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When the Next Recession Hits

The government has less flexibility to address a financial crisis than it did during the last one.

Illustration by Oliver Munday

In August 2008, just before the slow-moving financial crisis turned into outright panic, the secretary of the Treasury, Hank Paulson, traveled to the Summer Olympics in Beijing. At a private lunch with Chinese officials, he learned that members of the Russian government had been urging the Chinese to join them in selling off large portions of their holdings in Fannie Mae and Freddie Mac, the multitrillion-dollar companies that supported (and still support) much of the American mortgage market. The goal, it seemed to Paulson, was to force the U.S. government into an unplanned emergency bailout of the two companies—or risk destabilizing the economy by making it impossible for people to get mortgages. “Whenever I envisioned the Russians selling, the knot in my stomach got bigger,” Paulson told me recently. (The Chinese, for their part, declined to sell.)

Shares in the two companies had been declining precipitously since late 2007, and even before Beijing, Paulson had been scrambling for a solution. The month before the Olympics, Congress, with urging from Paulson, had passed a law allowing the Treasury to make unlimited investments in Fannie and Freddie—a sort of first-strike doctrine in case Paulson needed to offset a crash. As Paulson told the Senate Banking Committee, “If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.”

As the companies’ stocks continued to fall that summer, Paulson decided he was going to need the bazooka; he believed investors wanted assurance that Fannie and Freddie would not be allowed to fail. The problem was that the legislation, as written, gave the government the right to inject capital into Fannie and Freddie only until the end of 2009, which would not be long enough. So Paulson and his team took a little creative license. They devised a structure that in essence enabled the Treasury to invest in “perpetual preferred stock”—essentially loans with no date at which they had to be redeemed—from the companies to cover their losses for years into the future, as long as the deal to do so was struck by the end of 2009. The team at Treasury took what Congress had meant to be a temporary guarantee and transformed it into a permanent one.

In enacting the eventual bailout of the American financial system, Paulson—with Ben Bernanke at the Federal Reserve and Tim Geithner at the New York Fed—took his cue from leaders in other desperate times. “The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation,” said Franklin Roosevelt in 1932, as America battled the Great Depression. “It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.” When Roosevelt was sworn in as president the following year, he tried not just “some” things, but a lot of them, passing landmark financial laws, some of which still govern banks in this country. In 2008, Paulson, Bernanke, and Geithner were even bolder and more persistent in their experiments. They didn’t always wait for Congress to give them permission. Instead, they stretched existing laws to their legal limit, and used new laws in ways that defied congressional intent.

All three argue that their actions prevented the Great Recession from spiraling into a Great Depression. That may well be. But if another crisis were to arise today, would Americans want today’s Paulson, Geithner, and Bernanke to take similar license?

Paulson has said that the Fannie Mae and Freddie Mac takeover was his most important act at the time. But while it kept the mortgage market functioning, it did nothing to create calm. A week later, Lehman Brothers, the financial services firm, which had over $600 billion in debt, filed the largest bankruptcy in American history. Investors, alarmed at the collapse, began to pull their cash from money market funds, which provide financing for many businesses. A widespread run would send the economy into free fall.

So the Treasury got creative again. This time, the mechanism was the Exchange Stabilization Fund, a pool of money the Treasury is only supposed to use if the dollar comes under extreme pressure. This hadn’t happened, although one could argue, and Paulson did, that the potential demise of the U.S. economy would indeed cause the dollar “extreme pressure.” On September 19, the Treasury announced that up to $50 billion—nearly all of the ESF’s assets—would be made available to guarantee deposits in money market funds.

It didn’t stem the panic. The Dow Jones Industrial Average continued to plummet. On October 3, President Bush signed into law the $700 billion Troubled Asset Relief Program, or TARP. Again, Paulson and the others would do something Congress had not intended. Lawmakers thought that TARP would be used only to buy troubled mortgage assets from financial institutions. The specific language of the legislation, however, actually allowed the money to be used to buy just about anything, as long as Paulson and Bernanke deemed it necessary to protect the system. Almost two weeks later, on October 14, with the markets still deteriorating, the Treasury Department announced that $250 billion in TARP funds would go toward purchasing shares in banks instead of mortgage assets. When Paulson was asked if the Bush administration had misled Congress, he replied, in an echo of FDR, “I will never apologize for changing an approach or strategy when the facts change.”

That same day, the FDIC, at the urging from the Federal Reserve and the Treasury, took a step that involved a big stretch of existing rules. The FDIC announced that its fund, instead of exclusively guaranteeing the safety of depositors’ cash, would be used to temporarily guarantee the new debt issued by financial institutions that weren’t yet failing, including Goldman Sachs, Citigroup, and smaller firms. A key argument was that if the fund was not used for this purpose, the banking system would fail, and the fund quickly would be emptied, leaving the FDIC unable to insure deposits at all.

And with that, the acute period of the financial crisis ended.

Ten years later, much of the debate about how the crisis was handled focuses on its specific winners and losers. Why save Bear Stearns and let Lehman Brothers fail? Why bail out wealthy bankers but not taxpayers? Many economists and academics agree that Paulson, Bernanke, and Geithner prevented a far worse outcome, but there is dissent. Dean Baker, senior economist at the Center for Economic and Policy Research, and the author of Rigged: How Globalization and the Rules of the Modern Economy Were Structured to Make the Rich Richer, has long argued that warnings of another Great Depression were a “scare tactic,” and that had the government allowed firms to fail, “we could have quickly eliminated bloat in the financial sector and sent the unscrupulous Wall Street banks into the dust bin of history.” Others have argued that the banks should have been nationalized, wiping out shareholders and bondholders.

The failure of the argument that there had to have been a better way is it can never be resolved. People in power took the course they did, the economy didn’t collapse, and there is no way to know what would have happened otherwise. If Americans could do things again, in some parallel universe, would they want the government to take a different course, knowing that this one, however unfair, did not lead to a second Great Depression?

It may be academically interesting to debate the bailout, but it is ultimately beside the point. There hasn’t been much public discussion about what does matter, namely, how much flexibility there should be in a future crisis. There is less now than before. New regulations have made it so a future Treasury secretary would not be able to use the ESF in the same expansive way that Paulson did, and the FDIC can no longer issue blanket guarantees of bank debt without Congressional approval.

It’s possible that the Treasury and Fed won’t need so much flexibility in the future. The 2010 Dodd-Frank law requires U.S. banks to give regulators “living wills”—plans to dismember themselves in times of collapse. It also created an “orderly liquidation authority,” which is supposed to provide a process to liquidate, say, Goldman Sachs quickly and efficiently, with shareholders and creditors, rather than taxpayers, bearing the losses.

But there’s a real disagreement as to how “orderly” the process would be if multiple banks were failing all at once. The next crisis might unfold in ways the new rules and regulations haven’t anticipated. Fixing it with laws based on the last crisis is probably not the best approach. In any event, stopping a run probably would require taxpayer money—it is just about the only thing that has stopped bank runs since the nineteenth century.

According to a 2012 Harris Interactive poll, 84 percent of Americans oppose another bank bailout, and Pew data shows that trust in government has rarely surpassed 30 percent since 2007. This means that whoever serves as Treasury secretary or Federal Reserve chairman in a future crisis will face a daunting decision: Follow the laws as written and as Congress and the public intends, and let things play out—or forcefully attempt to shape a better outcome in the face of both legal and public opposition.