Tim Geithner Has Stressed Me Out: Saturday Focus: May 10, 2014

Over at the WCEG: I still do not have a copy of Tim Geithner’s Stress Test. That means I cannot take on the task of explaining, justifying, and putting in context (1) Bernanke-Geithner Federal Reserve and then (2) Obama administration macroeconomic policies from 2007-2012. All I can do right now is lay out my own errors of judgment from 2007-2012.

As I look back, I see that my serious errors of judgment were only secondarily about the state of the economy. They were primarily and overwhelmingly about senior Bernanke-Geithner Federal Reserve and Obama-Geithner policymakers and (a) how they viewed the economy and (b) what policies they would pursue.

My errors were:

1. In the fall of 2007, concluding that the situation was serious but not dire: that while the Bernanke-Geithner Federal Reserve had been seriously behind the curve, both in understanding how risky mortgage financing have become and in understanding how modern financial engineering have not distributed but concentrated that risk; that they now understood how serious the situation was, and would take appropriate action to prevent the development of a full-blown financial crisis.

2. In the spring of 2008, concluding that the situation was dire but not catastrophic: that the Bernanke-Geithner Federal Reserve had failed to head off a full-blown financial crisis; but that they now understood that their job was to build a firewall to prevent financial crisis distress from spilling over and causing significant recession in the real economy.

3. In the fall of 2008, concluding that the situation was catastrophic but not irreparable: that a major financial crisis was in progress, and the Bernanke-Geithner Federal Reserve had failed to loosen monetary policy fast enough to properly support demand and so keep that financial crisis from spilling over and causing a serious decline in total spending; but that they now understood that it was a time for the full-fledged application of Bagehot’s Rule–lend freely but at a penalty rate to solvent but illiquid institutions; take insolvent institutions and nationalize them, resolve them, place them into receivership, whatever term you prefer–and use truly extraordinary monetary, fiscal, banking, housing policies to fill in the large gaps in aggregate demand and prevent the recession already baked in the cake from becoming record-breaking one.

4. In the winter of 2009, concluding that the catastrophically-ripped macroeconomic fabric could not be repaired in time to prevent a record-breaking downturn, but that macroeconomic recovery would be accomplished within two or three years, because the senior policymakers of the Obama administration understood the situation and would use their tools: they would step up with a second round of expansionary fiscal stimulus if the Recovery Act proved too small; they would install the right people at the head of the Federal Housing Finance Administration, in order to use the GSEs’ control over housing finance as a tool of macroeconomic stabilization, foreclosing on the foreclosure wave and so boost housing construction; they would provide Ben Bernanke and his successor at the Federal Reserve with a left wing of Keynesian Governors, to balance out the austerity-minded Regional Reserve Nank Presidents, and so give Bernanke and his successor room to maneuver properly and technocratically; they would take TARP money, leverage it up, and use it as capital to restore the risk tolerance of investors and financial institutions; and they would maximize their freedom of action to pull the levers of macroeconomic policy without having to seek additional legislative authorization from the sclerotic Congress–for they understood how bad and unrecoverable it would be to land in the “jobless recovery” lower tail of the distribution of possible future outcomes.

5. Throughout, that policy would be governed by the background appreciation of what Robert Rubin calls probabilistic assessment: that at every decision point one does what seems best, but always in the background there are two questions: “What if we are wrong today in our assessment of this situation? If two years from now it turns out that we were wrong today, what steps will we wish two years from now that we had taken today in order to give us the ability to recover from our mistake?”

As I look back, it seems to me that I was broadly (not completely) right in my assessment of the economy at each stage:

• It was not the case that irreparable unrecoverable catastrophe was baked in the cake by the housing bubble and the derivative financial engineering-driven concentration of risk as of the summer of 2007 (the date when I at least first realized that financial engineering had not distributed but concentrated housing finance derivative risk to a dangerous degree).

• Rather, it seems to me that with proper handling of financial distress–as the Resolution Trust Corporation handled the Savings-and-Loan crisis of the late 1980s, say, or as the Reconstruction Finance Corporation made the Great Depression less great–we could easily have gotten through 2007-2009 with a minor recession; if so, we would now have a level of economic prosperity something like 8% higher than what confronts us now and into the indefinite future.

• And it seems to me that at each stage–as “dire” turned into “serious” and “serious” turned into “catastrophic” and “catastrophic” turned into “irreparable” and as “irreparable” turned into “unrecoverable”–that steps could be taken to stop the train, that those steps were clear if not obvious, and that first the Bernanke-Geithner Federal Reserve and then the Obama administration would take them.

What I hope to get from Stress Test is why I was so wrong in my reading of what first the Bernanke-Geithner Federal Reserve and second the Obama administration was going to do. For it is still, in spite of everything, a substantial mystery to me…

I guess I will see next week…