Near the end of his blow-by-blow account of how Hank Paulson's Treasury Department confronted an imploding economy, Phillip Swagel, the former assistant secretary for economic policy, makes a revealing and self-serving admission:
Treasury had to be able to explain what it was doing and how the programs fit together -- never our strength.
This is undeniable. Anyone who watched Hank Paulson testify before Congress when defending Treasury's original request for $700 billion in TARP funds will agree: He did a terrible job explaining what he wanted to do or how it would work. Maybe if he'd done a better job, he could have avoided the political circus that followed, a fiasco that probably contributed to further panic in financial markets and greater economic damage than would otherwise have occurred.
Of course, that supposes that the Treasury Department did actually know what it was doing and how all its programs fit together -- and the jury is still very much out on that question, despite Swagel's impressive job of making the case for the Treasury's various initiatives. His account, "The Financial Crisis: An Inside View," is packed with detail far beyond anything we've heard from the Bush administration so far. Swagel deals with efforts to slow foreclosures, the nationalization of Fannie and Freddie, the decision to allow Lehman to fail, and, of course, the big daddy of them all, TARP. Swagel's report will be an important footnote in every history of the financial crisis written from here on out.
There's a lot to digest, so let's focus on TARP. Swagel writes that as early as March 2008, the Treasury Department began to put together the elements that would later become integral parts of TARP -- "to buy assets, insure them, inject capital into financial institutions, or to massively expand federally guaranteed mortgage refinance programs in order to improve asset performance from the bottom up." The implosion of Bear Stearns in April only underlined the potential necessity for significant intervention in the financial markets.
But political constraints, argues Swagel, prevented Paulson from doing anything major at that time.
But these actions all required Congressional action and there was no prospect of getting approval for any of this. With [GDP] growth positive and the stimulus rebates only just beginning to go out in late April, it was unimaginable that Congress would give the Treasury Secretary such a fund. And it was doubly unimaginable that the fund could be enacted without immediately being put to use. Such a massive intervention in financial markets could only be proposed if Secretary Paulson and Chairman Bernanke went up to Congress and told them that the financial system and economy were on the verge of collapse. By then it could well be too late.
And in April 2008, while many economists and economy watchers were seriously worried about the long-term prospects of the economy, it was difficult to make the case to the general public that Armageddon was around the corner. Quite the opposite.
For several months in the second quarter of 2008, it seemed like things were improving. The housing adjustment appeared to be proceeding. Prices continued to fall and construction and sales were still in decline, but the rate of descent appeared to be slowing and our view was that by the end of 2008 housing would no longer subtract from GDP. The second half of 2008 looked to be difficult, but we expected the rebate checks to support consumption until the drags from housing and the credit disruption eased and growth rebounded in 2009.
What Treasury did not expect, however, was a huge spike in energy prices that effectively negated the impact of the rebate checks. Swagel also acknowledges that Treasury totally missed the boat in its predictions of what percentage of homes would go into foreclosure.
Fast-forward to September, when matters deteriorated far enough that Paulson and Bernanke could tell Congress that the economy was about to blow up. Swagel emphasizes several times that Paulson never meant to mislead Congress -- his original intention had been to do as he promised, to use the TARP funds to purchase toxic assets. But by the time the funds were finally approved, the situation had deteriorated so much that he had decided that direct capital infusions into the banking system offered the only option for stabilizing the financial sector. However, if he'd come to Congress with that plan, he'd never have gotten anywhere, writes Swagel.
The problem with the criticism on capital injections vs. asset purchases is that Secretary Paulson never would have gotten legislative authority if he had proposed from the start to inject capital into banks. The Secretary truly intended to buy assets -- this was absolutely the plan; the TARP focused on asset purchases was not a bait and switch to inject capital. But Secretary Paulson would have gotten zero votes from Republican members of the House of Representatives for a proposal that would have been portrayed as having the government nationalize the banking system. And Democratic House members would not have voted for the proposal without the bipartisan cover of votes from Republicans. This is simply a political reality -- it was a binding constraint on the Treasury. The calls from academics to inject capital were helpful, however, in lending support for the eventual switch from asset purchases to capital injections (even though at times the vitriolic criticism was frustrating in that it was so politically oblivious).
One of the more intriguing subtexts of Swagel's account are his frequent references to outside critics -- Paul Krugman's name comes up at least once -- and his frustration with their inability to understand the political and legal issues that restricted Treasury's operating room. For example:
Some steps that are attractive in principle turn out to be impractical in reality -- with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word "force" is used as a verb ("the policy should be to force banks to do X or Y"), the next sentence should set forth the section of the U.S. legal code that allows such a course of action --otherwise, the policy suggestion is of theoretical but not practical interest.
Swagel's point probably still holds for critics of the Obama-Geithner strategy for addressing the crisis. The political implications of going to Congress and asking for authority to nationalize Citigroup and/or Bank of America often seem to be left out of the equation. But I'm less sure of Swagel's overall theme, which he recapitulates at the close of his report, along with a clear swipe at the Obama administration.
An honest appraisal is that the Treasury in 2007 and 2008 took important and difficult steps to stabilize the financial system but did not succeed in explaining them to a skeptical public. An alternative approach to this challenging necessity is to use populist rhetoric and symbolic actions to create the political space under which the implicit subsidies involved in resolving the uncertainty of legacy assets can be undertaken. It remains to be seen whether this approach will be successful in 2009.
Swagel appears to be saying here that by demagoguing on such topics as the AIG bonuses and Wall Street greed, Obama is clearing room for the politically unpalatable bailout of the banking system that must happen, one way or another. But it might have been more polite for Swagel to concede that had it not been for his own Treasury's failure to communicate what it was doing, while appearing for all the world to be congenital flip-floppers, the Obama administration might not be facing a public as angry and skeptical and unwilling to extend the benefit of the doubt as it currently is.
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