved,Congressshouldtakeupthisissue.Whatare theappropriate constraintson theFederalReserve?The issue may wellbe on the congressional agenda at somepoint.Wesselflagstheissueinhisfirstchapter:

BarneyFrank,thesharptonguedsharpmindwhochairedtheHouseFinancialServicesCommittee,capturedtheissueclearly. Labeling Bernanke the loan arranger with hissidekick, Paulson, Frank said, I think highly of Mr. Bernanke and Mr. Paulson. I think they are doing well, although I think itsbeen inappropriate in a democracy to

have

them

in

this

position

where

they

were

sort

of

doing

this

stuffunilaterally.Theyhadnochoice.And itsnot to theirdiscredit,but...thisnotionthatyouwaituntiltheresaterrible situation and youjust hope that the chairman of theFederal Reserve would pop up with the secretary of theTreasury and rescue you. Its not the way in a democracy...youshouldbedoingthis....

Nooneinademocracy,unelected,shouldhave$800billiontospendasheseesfit,hesaid.93

Economistsalmostuniversallybelievethat thereshouldnotbepolitical interferencewith thecentralbanksmonetarypolicy decisions. A legacy of the Federal Reserves expansive

creditprograms

may

be

that

Congress

will

enact

constraints

on

theFederalReservethataffectitsmonetarypolicydecisionsaswellasitscreditpolicies.ManywillfindthepositionstatedbyBarneyFrankpersuasive;whethertheywillbeabletoseparatemonetaryfromcreditpoliciesislessclear.

VI. REFORMSTOENHANCEFINANCIALSTABILITYAdistressingfeatureofthefinancialcrisisisthatsuchevents

havehappenedsooftenbefore.CharlesKindlebergersclassicbook,Manias,Panics andCrashes:AHistory ofFinancialCrises,went through four editions and hasbeen updated since his

93.WESSEL,supranote5,at7.


19/21


death to a fifth edition.94 A more recentbookby Carmen M.Reinhart and Kenneth S. Rogoff, This Time IsDifferent: EightCenturies of Financial Folly,95 adds a great deal of data to the

Kindlebergerhistory.

The cost of the financial crisis is immense. One number issufficienttoindicatethescaleofthecostsintheUnitedStates:Thecrisisisresponsibleforreducingemploymentbyeightmillionjobsandperhapsmoredependingonexactlywhentherecoverybegins.96Largebanks thatget into financial troublenotonlyaffecttheirownshareholdersandemployees,butalsofirmsandemploymentacrossthecountryandaroundtheworld.

Themostfundamentalreformistoforcebankslargeenoughtocreateasystemicrisktotheeconomytoholdmorecapitalasa cushion toprotect thedeposit insurance fundand to createmoremarketdisciplineintheirmanagement.Economistshave

studiedthis

issue

for

years;

the

most

promising

approach

is

thatbanks shouldbe required to issue a substantialblock oflongtermsubordinateddebt.97

To illustrate the proposal, suppose every firm with abankcharterwas required tomaintainablockof tenyear subordinated notes equal to ten percent of its total liabilities. Everyyear, thebankwouldhave to rollover thematuringnotes; ifthemarketwereunreceptive,thebankwouldhavetoshrinkitstotalassetsbytenpercenttolivewithinitsremainingblockofoutstanding subordinated notes. Stability of thebanking systemandmarketdisciplinemightbe furtherenhancedbyproviding thatabankcouldconservecash thatwouldotherwise

beused

to

redeem

maturing

sub

debt

by

converting

the

sub

debttoequityatapredeterminedratio.Marketdisciplinerequiresthatsomecreditorsbeatrisk.Fi

nancial stability, however, requires that creditors who fear alossmustnotbeabletorun.Akeyfunctionofabankistooffer

94.CHARLES P. KINDLEBERGER & ROBERT Z. ALIBER, MANIAS, PANICS, ANDCRASHES:AHISTORYOFFINANCIALCRISES(5thed.2005).

95.CARMEN M. REINHART & KENNETH S. ROGOFF, THIS TIME IS DIFFERENT:EIGHTCENTURIESOFFINANCIALFOLLY(2009).

96.FloydNorris,TheJobsNewsGetWorse,N.Y.TIMES,Oct.4,2009,atWK3.

97.See BD. OF GOVERNORS OF THE FED. RESERVE SYS. STUDY GROUP ON

SUBORDINATED NOTES & DEBENTURES, USING SUBORDINATED DEBT AS ANINSTRUMENTOFMARKETDISCIPLINE172 (1999) (analyzing thoroughly thesubordinateddebtproposal).


20/21


demand deposits and other shortdated time deposits or depositlikeobligations.Theonlywaytoassurefinancialstabilityand toassurethatsomecreditorsbeatrisk istorequire long

termdebt

in

the

capital

structure.

The

proposal

also

has

the

advantage that, when abank is forced to contractbecause itcannotrollovermaturingsubdebt,thebankitselfmanagestherestructuring.ItisbesttoavoidregulatorydiscretionbecauseabankintroublemaybeabletoappealtoCongresstooverrideregulatorsdecisions.

Another useful reform wouldbe to encourage a less leveraged economy.Oneway todo sowouldbe tophaseout thedeductibilityof interestonall income tax returns.Atpresent,the deductibility of interest encourages debt over equity. Aquickcalculationindicatesthatphasingoutthedeductibilityofinterestoncorporatereturnsandreducingthestatutorycorpo

ratetax

rate

from

its

current

thirty

five

percent

to

fifteen

per

centwouldberoughlyrevenueneutral.

VII. REFLECTIONSONFREEMARKETSThe financial crisis is a sobering experience for a Chicago

schooladvocateofthemarket.Thefederalgovernmentwasnotwithoutblameforthecrisis,butthebasicproblemwasthatfartoo many financial firms pursued shortsighted portfolio policies.Banking101saysthatitisdangeroustodesignaportfoliowith longduration risky assets financed with shortdurationliabilitiesandthincapital.Thatiswhatonefinancialfirmafter

another

did,

and

the

government

is

not

to

blame

for

those

mis

guidedprivatesectorpolicies.Throughout history, financial crises occur when liquidity

driesup,usuallybecause solvency concernsarisewhen riskyassetsdeclineinvalue.Whyisitthatthemarketseemstomakethesamebasicmistakerepeatedly?Itisterriblyimportantthatwe figure out the answer to this question,because we alsoknowthatmarketsandnotgovernmentruneconomiesgenerateeconomicgrowth.Thisfinancialcrisiswascostly;ifwecannotfigureouthowtomakemarketeconomiesmorestable,weriskgrowing government involvement,whichwe canbe certainwillmakeeconomiesgrowmoreslowly.

My

tentative

conclusion

is

that

market

participants

system

aticallyunderestimate theprobabilityofextremeevents.Theyrelyon instincts describedby the normal distributionandby


21/21


formalmodelsbasedonnormality.Yet, there isanenormousamountofevidencethattheprobabilityofextremeeventsoutinthe tailsof theprobabilitydistribution ismuchhigher than

indicatedby

the

normal

distributionthe

fat

tails

problem.98

Ifthisobservationiscorrect,thenanappropriatefunctionofgovernment is tocreate incentivesthatoffsetthemarketsunderestimate of tail probabilities. For largebanks, the issue isoneof externalities.A largebank failurehas costly effectsonmanythirdparties.Eliminatingthedeductibilityofinterestontax returns would help to control the externality as would astiffsubordinateddebtrequirementforbanks.

Inreflectingonthecausesandconsequencesofthisfinancialcrisis, it isamistaketothinkofthesubprimemortgage fiascoasauniquecausethatwillnotrecur.Itisindeedunlikelythatthe subprime mortgage market itself will again create a sys

temicrisk,

but

some

other

new

and

creative

market

probably

will.Theessenceofadynamiccapitalmarketisthatitsearchesfornewopportunitiesandfeedscapitaltonewventures.Someofthenewventuresturnouttobebusts.Whatoughtnothappenisthatthebustsshaketheentireeconomybecausetheyarefinancedbybanksintooriskyafashion.Federalpolicyshouldrequirethatbanksholdalargercapitalcushionagainsttheinevitablebusts.Itismostunfortunatethatfinancialreformisnotyetaconsequenceofthisfinancialcrisis.

98.SeeBenoitMandelbrot,TheVariationofCertainSpeculativePrices,36J.BUS.394(1963).

Documents

Causes and Consequences of the Financial Crisis of 2007 to 2009