Read 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown Online
Authors: Simon Johnson
As the economy declined sharply, the sudden collapse in tax revenues left government finances in disarray. State and local governments resorted to severe cutbacks in services. The federal government dedicated $800 billion in new spending and tax cuts to stimulate the economy. However, stimulus spending and lower tax revenues pushed the 2009 federal deficit up to $1.6 trillion, or 11 percent of GDP, more than doubling the previous postwar record.
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The long-term effect of the financial crisis and recession is even greater. In January 2008, just as the economy was tipping into recession, the Congressional Budget Office (CBO) projected that, by the end of 2018, U.S. government debt would fall to $5.1 trillion, or 22.6 percent of GDP. Surveying the wreckage in August 2009, the CBO projected that debt at the end of 2018 would rise to $13.6 trillion, or 67.0 percent of GDP—a difference of $8.5 trillion.
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This should come as no surprise; Carmen Reinhart and Kenneth Rogoff have shown that, on average, modern banking crises lead to an 86 percent increase in government debt over the three years following the crisis.
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The financial crisis and the government’s emergency response also increased the likelihood of two bleak scenarios. First, the enormous amount of liquidity that the Federal Reserve poured into the economy created the long-term potential for high inflation; if the Fed cannot “mop up” that liquidity when the economy recovers, all that excess money could make dollars less valuable, driving up prices.
Second, the vast increase in the total national debt brought us closer to the point where it could become more difficult to raise money by issuing new government debt. Should that happen, the government will have to pay higher interest rates to borrow money, and those higher interest rates will spread throughout the entire economy, slowing economic growth. In a worst-case scenario, the government may have to raise money in foreign currencies, undermining one of our traditional advantages over much of the rest of the world. This is unlikely to occur solely as a result of the recent financial crisis; before the crisis, the United States was only moderately indebted by international standards and had the capacity to absorb one shock without seriously affecting our ability to borrow money. Whether we can absorb another such shock is another question. The United States did not look like an emerging market when the crisis began, but it has already become more like one.
J. Paul Getty is reputed to have said, “If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” The bank cannot afford a loss of $100 million, and therefore will do anything to help you avoid default—and that gives you power.
In 2008–2009, the tables turned. It was the major banks who were struggling with their debts, and it was the U.S. government that could not afford to let them fail, because of the damage that would inflict on the real economy and on tens or hundreds of millions of people. (Small banks, however, were like people who owed $100.) This meant that when the banks faced off with the government, they held all the cards. As Barney Frank put it, “All these years of deregulation by the Republicans and the absence of regulation as these new financial instruments have grown have allowed them to take a large chunk of the economy hostage. And we have to pay ransom, like it or not.”
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The fact that their failure could entail the loss of millions of jobs gave the banks the power to dictate the terms of their rescue. If the government insisted on paying market prices for toxic assets, or insisted on taking majority control, the banks could simply refuse to go along, secure in the knowledge that the government would have to come back to the table. In the end, the government had more to lose from major bank failures than did the bankers themselves, who had already made their money. Citigroup CEO Vikram Pandit, for example, made $38 million in 2008
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on top of the $165 million he made by selling his hedge fund to Citigroup in 2007.
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At most they would suffer a reputational blow should their banks fail—which they could always blame on market conditions and the failure of the government to come to their aid. This was the problem with the strategy of negotiating with Wall Street; Wall Street held all the cards.
But that is not a complete explanation, because there is little evidence that the government attempted to force the issue. It was not only that the government had a weak hand; it was that the government negotiators came to the table largely in agreement with the bankers’ view of the world. And it wasn’t just a few key people. Paulson, of course, was the former head of Goldman Sachs, and his aides at Treasury included Robert Steel, Steve Shafran, and Neel Kashkari from Goldman. In summer 2008, when he realized he needed reinforcements to fight the financial crisis, he summoned Dan Jester and Ken Wilson, also Goldman veterans.
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When faced with the potential insolvency of Fannie Mae and Freddie Mac in August 2008, Paulson hired Morgan Stanley (for a nominal fee) to analyze the two GSEs; Morgan Stanley was also hired by the Federal Reserve Bank of New York to advise on the AIG bailout.
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Given the urgency of the situation and the technical details involved, it made sense for the government to hire outside help. But that help could only come from one place: Wall Street.
What is more remarkable is that the policies of the Bush administration were largely carried over into the Obama administration, despite the enormous policy differences between George W. Bush and Barack Obama on almost every issue. This is because by 2009, the economic policy elite of the
Democratic
Party was fully won over to the idea that finance was good.
During the Democratic primary campaign, Obama’s chief economic adviser was Austan Goolsbee, an economics professor without a long track record as a party insider. But after Obama won the election, he turned to a Democratic establishment that was formed in the Clinton years, largely under the tutelage of Robert Rubin. Michael Froman, who was Rubin’s chief of staff at Treasury and followed him to Citigroup, and James Rubin, Rubin’s son, were both members of Obama’s transition team.
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(Froman was also an associate of Obama’s from their law school days, independently of Rubin; after the transition, he became a member of both the National Economic Council and the National Security Council.) Geithner, who had built close relationships with Wall Street CEOs during his five years as president of the New York Fed,
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became treasury secretary. Summers, most recently a managing director of the hedge fund D.E. Shaw, became director of the NEC. Peter Orszag, Clinton economic adviser and director of Rubin’s Hamilton Project, became head of the Office of Management and Budget; Gary Gensler, treasury undersecretary for domestic finance under Summers (and former Goldman partner), became head of the CFTC; Mary Schapiro, first head of the CFTC under Clinton and later head of the Financial Industry Regulatory Authority, the financial industry’s chief
self-regulatory
body, became head of the SEC; Neal Wolin, treasury deputy counsel and general counsel under Rubin and Summers, became deputy treasury secretary; Michael Barr, special assistant and deputy assistant secretary in the Rubin Treasury, became assistant secretary for financial institutions; Jason Furman, director of the Hamilton Project after Orszag, became deputy director of the NEC; and David Lipton, treasury undersecretary for international affairs during the Asian financial crisis and later Citigroup executive, also became one of Summers’s deputies at the NEC. Even President Obama’s chief of staff, Rahm Emanuel, had a similar background, having worked both as a Clinton adviser and as an investment banker at Wasserstein Perella.
Geithner’s counselors as treasury secretary included Lee Sachs from the Clinton Treasury (and most recently a New York hedge fund) and Gene Sperling, Rubin’s successor as director of the NEC (and most recently a highly paid adviser to a Goldman Sachs philanthropic project). The new blood that did not come from the Clinton establishment came largely from Wall Street. Mark Patterson, Goldman Sachs’s chief lobbyist, became Geithner’s chief of staff; Geithner’s counselors also included Lewis Alexander, chief economist at Citigroup, and Matthew Kabaker from the Blackstone Group.
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Assistant secretary for financial stability Herbert Allison was president of Merrill Lynch before heading TIAA-CREF (an asset manager) and Fannie Mae. Meanwhile, at the New York Fed, the board of directors picked William Dudley, a Goldman partner and then one of Geithner’s lieutenants, to replace Geithner as president.
There is nothing sinister about the appointment of so many veterans of the Rubin Treasury; according to usual Washington practice, Obama and his lieutenants were calling on people who had gained experience in the previous Democratic administration.
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And the fact that people worked under Rubin does not mean that they automatically sided with Wall Street on every issue. Some of them spent 2009 fighting for policies that were not friendly to Wall Street. Michael Barr, for example, was a strong advocate for a new Consumer Financial Protection Agency (CFPA), and Gary Gensler worked to plug loopholes in financial regulation bills as they worked their way through Congress.
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But the economic brain trust was largely shaped in two complementary environments: Wall Street and the Rubin Treasury. And while the Obama administration did not close ranks with the major banks, it also does not seem to have strongly considered policies that seriously threatened the power and profits of the major banks (with the possible exception of the CFPA).
The administration also included Democratic economists from outside the Wall Street–Washington corridor, but they were outnumbered and generally (though not always) placed in less central positions. Respected academic macroeconomist Christina Romer became chair of the Council of Economic Advisers; Alan Krueger, an economics professor who served in the Labor Department under Robert Reich, became a treasury assistant secretary; Jared Bernstein became chief economic adviser to Vice President Joseph Biden; and Goolsbee became director of the President’s Economic Recovery Advisory Board, a new organization that failed to gain any real influence. Even Paul Volcker, perhaps the most respected Democratic economist available, who endorsed Obama back in January 2008 when most of the establishment was backing Hillary Clinton, became chair of the Economic Recovery Advisory Board and seemed to fade from sight; in October 2009, responding to reports that his influence was fading, Volcker said, “I did not have influence to start with.”
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Not only did key policymakers have long-standing ties to Wall Street, but during the crisis they gave tremendous access to their Wall Street contacts. In his first seven months in office, Geithner’s calendar shows more than eighty contacts with Goldman CEO Lloyd Blankfein, JPMorgan CEO Jamie Dimon, Citigroup CEO Vikram Pandit, or Citigroup chairman Richard Parsons.
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While it is necessary for the treasury secretary to talk to Wall Street executives during a financial crisis, he had more contacts with Blankfein than with Senate Banking Committee chair Christopher Dodd and more contacts with Citigroup than with House Financial Services Committee chair Barney Frank. (This was a far cry from the tone of the Roosevelt administration in 1933, of which Arthur Schlesinger wrote, “When one remembered both the premium bankers put on inside information and the chumminess they had enjoyed with past Presidents and Secretaries of the Treasury, the new chill in Washington was the cruelest of punishments.”)
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In a world where access is a prerequisite for influence, Wall Street had access to the people who mattered, when it mattered.
As a result, economic policy in 2009, just as in 2008, was set by a group of people who, despite their considerable intelligence, experience, and integrity, seemed to believe that the banks were fundamentally sound and only needed an injection of confidence; that each subsidy to the banking sector was justified because the costs of not making the subsidy would be worse; that government takeover of major banks was so anathema to the American way that it would trigger panic; that meaningful constraints on banks’ activities would inhibit economic growth; and that meaningful constraints on bankers’ compensation would send them fleeing to unregulated hedge funds or overseas, leaving the American economy to suffer as a result. But this is not surprising, because everybody believed all these things—everybody, that is, in the New York and Washington elite. Over thirty years, Wall Street had plied Washington with tantalizing tales of financial innovation and efficient markets while pouring rivers of money into politicians’ campaign funds and lobbyists’ expense accounts. In 2008 and 2009, it all paid off.
As Michael Lewis put it in 2009,
It does feel a lot to me like the process has been queered by political influence, and it’s a very curious kind of political influence. Because it isn’t maybe always as simple as bribery, campaign contributions, and that kind of thing. I think that we’ve had twenty-five years of the Goldman Sachses of the world ruling the world, and the people like Tim Geithner, when they leave office, the way they make their living … is to go to work for a financial institution for huge sums of money; that people have trouble getting their mind around a world where that’s not the way the world works, and there is maybe a slight quickness to believe that the world can’t function without Goldman Sachs.
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