The unwinnable war

By G.I. | WASHINGTON, D.C.

Tim Geithner didn’t originally plan to write a book. He changed his mind, he tells us in Stress Test, because “our response to the global financial crisis is still wrapped in myth, and haze and misperception.”

Mr Geithner’s greatest frustration is his inability to persuade the public that saving the financial system was necessary to saving the economy. He couldn't ask for better proof than the simultaneous appearance this week of a book by two leading economists taking issue with that central plank of his legacy.

In this week’s issue, we both review Stress Test and devote Free Exchange to House of Debt, by Atif Mian and Amir Sufi. Mr Geithner’s book is part personal narrative and part treatise, laying out how he fought financial crises and why. Mr Mian’s and Mr Sufi’s book is an academic work laying out the case for why Mr Geithner’s approach (though they don't associate it with him personally) was wrong.

Banking crises, by conventional thinking, are damaging because they cut off the flow of credit to business. Mr Mian and Mr Sufi dispute this view:

The real cause of the post-crisis slump, they argue, was not the damage to the banks, but the run-up in household debt that came before, which became an anchor on consumption when home prices subsequently collapsed.

They compile data and research that shows that economic harm was much more correlated to the wealth of borrowers than the overall health of the banking system. In a separate blog post, they also dispute Mr Geithner’s arithmetic that spending the TARP money on underwater homeowners would have had only a trivial effect on output.

They argue, therefore, that the money spent on the banks was better spent writing down the debt of homeowners; and that more generally, we should try to replace debt with more flexible equity-like contracts where possible.

It’s an intriguing argument, but I think they take it too far. Both the banking system and leverage play a part in the damage that crises do. The fact that the economy’s descent accelerated notably after Lehman's failiure, and that it started to pull out after the successful completion of the stress test of banks (Mr Geithner’s brain child) seem pretty good evidence of the contribution of bank sector distress to the behavior of the economy. And if the banking system is defined to include all the less regulated intermediaries such as off balance sheet vehicles, the collapse in the supply of credit is unmistakable. Finally, is it plausible that letting more of the financial system fail would have had no impact on the economy?

But public opinion about the financial rescue is not, ultimately, going to be settled by economic arguments such as the relative importance of bank recapitalization and mortgage relief. It is inextricably linked to opinion about banks themselves. Indeed, critics of Mr Geithner persistently attack not just the substance of his policies, but his mindset: they believe he refused to attach tougher conditions to the banks’ bailouts or do more to help homeowners because he was captured by the banks and their self-serving arguments about how they were vital to the economy.

There’s no question that Mr Geithner consistently advocated the policy that was better for financial firms. He opposed forcing AIG’s counterparties and banks’ unsecured bondholders to take haircuts. Even among his fellow crisis fighters at Treasury and the Fed, Mr Geithner is always the advocate of more: more bailouts, more money for bailouts, and more authority to do bailouts. He wants to save not just Lehman but also the far smaller CIT Group. He opposed nationalizing banks, and imposing curbs on the compensation of banks that receive TARP money.

Mr Geithner does a good job of showing why this was part of a consistent playbook: repudiating the claims on weak firms will scare anyone holding claims on even the strongest, triggering more panic, more runs, more failures, more pain, and ultimately more bailouts and more moral hazard: “This is the central paradox of financial crises: what feels just and fair is often the opposite of what’s required for a just and fair outcome. It’s why policy makers generally tend to make crises worse, and why the politics of crisis management are always untenable.”

Mr Geithner dwells at length on his failings as a public speaker, his inability to articulate the greater good the financial rescues did, or to project empathy. “I never found an effective way to explain to the public what we were doing and why. We did save the economy, but we lost the country doing it.”

In reality, the idea that a Treasury Secretary or president better able to feel the public’s pain would have changed the politics is suspect; through history, political backlash to financial rescues is the rule, not the exception. In April, 2009, at the height of the outrage over the bank rescues, we wrote:

[M]any of the same political obstacles crop up from one crisis to the next. Japan's Ministry of Finance first sought private-sector solutions to its banking crisis so as not to arouse voter anger by using taxpayers' money. When those solutions failed, the government proposed in 1995 spending a mere ¥685 billion ($7 billion) to take over the problem loans of seven jusen, or mortgage-finance companies. The backlash was intense. Opposition parties called for the finance minister's resignation and staged a sit-in at parliament. In one poll, 87% of voters disapproved. The measure eventually passed, but the experience was so searing that it discouraged the government from tackling the banks' much bigger bad loans until 1997.

Go all the way back to 1931 and Harold James tells us in his book The Creation and Destruction of Value how Austria spent 9% to 10% of GNP bailing out the bank Creditanstalt (whose collapse helped steepen the depression):

Like modern bailouts in emerging markets, it was accompanied by massive corruption, the revelation of which became the stock in trade of the opposition Nazi movement in Austria. Then, as now, there was massive public hostility to the idea of a bailout, in that it appeared to be a form of support for the institutions and people responsible for the crisis.

Mr Geithner's crisis management playbook, relying as it does on a readiness to back a broad range of institutions and resistance to the imposition of conditions on recipients, seems guaranteed to generate the maximum political blowback. Future crisis fighters will glean valuable lessons and insights from that playbook; but they won't learn how to make the public like it. It's not in the nature of crises.