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When They Were Young

Thursday, July 16, 2009

Why look back to the last time that Messrs. Geithner and Summers ‘saved the world’? Because they are doing it again in the same way.

President Obama entered office with virtually no track record of economic policy making. The slate is far from blank for some of his key economic advisors. Two men, in particular, at central nodes in administration decision making were at comparable commanding heights in the 1990s.

Larry Summers, Director of the National Economic Council, and Timothy Geithner, Secretary of the Treasury, were key figures in the Clinton years guiding the global response to the Mexican Crisis of 1994–1995 and the Asian and Russian Crises of 1997–1998. Indeed, Summers found his way to the cover of Time magazine in February 1999 as part of the “Committee to Save the World,” along with Alan Greenspan and Robert Rubin. In the associated story, Geithner is singled out as providing essential support to those main players.

Knowing a bit of that history helps to understand the economic and financial policies of the Obama administration. And whether the right lessons were in fact learned will determine our economic progress for some time to come, an essential element of President Obama's place in history.

The global economy scored some impressive gains in the 1990s. In the United States, there was one short and shallow recession, but otherwise the economy expanded with a vigor that made many wonder if the old rules of boom and bust no longer applied.

For many emerging market economies, that question was premature. Mexico faced significant downward pressure on its peso late in 1994, associated with political turmoil that included the assassination of a leading presidential candidate. Thailand's turn to tumble came in 1997. Ultimately, financial markets in Indonesia, Korea, and Malaysia all came under speculative attack. In each case, a drying up of funding triggered wrenching economic contraction.

The policy response—ad hoc at first but increasingly involving the resources of the international financial institutions (including the International Monetary Fund and the World Bank)—boiled down to lending in extremis to rebuild market confidence. Arranging that financing was the crucible in which Messrs. Geithner and Summers apparently learned four lessons.

Why did officials strong-arm banks to agree to an inversion of debt-holder rights in the Chrysler bankruptcy? It worked for Robert Rubin in December 1997.

First, financial markets sometimes get prices wrong when unjustified self-doubt causes a flight from risk-taking. In Geithner's and Summers's world, that is the time for public officials with steadier nerves to intervene. And such intervention will be profitable, because assets bought cheap when global investors are averse to risk will become dear when their “touch of the vapors” is over.

Second, that intervention has to be conveyed with complete confidence. Doubt is debilitating to investors and contagious across markets. Enlightened officials, among whom Messrs. Geithner and Summers no doubt include themselves, should look for opportunities to knit the frayed nerves of the investing public. A massive amount of resources, thrown together in a well-publicized package, is a useful device to capture the high ground of public opinion.

Third, there is no time in a crisis to wait for those resources to be appropriated by the Congress. The government's balance sheet is big and the rules governing its use are intricate. To clever minds, funds can be made available for good purposes by reinterpretation of existing authorities and reliance on off-balance-sheet entities. Officials can pull in private sector resources to the cause, too, by reminding bank executives of the importance of remaining in the good graces of their regulators.

Fourth, a crisis in markets gives leverage to the government to advance other policies. While the view that a crisis is “too good an opportunity to waste” is associated with another Clinton veteran, Rahm Emanuel, it is also embraced by the remaining members of the Committee to Save the World who are in a position of power.

The list of similarities lengthens each week as we live through the application of lessons learned by current officials when they were young. The risk to our nation is that they may have drawn the wrong lessons.

Why did officials strong-arm banks to agree to an inversion of debt-holder rights in the Chrysler bankruptcy? It worked for Robert Rubin in December 1997, when he talked bankers into rolling over Korean debt.

Why do officials think bankers can be bullied into more generous mortgage forgiveness? The Indonesian government was induced to disband its monopoly on cloves as a condition for IMF loans in 1998.

Why do U.S. regulators talk up market confidence with stress tests that deliberately omit the recognition of losses associated with bad mortgage decisions? Banks got a similar free pass, at least for a time, when debt values melted away in the 1990s.

Is there anything new in cramming risky lending into off-balance-sheet entities, such as the Federal Reserve? The Exchange Stabilization Fund was used as part of the bailout of Mexico, despite the limitations on its use that its name would seem to imply. Later in the decade, the IMF and the World Bank proved pliant lenders, far in excess of precedent, when encouraged by their chief shareholder, the United States.

The list of similarities lengthens each week as we live through the application of lessons learned by current officials when they were young. The risk to our nation is that they may have drawn the wrong lessons.

True, markets have withdrawn from large financial institutions on exaggerated fears of mortgage losses. But losses are out there, perhaps larger than officials can paper over by blustering on about confidence. If so, shifting the burden to off-balance-sheet entities will hit a capacity limit, even in a place as cynical as Washington, D.C. At that point, all the prior efforts of Messrs. Geithner and Summers will be seen as an evasion of their responsibility to make evident to the nation and the Congress the harsh reality. Reestablishing confidence then will be a far harder task than anything they had previously known.

Vincent R. Reinhart is a resident scholar at the American Enterprise Institute.

FURTHER READING: Reinhart wrote “The High Cost of Getting the Story Wrong” on how the narrative first written about the Great Depression was mistaken in many important respects, as is the initial narrative on today’s crisis.

Image by Darren Wamboldt/Bergman Group.

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