In Fed We Trust: Ben Bernanke’s War on the Great Panic
(Crown Business, 2009)
Financial Shock: Global Panic and Government Bailouts — How We Got Here and What Must Be Done to Fix It
(2nd ed., FT Press, 2009)
John B. Taylor
Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis
(Hoover Institution Press, 2009)
Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe
(Free Press, 2009)
William D. Cohan
House of Cards: A Tale of Hubris and Wretched Excess on Wall Street
Richard A. Posner
A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression
(Harvard University Press, 2009)
Gerald F. Davis
Managed by the Markets: How Finance Re-Shaped America
(Oxford University Press, 2009)
The definitive account of the financial meltdown of 2008–09 has not been written, and cannot be just yet because the story is unfinished. A degree of stability returned to financial markets this summer, but the system is still stressed and nobody can be sure what will happen next. The broader economy shows signs of recovery, but unemployment is high and likely to rise further, a prospect with political and economic implications still unknown.
By the autumn of 2009, only a small part of the huge fiscal stimulus deployed against the downturn in the U.S. had made itself felt. In monetary policy, the Federal Reserve and its counterparts intervened to support the banking and credit systems in new ways and on a wholly unprecedented scale. To call these interventions “unfinished business” would be putting it mildly. Meanwhile, not just the future is uncertain. The next surprise could change our understanding of what has happened so far, as earlier shocks already have.
Never mind: A crop of new books on the subject has already come to market. All were written under the pressure of short deadlines and fast-changing circumstances — and, as you might expect, many were worthless on arrival. But there are some splendid exceptions. The best books from this first crop are fine by any standard.
Among the successful books, the range of explanations for the crisis is wide. Some focus on economic policy, others on closely reported tales of greed and fallibility. One locates the root cause in the triumph of finance over manufacturing in the United States. Another asks whether capitalism itself stands condemned. Just as the crisis had no single source, there is no single way to best tell what happened. This makes it hard to say which book is best. Nonetheless, if forced to choose just one, I would pick David Wessel’s In Fed We Trust: Ben Bernanke’s War on the Panic — an excellent work on a crucial aspect of the story, and one that addresses my professional interest in economic policy.
The Fed’s-Eye View
Wessel, the Wall Street Journal’s economics editor, tells the story from the point of view of policymakers in the Department of the Treasury and the Federal Reserve, and especially that of Ben Bernanke, the Fed’s chairman. The book is beautifully written and a gripping read throughout. Although Wessel provides enough context to make the crush of events intelligible, unraveling causes is not his main concern. In Fed We Trust is about how the key officials coped, usually none too confidently, with the torrent of disasters that began in 2008. The cast includes Bernanke; Henry Paulson, who was Treasury secretary in the Bush administration when the crisis broke; Timothy Geithner, president of the Federal Reserve Bank of New York when the emergency started and now Barack Obama’s Treasury secretary; and many others in cameo roles.
Wessel’s telling arouses sympathy for all the main players. Mistakes were made, to be sure, but they were not obvious errors at the time. These leaders all did their best in extremely trying circumstances. Still, some of the principals emerge looking better than others.
Wessel is not much impressed with Paulson, arguing that his trader mentality — instinctive more than calculating, inclined to abrupt and unpredictable changes of position — was ill suited to the problem. Greater consistency was needed. No doubt, but was anybody inside or outside government supplying that at the time? George W. Bush is also somewhat unfairly impugned for choosing to take a backseat. When you recall that his rare interventions on the subject unsettled markets more than calming them — that deer-caught-in-the-headlights affect was enough to panic anybody — you might thank him for recusing himself as often as he did.
It is hard to disagree with Wessel’s criticisms of Alan Greenspan, Bernanke’s once-lionized predecessor at the Fed. If any official should have acted to avert this crisis, either by raising interest rates sooner to choke off the credit boom, or by bringing subprime mortgages under stricter regulation, it is he. Again, though, one should remember that Greenspan was little criticized on either score while the bubble was inflating. As recently as 2007, the politicians and commentators now pillorying him were cheering him on.
Many would say that Geithner faltered in his early days as Treasury secretary. He started under a cloud because of his difficulties during confirmation; he was ridiculed for his first lamentable performance for the cameras; and his previous position at the New York Fed implicated him in the mess. Lately his stock has risen, and he will not be displeased with Wessel’s essentially sound take on him. The book treats him kindly, calling him calm and coherent, and well prepared to lead by his experience from earlier financial crises.
Wessel touches on wider issues, but he keeps the focus on the Fed. This emphasis guarantees the book an extended shelf life, because the salience of the Fed is only going to grow, not just in the domestic economy but internationally as well. The awkward unwinding of the Fed’s financial interventions, its role in managing the dollar and the external deficit, the new duties envisaged for it in the Treasury’s blueprint for financial regulation, and the disenchantment of many in Congress with the way it has performed — raising the possibility of stronger external oversight, which Bernanke opposes strenuously — all put the Fed at the center.
A Myriad of Causes
In Fed We Trust is superb, but if you want a brisk overview of the whole story, Wessel’s book is not it. Here the honors go to the new edition of Financial Shock: Global Panic and Government Bailouts — How We Got Here and What Must Be Done to Fix It, by Mark Zandi, the chief economist of Moody’s website Economy.com.
As he finished work on the first version in the summer of 2008, Zandi wrote, “The worst of the crisis appears to be over.” Not long after, the authorities made their fateful decision to let Lehman Brothers go bankrupt. That decision, which most observers now regard as a terrible error, shut the credit system down and precipitated the full fury of the crisis.
This gives Zandi reason to argue — as he does, in this revised edition — that the Lehman decision “turned a serious yet manageable financial crisis into an out-of-control financial panic.” Yet in Zandi’s view, although mistakes were made, they were not inexplicable or downright stupid. His retelling of his own mistaken prediction seems to inoculate him against the 20/20 hindsight to which most authors on this subject fall prey. He writes with a keen sense of the complexities that confronted policymakers. He is level-headed and fair.
Of all the books in this review, Zandi’s ranges most widely over the economic causes of the meltdown. He discusses the sources of the surge in subprime lending; the American obsession with home ownership; the tax breaks that promote borrowing of all kinds; the roles of financial engineering, loan securitization, and exotic financial instruments; attitudes toward risk; the role of the rating agencies; monetary policy before and after the credit crunch; fiscal policy; regulatory policy — you name it.
Lacking the flair of a David Wessel, Zandi nonetheless writes clear, straightforward prose and puts this bewildering mass of material in some kind of order. He ends with a 10-point checklist of actions we can take to avoid the next crisis. The seventh one is “Fix Securitization, Don’t Scrap It.” That is, regulate the complex repackaging of assets more carefully, don’t regulate it out of existence. This is characteristic of Zandi’s calm approach. He does not hyperventilate. He recognizes the benefits that modern finance has brought, as well as the damage done in this crisis.
Before we leave books that concentrate on causes, John B. Taylor’s Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis deserves honorable mention. It is as narrow in its focus as Zandi’s is wide, concentrating almost exclusively on interest rate policy before the crisis, and arguing that this is where the critical mistake was made. Taylor disagrees, for instance, that the Lehman decision was the pivot on which everything turned. He is not even very interested in subprime mortgages — they were a symptom, in his view, not the cause. Everything went wrong for one simple reason: the Fed abandoned its tried-and-true rule for setting interest rates — a rule, it so happens, that Taylor, a senior fellow at the Hoover Institution and a Stanford University professor, first formulated.
The Taylor rule was devised as a recommendation to central banks, and was later seen as a way to predict how the Fed actually will behave. It says that central banks should set interest rates equal to one and a half times the inflation rate, plus half of the gap between actual and potential gross domestic product, plus 1. So if inflation is 5 percent and the output gap is 3 percent, the rule says to set the short-term interest rate at 10 percent: one and a half times 5, plus half of 3, plus 1. From the late 1980s onward, deliberately or otherwise, the Federal Reserve followed the rule. Earlier this decade, it stopped.
Aiming to speed the recovery from the previous recession, the Fed cut interest rates in 2002 and kept them low even when the Taylor rule said to raise them. Hence the boom in house prices, hence the boom in mortgage borrowing. Taylor presents a simulation that shows what would have happened with “normal” interest rates: no meltdown.
This mono-causal explanation is not altogether persuasive. A once-in-a-half-century crisis, which this is, must be a perfect storm of multiple forces. A lot has to go wrong at once; otherwise, such wrenching events would be commonplace. Yet Taylor believes in the one true cause. Questionable as this approach may seem, in fact he makes a powerful case. At the very least, he establishes the centrality of monetary policy earlier in the decade among the various causes, a perspective that is lacking in many other accounts. Extra marks for brevity, too. The main text runs just 60 pages. They are well worth reading.
A Fly on the Wall
Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe, by Gillian Tett of the Financial Times, and House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, by William D. Cohan, investment banker turned financial writer, zoom in, minutely reporting a fragment of the action, hoping to clarify the bigger picture, ever in search of a ripping good yarn.
Tett turns the microscope on the elite team of bankers at JPMorgan that in the 1990s developed a family of new financial instruments — credit default swaps, synthetic collateralized debt obligations, and other so-called credit derivatives. These were seen as a way to manage risk more effectively, and to spread it around. Investors could fine-tune their exposure in more sophisticated ways, diversifying their risk or concentrating it, according to what made sense for them.
As these derivatives caught on, financial engineers at other firms married them to recent innovations in mortgage finance. Mortgage debt could now be sliced and diced, and the pieces traded every which way. The breakthrough was combining debt securitization and credit derivatives. Soon the traditional mortgage loan — lender, borrower, documented income and assets — was regarded as passé. The new technology encouraged the spread of much riskier arrangements, extending even to “ninja” loans (no income, job, or assets) that came close to sanctifying fraud. But the risk was always under control, you see, because those guys at JPMorgan really knew their stuff.
In a way, they did. Tett explains that despite coming up with the new techniques and selling them to others, the firm consistently exposed itself much less to the dangers, as they proved to be, than did more adventurous outfits such as Bear Stearns and Lehman. Partly for this reason, she has been accused of being too sympathetic toward her sources at JPMorgan. That was not my feeling. These people were not evil, and in a way, that is the point. They worked insanely hard and had brains to spare. They saw themselves as pioneers — getting rich, to be sure, but doing it by inventing a marvelous new technology, not by gulling anybody. However, despite the brains, the work, and the good intentions, the risk got out of control.
In House of Cards, Cohan does for the team at Bear Stearns what Tett does for JPMorgan — but with a tighter focus on the instant of Bear’s demise and everything that brought the firm to that point, plus amped-up disapproval of the principals. These characters might not actually be evil, but, in Cohan’s telling, they are certainly disagreeable: brash, bullying, loudmouthed, foulmouthed, and oozing testosterone — reminiscent of the sociopaths described by Michael Lewis in Liar’s Poker: Rising through the Wreckage on Wall Street (Norton, 1989), the seminal work (forgive the expression) of this genre. Of course that book was a fabulous, irresistible read, and so is House of Cards.
Cohan’s sourcing is especially impressive. The book is richly detailed and brilliantly constructed. Its only real flaw is that the Bear Stearns failure no longer seems as significant as it did pre-Lehman. That is an odd thing to say, admittedly. At any other time, the collapse of a once-mighty investment bank would have been regarded as a monstrous shock in its own right. From where we stand now, it looks like a lesser part of the story.
Fundamental Systemic Flaws?
Moving to the opposite extreme, two books zoom out wider even than Zandi’s encompassing perspective. They take in more than mere issues of economic management, and ask questions that are bigger still.
Richard A. Posner’s A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression tries to say what kind of calamity this really is — is it a breakdown caused by structural flaws in the market system, or the end result of an orgy of individual greed and irrationality? One could always say it was both, but Posner takes the more intriguing line of arguing it was the former and not the latter. The people involved were no more or less rational than usual, he says; on the whole, they acted in their own best interest. The problem is that an outright depression — for that is what we are in, according to Posner — is so rare an event that investors cannot sensibly take account of it. “The profit-maximizing businessman rationally ignores small probabilities that his conduct in conjunction with that of his competitors may bring down the entire economy,” he writes. Through the systemic vulnerability of the market economy, individual rationality conspires to cause a collective nervous breakdown.
It is an interesting argument, though not in my view a very convincing one. You can pick any of the other books mentioned here for instances of outright individual irrationality — ninja loans, for one; debt valuation models that returned “cannot compute” when asked to contemplate a fall in house prices, for another; the list is long. A Failure of Capitalism is indispensable nonetheless, for Posner’s trademark intellectual vitality and his tireless instinct to start a quarrel. And it is a pleasure to find that a public intellectual of Posner’s amazing productivity — he seems to publish a book every six months — is still capable of surprising his readers. Despite his free-market instincts, his book confronts the limits of the market system.
The most scholarly book of the bunch, with due respect to Posner, is Gerald F. Davis’s Managed by the Markets: How Finance Re-Shaped America. Davis is a professor of management at the University of Michigan, with particular interest in sociology and finance. He steps back farthest of all, and asks whether the crisis is a sign that finance has vastly outgrown its proper place in the U.S. social and economic system.
This is an excellent question, and Davis deserves great credit for trying to answer it in a serious way. His basic argument is that “twentieth century American society was organized around large corporations, particularly manufacturers, and their way of doing things. It is now increasingly organized around finance — not just particular Wall Street banks, but finance as a model of how things are done.… The consequences of tying the well-being of society to financial markets have become starkly evident.” Even aside from the immediate crisis, in Davis’s view, those consequences are mostly grim.
This is a valuable and novel perspective. Seen from high altitude, things look different. You see features of the economic and social landscape that escape your attention at ground level. Davis explains how many aspects of U.S. society shaped themselves around the traditional large corporation, and especially around manufacturing: a settled career pattern; lifetime employment with a company pension to follow; the phenomenon of the company town; the company as welfare state, almost. Then, thanks partly to information technology, financial services gradually gained the societal upper hand. The sector made the most money, offered the highest salaries, and attracted the best talent — and prospered in part by breaking down the traditional structures.
Today, Davis argues, an individual’s prospects in work and in retirement are tied less to the fate of one long-lived company than to the vagaries of financial markets. This is a shift as profound as the transition from farming to manufacturing, though as yet much less well understood. One consequence is economic insecurity, a problem writ large in the current crisis (which is itself a product of the hegemony of finance).
The book is too gloomy for my taste, although in this it conforms to the current mood. And Davis expresses a faith in good government that strikes me as naive. But Managed by the Markets gave me more food for thought than any of the other books mentioned in this review. In the past 20 years, finance did indeed triumph over other modes of enterprise in the U.S. and elsewhere. This was, as Davis says, a momentous shift. To the victor went the spoils, with far-reaching social and economic consequences. In contemplating the wreckage of the crisis, one should follow Davis’s example, and ask whether this was either inevitable or desirable, and what, if anything, we might learn from it.
Because the crisis is not yet over, many of the lessons must be tentative. But one certain casualty of the meltdown — as nearly all of these books, in their different ways, confirm — is credulous faith in self-regulation. This has been the principle underlying financial regulation in recent years. Financial institutions need to be supervised, went this credo, but what they do is so complicated, and the regulator’s powers necessarily so circumscribed, that firms must be trusted not to do things reckless or stupid enough to put themselves in jeopardy. What we have learned is that, as a group, financial institutions cannot be trusted even that far — and when they put themselves in harm’s way, the rest of us share in the consequences.
The credo was right about the difficulties of regulating effectively. But that will no longer serve as an excuse. Governments will have to try harder. After this crisis, they will no longer be able to stand aside.
- Clive Crook is a senior editor of the Atlantic, a columnist for National Journal, and a commentator for the Financial Times. He was formerly a deputy editor at the Economist.