History Lessons

As the crisis enters its second year, the economic history books have already begun publishing an early account of first stages of the crisis. In particular, two articles have been released this week that serve as essential reading.

First, this month's Vanity Fair features an excerpt from Andrew Ross Sorkin's upcoming book, Too Big to Fail. Sorkin's piece gives a thrilling, minute by minute account of the chaos within the halls of Wall Street during the aftermath of the Lehman collapse. The article offers a view of the day's events through the perspective of the most important players in finance, including Timothy Geithner.

Due to disastrous bets on Lehman paper, the giant Reserve Primary Fund had broken the buck a day earlier, causing an investor run on the money-market funds. Between that, Geithner thought, and billions of dollars of investors’ money locked up inside the now bankrupt Lehman Brothers, that meant only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

...and Hank Paulson:

‘This is an economic 9/11!” There was chilling silence in Treasury Secretary Hank Paulson’s office as he spoke. Nearly two dozen Treasury staffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge of Paulson’s desk, scribbling on legal pads. Paulson was seated in a chair in the corner, slouching, nervously tapping his stomach. He had a pained look on his face as he explained to his inner circle at Treasury that in just the past four hours the crisis had reached a new height, one he could compare only to the World Trade Center attacks, seven years earlier, almost to the week. While this time no lives may have been at stake, companies with century-long histories and hundreds of thousands of jobs lay in the balance.

Sorkin reminds us of the important, and occasionally catastrophic, role that emotion and uncertainty played during the chaos of last September.

Next, this week's New Yorker has a lengthy article by Ryan Lizza on Larry Summers and the White House economic team, offering a thorough account of the crisis through the lens of Barack Obama's most trusted economic adviser. The essay gives an excellent overview of the embryonic stages of the Obama administration's crisis response, and serves as a necessary reminder of the uncertainty prevailing during that period.

Here is an example of the debate within the administration over whether or not to nationalize the country's beleaguered banks, beginning with a discussion over the value of "toxic assets" on banks' balance sheets: 

“If you think about a security that is bought on margin,” Summers explained during a speech early last year, “when its price goes down there are margin calls which force liquidations, and more of it is sold. So a falling price is not a stabilizing mechanism, but it is potentially a destabilizing mechanism.” He called this “the liquidation vicious cycle,” and the result can be that institutions are depleted of capital as the psychology of a bank run prevails and the value of their assets plummets.

This insight formed the basis of the Obama Administration’s understanding of the crisis, especially the debate over nationalization. The nationalizers thought that the banks were insolvent—that the toxic assets were worthless. But Summers and Geithner, though they disagreed on some aspects of the stress tests, agreed that the asset prices were simply under attack from the liquidation vicious cycle, and that recapitalizing the banks and restoring confidence would stem the panic and restore some value to the bad assets. The recession had saved Summers. It made him indispensable, especially to a young President facing an economic calamity of which very few people seemed to have any understanding.

The article is worth a read, especially for the accounts of the debates within Obama's economic team. It credits these debates for coming up with a policy response that has, up to this point, prevented an economic collapse. In the words of one adviser, “History has not been kind to Administrations where everybody agreed with each other and all they ever had to say was, Good idea, boss.”

These debates may have helped save us from the worst. Let's hope they continue well on into the recovery phase.