On the Brink: Inside the Race to Stop the Collapse of the Global Financial System Henry M. Paulson, Jr. Business Plus, 2010
Henry Paulson was the U. S. Treasury Secretary for the final two and a half years of the George W. Bush administration, serving from July 10, 2006, until Barack Obama's inauguration as president on January 20, 2009. This makes Paulson one of the two figures most at the center of the government's response to the Great Credit Crisis of 2007-9. The other was Ben Bernanke, who on February 1, 2006, had replaced Alan Greenspan as the chairman of the Federal Reserve. When Paulson accepted appointment to his position, he had an express understanding with President Bush that he would be Bush's "primary economic adviser and spokesman." This primacy was an enhancement of the Treasury's assigned function, which was to be "primarily a policy-making institution, charged with advising the president on economic and financial matters."
The point has often been made that the United States needed an officer or agency to track the systemic health of the financial system. It would seem, however, that the successive Secretaries of the Treasury, in their role as adviser to the president of the United States, were in the ideal position to play this role (with the help of their expert staffs), in coordination with the banking committees of the Congress. It is hard to see how they could carry out their function without a broad systemic concern. Indeed, soon after assuming office as the Treasury Secretary, Paulson met with President Bush and "detailed the big increase in the size of unregulated pools of capital such as hedge funds and private-equity funds, as well as the exponential growth of unregulated over-the-counter derivatives like credit default swaps. 'All of this,' I concluded, 'has allowed an enormous amount of leverage - and risk - to creep into the financial system.'" It is understandable that Bush wanted to know, "how did we get into this position?"
It was a question that pointed directly to an intellectual and political failure of the first order. To be sure, recent years have seen magnificent advances in science and technology, but in matters economic, social and political in the United States there has been a serious default. An elite, large and amorphous but bound together by a common impulse and considerable self-interest, dominates both of the major political parties and the commanding heights of business and academia, while its regnant ideology of globalism, multiculturalism and unrestrained markets has come to spurn the interests and wishes of the average citizen.
For his part, Paulson was a member of that elite, having long been the top man at Goldman Sachs, and, as we will see, his actions reflected its predilections. Nevertheless, Paulson deserves credit for not himself having been in altogether deep sleep through the lead-up to the crash. In March 2008, the administration, acting through him and his staff at Treasury, proposed a "raft of recommendations" for financial reform and for "a new regulatory structure" that would include "a macrostability regulator." But this was twenty months after Paulson was sworn in, and in any event the reforms had been needed for several years. If Paulson is to bear responsibility for the factors that led up to the crash, it would simply be that he shared, to some degree, the government's, economists' and financial institutions' lack of urgency that the extreme brinksmanship of global finance required.
The dangers had long been seen. An important minority of commentators had warned of them. As far back as 1997, William Greider, in his One World, Ready or Not: The Manic Logic of Global Capitalism, described the growth of a rapidly expanding global financial market in which trillions of dollars sloshed around at great speed, warned about how that market tip-toed on the brink of disaster, and recommended reforms to tame it. He spoke of an "acceleration in trading" that had spread beyond currencies to "bonds, stocks, commercial notes, even bundles of home mortgages." As an example, bond trading burgeoned during the 1980s "from $30 billion daily to more than $500 billion." The market dwarfed the resources of central banks, and was prone to "violent oscillations" because "the impulses of investors were transmitted almost instantly as abrupt shocks throughout the global system." Greider said that "if my analysis is right, the global system of finance and commerce is in a reckless footrace with history, plunging toward some sort of dreadful reckoning...."
He thought this outcome could be avoided "if nations will put aside theory [i.e., the idealization of global free trade] and confront what is actually occurring." What was needed was for governments "to reregulate finance capital," reimposing "some of the control measures that they discarded during the last generation." To "moderate the gargantuan daily inflows and outflows of capital across national borders," he called for "measures like transaction taxes on foreign exchange," and explained that "by raising the cost of shortrun transactions, capital controls would take some of the fun out of currency trading and other speculative activities...." He saw that this "would not inhibit the long-term flows of capital for foreign investment." Greider pointed out that such a tax had been "proposed more than fifteen years ago by Yale economist James Tobin."
Would such controls and a transaction tax have required an unattainable level of intergovernmental cooperation? Greider didn't think so. He argued that controls could be imposed unilaterally, if necessary, by the United States. Foreign investors "would discover that they need the American market" and American investors would have to "respect U.S. rules if they wish to rely on U.S. protection." For one, "the Federal Reserve could eliminate the leakage from offshore banking centers in an instant... simply by declaring that U.S. banks cannot accept transfers from them." It is relevant to the reforms now being put into place after the 2008 crisis that Greider admonished that "reforms that simply stabilize the present system by reducing the most visible risks are an insufficient answer...."
Greider was unfortunately accurate when he saw that "a genuine debate on these questions in America is most unlikely," because "the orthodoxy reigns confidently despite gathering signs of systemic stress." The prevailing global free trade ideology stood in the way. To this, we might add that powerful commercial and financial interests, represented by an army of lobbyists, have a grip on both of the main political parties, and militate precisely in favor of such things as tax-and-regulatory-havens and unrestrained trade. Yet another factor that barred preemptive reform was, as Paulson repeatedly points out, that Congress cannot move itself to act until a crisis occurs. This creates a structural inability to act proactively. For all these reasons, a generation's leadership set up shop on the side of an ominously rumbling volcano while persuading itself that there was no urgency.
Because the table had long been set for the crisis, the judgment about Paulson's own performance must turn on how he responded to it when it struck. Unfortunately, this response was marked by a certain tunnel vision; he reacted instinctively and with a preoccupation with the financial giants, no doubt reflecting his own background with Goldman Sachs. He lacked a broad vision of how the underlying pathology was to be addressed. The method that Paulson, working with Bernanke, used in combating the financial crisis was the same as the one that had been used by Alan Greenspan when he was chairman of the Fed: a case-by-case (i.e., firm-by-firm) scramble to prevent the imminent collapse, one after another, of massive financial companies, each of them perceived as "too large to fail." (Each company had intricate connectivity with the financial web internationally.) The imperative, as Paulson saw it, was to "act out of necessity"; saving each of the behemoths was essential "to preempt a market panic." By the fall of 2008, the emergencies followed each other so quickly that there was hardly time to think.
What was needed was for Paulson to have thought ahead of time about how to respond to a crisis. Paulson's book, though, shows that he came from a world of acting men and was scarcely an intellectual. He preferred short conversations on policy issues and calls to CEOs of major companies such as he had been, and detested "briefing papers" (which could have brought the world of ideas and expert opinion to him). His book tells of his own decisions and his insistence that each represented the only acceptable course of action (even though he belied this by changing course over time), but ignores the need to explain the rationale for picking them over alternatives. On the Brink is not an analytical book. There is no indication that Paulson was plugged into the best thinking available in academia and elsewhere. The index contains no reference, for example, to Greider (or to the economist Paul Craig Roberts to whom we will be referring). It is revealing that Paulson says that it wasn't until the very day the mortgage debacle created a "crisis in the financial markets" (August 9, 2007) that "we went into high gear," with the Treasury's legal department just then beginning "to examine the statutes and historical precedents to see what authorities the Treasury - or other agencies - might have to deal with market emergencies." Such a lack of preparation is almost incomprehensible, since we might presume it to have been a standard part of Treasury's accumulated knowledge. Several months later, in March 2008 when Bear Stearns was in trouble and was about to be bought out by JPMorgan, Paulson still had no well-thought-out plan, telling President Bush that "the whole system is so fragile we don't know what we might have to do if a financial institution is about to go down."
Just the same, readers cannot help but feel sympathy for Paulson in the agonies he suffered in 2008 when circumstances called upon him to meet one emergency after another in rapid succession as major financial institutions approached collapse. This book is told in the form of a diary, in effect, of his decisions and interventions, primarily in the fall of that year. We are even told such personal details as his inability to sleep on a given tension-filled night. Readers struggle with him as he goes through his ordeal.
This sympathy doesn't keep us from seeing that Paulson gave little respectful attention to other proposed solutions. There were ideas that, if taken to heart, would have been immensely helpful. In meeting the needs of the major financial institutions, Paulson addressed the problems from the top down, dealing with devastating symptoms rather than removing the causes. Even though the arranging of emergency assistance to troubled companies from other firms that were still viable was questioned by Wall Street bankers who asked "where would it end?," Paulson was convinced this was the best method: "Using the analogy of a forest fire, I said it mattered less how the blaze started than it did to be prepared to contain it - and then put it out" (our emphasis). (The point may be a good one for some fires, but not for those where an underlying cause, such as a flow of natural gas, remains active.)
Paulson's second strategy, once he decided that the company-bycompany approach needed to be supplemented by something more, was to use the federal bailout money to buy up the "toxic assets" held by the troubled financial institutions. From everything financial experts have told us about the crisis, however, we know that there was no finite class of "toxic assets." The global financial problem was that unsound mortgages had been mixed into complex securities that included large bundles of mortgages and were sold worldwide, so that the problem was precisely that the markets were paralyzed with uncertainty about which assets were good and which bad. Countless billions of dollars spent buying some of these securities would not solve the problem. When it became apparent to Paulson that this wouldn't work, he shifted to injecting capital into companies in exchange for equity. This strategy continued the fixation on the large companies, while others in the economy suffered as though their travails did not count as "systemic."
Paul Craig Roberts, who had been Assistant Secretary of the Treasury during President Reagan's first term, has made himself a persona non grata in many quarters by so long being stridently outspoken about the plight the elite has gotten the U.S. economy into, and about what should have been done to meet the crisis. In a column on October 9, 2008, right in the middle of the crisis, he wrote that "instead of wasting $700 billion on a bailout of the guilty that does not address the problem, the money should be used to refinance the troubled mortgages, as was done during the Great Depression. If the mortgages were not defaulting, the income flows from the mortgage interest through to the holders of the mortgage-backed securities would be restored. Thus, the solvency problem faced by the holders of these securities would be at an end." In other words, he would have gone to the source of the toxicity, removing it and thereby taking the incubus off the back of financial institutions and investors worldwide. To provide time for them to "sort out derivative values" and "to halt the forced sale and write down of assets," Roberts would have suspended, for the emergency, the "mark-tomarket" rule that required such a write down. "Stopping the problem at its origin would restore the value of the mortgage-based derivatives and put an end to the crisis."
A further step would have been "to prohibit short-selling" or at least to "reinstate the uptick rule" (an earlier rule that had "prevented short-selling any stock that did not move up in price during the previous trade"). Applying the rule would stop speculators from "ganging up on a stock and short-selling it trade after trade." " To complete the rescue," he proposed, in addition to reinstating the uptick rule, a second act that would not have "cost the taxpayers one dollar: an announcement from the Federal Reserve that it will be lender of last resort to all depository institutions including money market funds."
But Roberts looked even further. He saw that the offshoring of American jobs had diminished the economy's ability to generate consumer demand. The later "stimulus package" of additional billions would simply "stimulate production in China and other offshore sites." The unemployed would suffer; and without consumer demand, businesses would languish. Monetary and fiscal policy could be no help, since they had little to act upon. By pointing to this, Roberts stood in opposition to the business interests that had long profited from the offshoring and to the globalist consensus that American deindustrialization was a welcome manifestation of "the growing international division of labor."
Paulson's book reveals no awareness of such a truly systemic approach. The closest he came to it was in mid-crisis when he decided that the company-by-company approach "was no longer enough" and began seeking a large bailout bill for money to buy toxic assets. As we have seen, this wasn't "systemic" in the sense of going to the root of the problem. He wasn't prepared for a crisis, and he either didn't inform himself of other views or looked upon them with intolerance. (Partly this was because he felt the need for a less-than-democratic approach, given the emergency, as he pressed Congress to approve the bank bailout: "We felt we could not show any doubts about our approach or any openness to other ideas.") His focus, as we have said, was at the top. The prevailing consensus, to which he held, would consider Roberts "a populist." We see the clash of opposing forces within American society when Roberts says that "never before in our history has the elite had such control over the government."
We have given so much attention to Roberts as the opposite pole from Paulson because Roberts seems to have taken a more comprehensive view than was taken by any of the other voices speaking up for alternatives. Some did press for mortgage renegotiation, thus paralleling one of Roberts' main points. Sheila Bair, head of the Federal Deposit Insurance Corporation (FDIC), was one who wanted "to dramatically broaden the scope of relief efforts" relating to mortgages. Others opposed bailouts of any kind, perhaps premising their position on the theory that economic downturns are most expeditiously resolved by letting things hit bottom as quickly as possible so that a rebound can get underway. (Roberts would point out, of course, that there is little to rebound to in light of deindustrialization's having hollowed out the American economy and cut sharply into well-paid jobs.) On the Brink acknowledges that House Republicans had "philosophical reasons" for opposing bailouts and foreclosure legislation, but Paulson passes them off without examination or even telling readers what those reasons were. Our reviews in this Journal of books by several other financial experts have spoken of the wide variety of solutions they preferred. It is worth noting that almost none have thought well of the "top-down" bailout method. Joseph Stiglitz, for example, spoke of it as "trickle-down economics" premised on the idea that by helping the banks enough, homeowners and the rest of the economy might get some respite." But even he did not look as deeply as Roberts.
Readers who would like a readable chronology of the credit crisis will find that On the Brink traces it primarily from the standpoint of the Treasury Secretary, while David Wessel's In Fed We Trust: Ben Bernanke's War on the Great Panic follows the Federal Reserve chairman's handling at his end. Of course, Paulson and Bernanke worked closely together, as each book reflects. There is much that is of interest, as the books cite the details of the critical moments involving Countrywide Financial, Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, AIG, Washington Mutual, Wachovia, GE Capital, Citigroup, Chrysler, General Motors, and Bank of America. The coverage in the two books is not identical, so there is benefit from reading them both.
Dwight D. Murphey