Contradicting Secretary Geithner

Crossposted with The Baseline Scenario.

Speaking Thursday morning on the Today Show, Treasury Secretary Tim Geithner insisted on two points:

1. If the bank rescue of 2008-09 had been handled in any other way -- for example, being tougher on bankers -- the costs to the real economy would have been substantially higher.

"again, what was the choice the president had to make? He had to decide whether he was gonna act to fix [the banking system] or stand back because it might be more popular not to have to do that kind of stuff, and that would have been calamitous for the American economy, much, much worse than what we went through already."

2. The reform legislation currently before Congress would end all concerns regarding Too Big To Fail in the future.

"The president's not gonna sign a bill that doesn't have strong enough teeth."

In 13 Bankers, we disagree strongly with point number one (see this excerpt) and find point number two so at odds with reality that it is scary. Friday morning, also on the Today Show, I have a brief opportunity to suggest a different narrative.

First and foremost, it is impossible to believe that the government could not have been tougher on banks and bankers in spring 2009. The idea that every failed top banker needed to keep his job -- and that every director of a failed bank needed to stay in place -- is simply preposterous.

Of course, the people who ran our biggest banks onto the rocks think they are indispensable, but as Charles de Gaulle reportedly said, ""The cemeteries of the world are full of indispensable men."

This is not about being vindictive. This is about holding people accountable. We argue in 13 Bankers that the government could have taken over big insolvent banks -- and applied a FDIC-type resolution process. At the very least, top management and boards of directors at failed banks -- i.e., all those rescued by the government -- should have been fired.

Not only that -- but all those people should have had their contracts broken and their bonuses clawed back to the full extent possible. Losing personal money is the only thing that modern American financial executives ultimately understand. And if that was breach of contract -- let them sue and good luck to them in court; just think of the extra evidence for wrongdoing that would uncover.

The costs of this excessively nice approach are enormous. "[I]t is certain that a healthy financial system cannot be built on the expectation of bailouts" -- that's what Larry Summers said in his 2000 Ely Lecture to the American Economic Association, and it's true (see the American Economic Review, Vol. 90, No. 2; no free weblink available). Now we have a system where the biggest banks expect to be saved, come what may -- and the credit markets share that view. This is monstrously unfair and extremely dangerous.

In fact, it's exactly the kind of financial structure that Larry Summers railed against in 2000 -- that lecture was mostly about "emerging markets" and how they get into repeated financial crises. This is where the US is now heading.

As for the financial reform bill now before Congress, Secretary Geithner is completely wrong if he thinks it "has teeth." There is simply nothing there that will rein in our largest financial institutions -- and you can see this in the financial markets. Even as some sort of legislation moves closer to passing, massive banks retain their funding advantage -- and continue to look for ways to get larger (see Jamie Dimon's letter to his shareholders this week).

And as a symptom of these continuing problems, see the latest round on executive pay at banks -- we're back to cash and other short-term oriented payouts. This administration recognizes that such incentives are dangerous -- particularly when combined with implicit government guarantees. But they can do nothing -- and will do nothing -- about this or about the deeper underlying issues.

The biggest and most dangerous elements of Wall Street have taken over Washington.