Stress Test: The Indictment of Timothy Geithner

Even if a bank had never officially employed Geithner, his attitudes and concerns clearly reflect those of the financial industry. This comes through in matters big and small.
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At one point in his autobiography, Timothy Geithner proudly recounts responding to a question from Damon Silvers, a lawyer with the AFL-CIO who was at the time a member of the Congressional Oversight Panel for the Troubled Asset Relief Program (TARP). Silvers had referred to Geithner's background in banking. As Geithner relates the story, he corrected Silvers by pointing out that he had never worked in banking, never worked in investment banking, but rather had spent his whole career in public service.

Anyone reading this book will forgive Silvers for his confusion. Even if a bank had never officially employed Geithner, his attitudes and concerns clearly reflect those of the financial industry. This comes through in matters big and small.

On the small side, Geithner tells us that Jamie Dimon, the CEO of J.P. Morgan, offered to have his staff draft the financial reform bill. He adds that Dimon later expressed his irritation to President Obama because Geithner would not take him up on this offer, explaining that Dimon apparently did not recognize that having the staff of the country's largest bank draft financial reform legislation was not the message the administration wanted to send the public. Apart from the messaging issue, Geithner doesn't seem to see a problem with having the largest firm in the industry deciding how it will be regulated.

In the same vein Geithner tells us that Robert Rubin didn't like the Volcker Rule. This is a surprise? The Volcker Rule was designed to be a substitute for Glass-Steagall, which Rubin helped repeal as Treasury Secretary. Rubin then went on to personally profit to the tune of more than $100 million as a top executive of Citigroup, the firm that benefitted the most directly from the repeal.

On the more substantive side, Geithner's concerns seem to begin and end with finance. We see this early on in his recounting of the heroics of the Clinton era in engineering various bailouts. For example, he tells us about the twists and turns that the Treasury Department went through to rescue Mexico from its financial crisis in 1994. In his account he saved 90 million Mexicans from default, which would have implied hyperinflation and mass unemployment.

While we can never know the counter-factual, Mexico had the worst per capita growth of any major country in Latin America in the two decades following the Clinton administration's bailout. By contrast, Argentina, which did default in 2001, quickly recovered the ground lost in the ensuing crisis and grew rapidly until the world economic crisis in 2008. Of course the financial industry was much happier with the Mexican route, in which their loans were repaid in full, than the Argentine route where they were forced to take substantial losses.

The confusion of the health of the financial sector with the health of the economy continues with his discussion of the East Asian bailouts. Here also the rules were that the creditors would be repaid in full, with money and guarantees coming from the International Monetary Fund. Geithner presents the bailouts as overwhelming success stories, ignoring the fact that the condition for these countries repaying their loans was a depreciation of their currencies against the dollar, which led to massive trade surpluses for them and massive trade deficits for the United States.

In fact, the harsh terms of the East Asian bailouts led to a change in behavior for developing countries around the world. They begin to accumulate huge amounts of dollars to bolster their reserves as protection against ever being in the same situation as the East Asian countries. This pushed up the value of the dollar, making our goods and services less competitive internationally. As a result, the trade deficit soared from a bit over 1.0 percent of GDP in the mid-1990s to a peak of almost 6.0 percent of GDP in 2006.

This massive trade deficit created a fundamental imbalance in the U.S. economy. Geithner either does not understand or opts to ignore the basic economics. A trade deficit creates a gap in demand that must be filled by either large public deficits or large private deficits, meaning that private investment must exceed private saving.

In the late 1990s the surge in investment associated with the stock bubble, coupled with the consumption boom attributable to the stock wealth effect filled the gap in demand. In the last decade the housing bubble filled the demand gap. This was done both through a construction boom and consumption boom attributable to the housing wealth effect. In the years since the collapse of the bubble, we have partially filled the demand gap with budget deficits. However the budget deficits were never large enough to bring us back to full employment and with their shrinkage we are left with an economy operating almost 6 percent below its potential (@ $1 trillion a year in lost GDP), more than six years after the onset of the recession.

The Second Great Depression Myth

While Geithner occasionally throws out a line to assure readers that he feels their pain, his bottom line is that we should be thankful that we averted a second Great Depression and also that we made back the money we lent out through the TARP. Both of these assertions deserve nothing but derision.

The first Great Depression was not just the result of the Fed's inadequate response at the start of the crisis; it was the result of the persistent failure of the government to spend enough to boost the economy back to full employment. In 1941, the government eventually did spend enough to restore the economy to full employment as it entered World War II. There was no economic reason that this spending could not have taken place in 1931, sparing the country a decade of double-digit unemployment.

The problem was purely political. Letting the banks fail in 2008-09 would have only led to a decade of double-digit unemployment if the government had refused to come forward with a serious spending package in response to the downturn. While anything is possible, even George W. Bush was prepared to act quickly to stimulate the economy as it slipped into recession, signing the first stimulus bill when the unemployment rate was just 4.8 percent.

It is important to deflate the second Great Depression myth because anything looks good by comparison. The myth allows Geithner to celebrate a recovery that has still left us more than 6 million jobs below trend, because at least we don't have double-digit unemployment.

The best route would have been to keep the banks in business but on terms that would require they fundamentally change the way they operate. The Fed and the Treasury held all the cards in dealing with the financial industry. Any firm that was publicly cut off from access to special Fed lending facilities, and denied Treasury, Fed or FDIC loans or guarantees, would have soon been toast in the crisis atmosphere of this period. The condition for staying in business could have been concrete commitments to downsize and become boring banks, brokerage houses,or insurance companies. As a condition of getting support from the government, banks also could have been required to modify underwater mortgages. From reading Geithner's book, no such discussions ever took place at the Fed or Treasury, except to amuse populist sentiments expressed by members of Congress.

If it was too much to expect serious conditions from the Fed or Treasury, the next best solution would have been a full-fledged collapse that would have permanently alleviated the country from the burden of a bloated financial sector. Geithner is very proud of the fact that he managed to keep the sector largely intact.

In this respect it is perhaps worth noting that contrary to the implication of the book, Warren Buffet apparently didn't buy the second Great Depression story either. Geithner proudly recounts how Buffett told him after the Bear Stearns bailout that Geithner had done the right thing for the country (page 161). According to Geithner, Buffett said that if there had been no rescue of the investment bank he personally stood to make lots of money by buying things up after the crash, but Geithner had done the right thing by preventing the crash.

Of course if Buffett anticipated that a decade of double-digit unemployment would follow from a financial crisis then he probably would not have made money from buying stocks on the cheap. They would stay cheap for long into the future, meaning that Buffett's money would likely be better placed elsewhere. But stories about second Great Depressions are not invented for people like Warren Buffett.

Geithner's other central theme about making money on the bailouts also deserves a healthy dose of derision. In the middle of a financial crisis the government privileged the largest financial institutions with a set of implicit and often explicit guarantees. As Geithner says repeatedly throughout the book, there would be no more Lehmans.

As a result these banks were able to borrow at far lower costs than those firms that did not enjoy the "no more Lehmans" guarantee from the Fed and Treasury. This gave these firms an enormous advantage over others in the market and it meant that through time in almost every case they would eventually be able to earn enough to repay the money lent. This speaks more to the value of government guarantees in a crisis than the wisdom of the loans. If the government had offered to guarantee loans to Baker's Lemonade Stand in 2008, it would have soon been one of the titans of corporate America.

The Housing Bubble: Who Could Have Known?

Geithner's discussion of the housing bubble and its collapse is sufficiently naïve that one hopes he is not being honest. He recounts research from the New York Fed from the period in which he was its president that concluded there was no bubble in house prices. This research rested largely on the premise that real house prices actually were not rising because conventional measures were not picking up quality improvements. This claim was laughable at the time since we had data showing that spending on quality improvements had actually fallen relative to the value the housing stock. A decade later Geithner really wants to hold this up as the basis for his failure to see the bubble?

In the same vein he tells us that he and his colleagues at the Fed were surprised that house prices would slump nationwide based on "seven decades of history." Did his colleagues not know that there had not been a nationwide run-up in house prices over the prior seven decades? You can't fall off a mountain unless you have climbed up a mountain.

He tells that even with a sharp decline in house prices their stress tests showed no large-scale defaults or serious impact on the financial system or the economy. Really? The National Association of Realtors reported that almost half of first-time homebuyers put zero down or less in 2005, the Fed's models didn't show these loans defaulting in response to 20-30 percent declines in price?

It should have been pretty obvious to anyone involved in economic policymaking that the housing bubble was driving the economy in the years 2002-2006. Residential construction, which had averaged 4.0-4.5 percent of GDP, exceeded 6.0 percent of GDP in 2005. The savings rate out of disposable income had averaged more than 8.0 percent in the years before the wealth effect from the stock bubble drove it down to 4.0 percent by 2000. While the saving rate rose following the stock crash, the wealth effect from the housing bubble drove saving rates even lower than had the stock bubble, with the rate averaging just 3.0 percent from 2005-2007.

The simple arithmetic showed that the bubble adding as much as 5 percentage points of GDP ($850 billion a year in today's economy) to demand. With housing likely to fall below its historic norm due to the overbuilding from the bubble years, a collapse in house prices was certain to create a huge hole in demand.

What could Geithner and his colleagues at the Fed possibly think would fill this gap? That's a serious question with a very short list of potential answers. Demand comes from consumption, residential investment, non-residential investment, government and net exports. With drops in the first two being the source of the problem, we are left with the last three categories.

Did Geithner and his colleagues at the Fed think that the collapse of the housing market would set off an investment boom? (There was also a bubble in non-residential construction that burst in 2008, making the situation worse.) We could have addition government spending, but we know that Geithner felt we had to be cautious on stimulus.

That just leaves net exports. We could have hoped to fill the gap in demand by a large fall in the trade deficit. (We actually have seen a substantial decline in the deficit, from 6.0 percent of GDP in 2006 to 3.0 percent of GDP at present.) The main mechanism for this would be a fall in the dollar, reversing the rise that came about as a result Geithner and company's "successful" East Asian bailout.

Incredibly net exports don't appear anywhere in this long book. It is almost as though Geithner does know the basic income accounting identities taught in every intro macroeconomics class. Anyhow, if he and his Fed colleagues had a route through which the demand gap created by a collapse of the housing bubble could be filled, there is no hint of it in the book.

Creative Reconstructions of History

1) Stimulus
In addition to the issues where one hopes that Geithner is being less than honest, there are several important parts of the book where we know that he is not being honest. The one I'll note first is Geithner's boasts about the size of the stimulus. Geithner writes that President Obama's stimulus request of $800 billion over two years "was considered extraordinarily aggressive, twice as much as a group off 387 mostly left-leaning economists had just recommended in a public letter, more than the entire New Deal in inflation-adjusted dollars."

I happen to be familiar with that letter signed by 387 mostly left-leaning economists since I helped to draft it. The letter actually called for a stimulus of 2-3 percent of GDP, which would have implied a stimulus of $600-$800 billion over the years 2009-2010.

Furthermore, this letter was released in November of 2008. It had been drafted in the early days immediately after the Lehman collapse; before we had data showing that the economy was losing 700,000 jobs a month. I and many of the other signers had substantially revised upward my assessment of the need for stimulus based on this new information. By the time the President released his stimulus package in January, I was arguing that a stimulus package of more than twice this size would be needed. Others, like Paul Krugman, were very visibly arguing the same position.

Geithner can argue that we did not need a bigger stimulus or that it would not have been possible to get a bigger stimulus through Congress, but it is just dishonest to imply that Obama was out on a limb with a stimulus package way larger than anyone thought reasonable. In the context of the times it was a very modest (and inadequate) proposal.

If anyone doubted that Geithner's point is to create a false impression rather than convey information the comparison to the New Deal seals the case. In inflation-adjusted dollars the economy was 15 times larger in 2009 than it had been in 1933. A comparison in inflation-adjusted dollars (rather than one based on the size of the economy) is the sort of thing that may sell on the David Gregory Sunday morning talk show circuit, but it is an insult to the intelligence of serious readers.

2) TARP and the Fed Commercial Paper Lending Facility

The next excursion in deception is the discussion of the debate over the passage of the TARP in the weeks following the collapse of Lehman. Geithner chronicles the political debate against the backdrop of what was happening in financial markets and the Fed's actions. In the case of the latter, Geithner notes that Federal Reserve Board Chair Ben Bernanke announced the creation of the Commercial Paper Funding Facility in October and that it began operations by the end of the month (page 229). The key fact that Geithner leaves out of the discussion is that Bernanke's announcement took place the weekend after the House approved the TARP on a very close vote, after previously rejecting it.

This is important because the most compelling argument that there was an urgency to pass the TARP was the claim the commercial paper market was shutting down. Major companies like Boeing and Verizon rely on borrowing in the commercial paper market to finance their ongoing operations. If these companies could not get the funding needed to meet their payrolls and pay their suppliers we would literally be looking at a complete economic collapse.

If Congress recognized that the Fed actually had the power to support the commercial paper market without the TARP then it might have felt less urgency to rush to approve the bill. This would have allowed room for more debate and perhaps more conditions - like a requirement that TARP beneficiaries write-down principle on underwater mortgages. But the threats from the Paulson, Bernanke, Geithner team that the alternative to TARP was the end of the world prevented a more levelheaded discussion.

3) The First-Time Homebuyers Tax Credit

This brings up another major lapse in Geithner's account. The first-time homebuyers' tax credit, one of the all-time greats in hare-brained policy proposals, conveniently disappears from history. This also is a case of deliberate deception. The book features a chart showing how house prices stopped falling in early 2009 and began rising into 2010 (page 304). The captions claims the chart shows the effect of supporting Fannie Mae and Freddie Mac, lower mortgage rates and efforts to prevent foreclosures.

Whatever impact these measures may have had they were swamped by the impact of the first-time homebuyers' credit which provided up to $8,000 to people who had not owned a home in the prior three years. (I confess to being a beneficiary of this awful policy.) The credit was inserted into the stimulus package by a House Republican, who was a former realtor, but it enjoyed broad bi-partisan support and the administration never publicly indicated any opposition.

House prices stopped their steep fall and began rising almost immediately upon the credit taking effect. However the problem was that the bubble had far from fully deflated at that point. This meant that the credit encouraged millions of people to buy into a bubble-inflated market. If Stress Test had been written by a more honest person the chart would not have ended in 2010, but would have instead shown the subsequent decline in house prices that began in the second half of that year, after the end of the credit.

The index in the chart would have showed a 6.5 percent drop in prices over the next year and a half, but the most affected markets saw much sharper drop-offs. For example, the prices of homes in the bottom third of the Las Vegas market fell by 18.2 percent after the temporary lift from homebuyers tax credit. The price of houses in cheapest third of the Minneapolis fell by 28.6 percent and in Atlanta the drop was 51.9 percent. In these and other markets house prices did begin to rebound in 2012, but people who were forced to sell in the interim would have incurred huge losses and many people who bought during this period are undoubtedly still underwater.

The first-time buyers credit effectively allowed many homeowners who would have been underwater otherwise to transfer homes their homes to new buyers. These people would then be faced with the further drop in house prices. And, in the process many mortgages held by banks and private issue mortgage backed securities would be transferred to Fannie Mae, Freddie Mac and the Federal Housing Authority. That may not be good housing policy, but it is good policy if the point is to help the banks.

It is striking that Geithner and his friends could be very creative in finding ways to rescue failed banks and financial institutions, but they were largely at a loss when it came to helping underwater homeowners. He tells us that allowing for cram down of mortgage debt in bankruptcy was a political non-starter that couldn't pass Congress.

Clearly it did not pass, but we can only wonder how hard the Obama administration tried. In 2010 I was on a radio show with the chief spokesperson for the main bankers lobbying group. He said that they could accept cram down as long as it was sharply limited by the size of the mortgage and the dates from which it would apply. That may have just been a public posture, but if the financial industry was openly saying that it could accept some form of cram down legislation, it's hard to believe that Congress would touch nothing.

My alternative was Right to Rent, which would have allowed homeowners the right to stay in their home as renters paying the market rent for a substantial period of time (e.g. 5 years) following foreclosure. This would have given underwater homeowners security in their homes and also made foreclosure less attractive for creditors. In many cases they would have likely decided it made more sense to modify a mortgage rather than be stuck with a tenant for five years.

This proposal had the advantage of being a one-time change in rules to benefit homeowners in an extraordinary situation rather than being a big government program. For this reason many conservatives considered it reasonable. (Even Fox News host Neil Cavuto said the idea wasn't "crazy" after he stopped yelling at me, and then sent me a note the next day saying that he agreed with the policy.)

The administration's alternative was a set of programs that were at best badly designed. They required complex decisions on restructuring mortgages. Apparently Geithner and other top officials didn't realize that the major servicers had downsized and outsourced their operations to the point that the administration was effectively asking decisions on families keeping their homes to be made by people working in call centers in India. Over time the programs improved and the number of successful modifications increased. But Geithner repeatedly indicates that he was far more worried about helping someone who had spent too much on buying home than on bailing out an investor who took a risky bet on a bad bank.


Anyone reading the book will have little doubt that it is the bankers who ultimately enjoy Geithner's sympathy. Based on a study of bankers' home buying behavior he tells us that they were not acting criminally, but rather were caught up in the irrational exuberance of the housing bubble, as though these were mutually exclusive possibilities. It is likely that many of the top criminals in Enron ultimately believed in the company's business model. That doesn't mean they didn't break the law. In the same vein, bankers may have knowingly issued and securitized hundreds of thousands of fraudulent mortgages even if they believed that ever-rising house prices would make every mortgage a good mortgage.

Geithner also briefly comments on the efforts of Erskine Bowles and formers Senator Alan Simpson to craft a deficit reduction package. He says the effort to have the government live within its means is "a fight worth having (Page 451)." Given that the major problem now and for the foreseeable future is a lack of aggregate demand, and therefore a government deficit that is too small, many might think that educating the public on the relationship between the deficit and demand and employment is a fight worth having, but not Timothy Geithner.

The reality is that we had a completely preventable economic disaster hit the country. The result was millions of people losing their homes and/or their jobs, in many cases seeing their lives and the lives of their children ruined. With almost no exceptions the policy makers responsible for the disaster and the bankers who profited from it are doing just fine. And Timothy Geithner can't understand why everybody isn't happy.

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