Ellis Tallman is the Danforth-Lewis Professor of Economics, Oberlin College, and was formerly Vice President, Federal Reserve Bank of Atlanta.
David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more. The book gives us an inside view of how policy making took place in response to the striking events. Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded. In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process. Here, we emphasize three serious flaws in the policy-making process that Wessel describes: the consistent lack of a plan and short-time horizon of the decisions, the insularity of the decision makers, and the apparent disregard for FOMC information-security rules governing meetings and associated documents. We conclude by noting some oversights in Wessel’s account of the Great Depression and the Panic of 1907.
Lack of a Plan
The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded. It is not a pretty picture. His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed.
The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them. The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency. The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not. The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences. For example, the problems of exiting from many of the policies are now significant and have yet to be addressed.
Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted. This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing. It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008. That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem.
By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis. Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available. Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated. This was long before the problems in Lehman Brothers emerged. Market participants’ concerns, as subsequent events proved, were well-founded. It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans. Most of the largest financial institutions – both domestic and international – proved to have inadequate capital. Some failed, and many were bailed out by their respective governments.
Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time. The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved. And lacking a plan, it is harder to see if and when a decision was wrong.
Delegated and Concentrated Decision Making
The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC. Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information.
Why did it happen? Under what authority did this happen? One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies. Let us explain. Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions. According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and, at a minimum, an agenda must be provided,. For this reason, only three governors can get together in the same room without it constituting a “meeting” and invoking the provisions of the Sunshine Act. But during the entire crisis there have only been five governors on the Board, with two vacancies. (David Kotok has written extensively on this issue in previous commentaries.) Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions. Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared. It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative. Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs.
The Sanctity of FOMC Meetings
From the perspective of former senior officials of the Federal Reserve System, the details that Wessel reports about specific material in confidential FOMC documents and discussions that took place during FOMC meetings are especially discomforting. FOMC security is governed by the FOMC’s Program for Security of FOMC Materials, which is a classified program that defines the security levels and handling of FOMC-classified documents. The Program also sets out rules for how many people can have access to such documents. At one time, only 10 people at each reserve bank (with the exception of New York and the Board) could have access to the Bluebooks, which contain the policy options presented by the staff to the FOMC. The Bluebooks receive the highest level of security classification. The procedures also require detailed record keeping and govern storage and delivery of both hard-copy and electronic documents.
Most importantly, it is also clear in the Program to every attendee that what goes on in that board room at the Board of Governors stays in that room until the transcripts are made public five years later. In the past there have been a few leaks. When that happened, staff who attended the meetings, as well as bank presidents, and presumably Governors, were interviewed under oath by the FBI in one case and by a representative of the Board’s Inspector General in another case in an attempt to smoke out the source of the leaks. The penalties for divulging classified information are extremely severe and might even include criminal charges.
Against that background, the kinds of candid conversations that Wessel had and divulged in his book are indeed surprising. There are at least a dozen revelations of what went on at various FOMC meetings, who said what, and even what was substantively covered, that rise to a level of severity far above that which triggered investigations by the FBI and Inspector General during the Greenspan era. One might deduce by simply examining historical Bluebook documents released on the Board’s website that the staff typically offers three policy options for FOMC consideration at each meeting. So in describing that process Wessel is merely drawing on public information. However, Wessel indicates that in one meeting during the crisis there were actually four options presented, and he describes what some of those options were. Either there have been significant revisions in the Program for Security of FOMC Materials in the past couple of years or there is now blatant disregard, for whatever reason, of the rules and sanctity of the meetings. One could view this as another example of how the rules are now being bent at the Fed. In the near term, these revelations may further damage the credibility of both the FOMC and the Federal Reserve. It certainly weakens the Federal Reserve’s arguments against additional Congressional auditing of Federal Reserve activities. After all, if FOMC participants can freely talk to the press in violation of their own security rules, surely Congress has a right to know what is going on as well.
Prior Financial Crises: 1907; The Great Depression vs. Depression 2.0
Wessel devotes Chapter 2 to describing what he believes are parallels between financial crises of the past and present. In the interest of historical accuracy, even if it appears that we are nitpicking, it appropriate to point out a couple of factual oversights. In the second chapter of the book Wessel mischaracterizes key events during the Panic of 1907. Specifically, he notes that the suspension of Knickerbocker Trust on October 22, 1907, after several days of depositor withdrawals, was the catalyst for the onset of that crisis. Wessel refers to the Knickerbocker Trust as the “Bear Stearns” of its day, claiming that Knickerbocker had lent heavily to the copper speculators, who failed in an attempt to corner that market and brought that firm down, just as Bear Stearns’ mortgage activities brought it down. But in fact, such allegations about Knickerbocker have never been substantiated, and Wessels may have drawn upon a flawed analogy. Bear Sterns’ problems were of its own making and not due to the actions of its borrowers. In discussing Knickerbocker’s failure, Wessels also suggests that Benjamin Strong, then a Morgan employee who was asked by Morgan to inspect the books of the trust company, said that Knickerbocker Trust was insolvent. Rather, Strong said that he was unable to determine whether it was solvent or not, a subtle but important difference. That uncertainty parallels the uncertainty that market participants apparently felt about counterparties during the current crisis. Finally, in contrast to Bear Stearns, which was rescued, Knickerbocker Trust suspended operations but eventually reopened as a going concern in March of 1908. Ironically, the corrected analogy is likely a closer parallel than the one Wessel draws. It is precisely the lack of clarity about financial-market solvency in 1907 that parallels the opacity that existed in 2007-2008.
Regardless of perspective, we do not really know how close the financial market came to collapse in 2008. Whether letting Lehman Brothers fail was good policy or not, it is clear that timely resolution is critical when systemic issues are of concern. If policy makers, present and future, draw their insights from past attempts to alleviate crises, they should distinguish the successes from the failures during those episodes. Allowing Knickerbocker Trust to fail was likely a mistake, and one that arose from the lack of timely information about its solvency to the existing lender of last resort at the time (Morgan).
In another section, Wessel suggests that the Federal Reserve System’s creation was largely based on an earlier plan written by investment banker Paul Warburg. The statement overlooks the overarching point that the Federal Reserve Act was not the work of one person, but was in fact the outcome of several years of careful research, discussion, and debate. In particular, the National Monetary Commission and its proposal for banking reform, named the National Reserve Association, did incorporate many of Warburg’s ideas. But Wicker (2005) emphasizes that the Federal Reserve Act bore a striking resemblance to the National Reserve Association legislation. More importantly, the process was completed nearly five years after the Aldrich-Vreeland Act created the commission to study the reform of the monetary system. The larger point about the time taken to appropriately reform the financial and monetary system is especially relevant today, as the Congress seems to be in a great rush to reform our financial regulatory system in response to the current crisis.
Wessel’s treatment of the Great Depression era is essentially in accord with the standard views regarding that period. There are two minor points of difference, however. First, some of the Reserve Bank presidents (governors, as they were then called), most particularly Eugene Robert Black of Atlanta, were consistently supporting the extension of liquidity, rather than policies to enforce the gold standard. It was this policy that Friedman and Schwartz document and that resulted in a one third contraction in the U.S. money supply, thereby exacerbating the depression.
Wessel’s book confirms that the process of saving the financial system was, to no one’s surprise, ad hoc. Further, the decisions were imperfectly informed by the principals’ perceptions of what was actually occurring. Clearly, Chairman Bernanke understood the big risk of a financial meltdown and made bold moves to ensure that we didn’t experience another Great Depression. President Geithner, now Treasury Secretary Geithner, is described as an interventionist whose main concern was the short run and who was willing to deal with the unintended consequences as they arose. Finally, Secretary Paulson seems to have been solely a markets person, long on the bravado associated with a deal maker and short on the analytics required to formulate good policy.
Whether all the actions taken were necessary we will never know, because we can’t observe what might have been had other policies been followed. But it is clear that the process of dealing with the crisis might have benefited from additional inputs and analysis by people who held responsible positions within the Federal Reserve, but who, for whatever reasons, were not actively involved in the policy-framing process. Perhaps in the debate that surrounds regulatory reform of the financial markets, the basic management issues of decision-making process design and planning should become a priority. If not, then we may in the words of Yogi Berra experience déjà vu all over again.
We would like to note that we benefited greatly from the comments of Kenneth Kuttner who is the Robert F. White Class of 1952 professor of Economics, Williams College.