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The High Cost of Getting the Story Wrong

Tuesday, June 2, 2009

The narrative first written about the Great Depression was wrong in many important respects. Likewise with today’s crisis, the initial narrative is badly mistaken. And it will cost us dearly.

The global financial crisis has been with us for more than a year. Despite all its twists and turns, the United States is only now entering the most expensive phase of the crisis. Given the current political climate and widespread misunderstanding of the origins of our problems, the cost is unfortunately going to be very considerable and long lasting.

The most expensive stage of a financial crisis is not the initiating economic loss—in our case, an unsustainable boom in residential construction that left too many houses and a mountain of debt. Nor are the largest losses racked up as investors withdraw from risk, markets freeze, and balance sheets implode. Policy missteps, including the continuing confusion of solvency problems for liquidity ones, no doubt add to the tab. These costs, while they may be big, pale to insignificance compared to what follows.

The most expensive stage of a financial crisis occurs when society tries to explain to itself what just happened. The resulting narrative is not the product of one person or institution. Rather, it gets written in the tell-all “tick-tocks” of major newspapers, the inside accounts in bestsellers, the speeches of leading officials, and the punch lines of late-night comedians. The narrative determines our attitudes toward the actors and events of the crisis. It also identifies the structural problems thought suitable for legislative and regulatory remedy.

Why are compensation limits on the administration’s list of needed reforms? Why has a bipartisan desire for new regulatory powers and additional layers of supervision emerged? Why was it easy to invert the order of debt repayment in the bankruptcy of Chrysler? Indeed, why do, as suggested in recent polls, an increasing share of twentysomethings view socialism with interest?

Here we are, still paying the cost of writing the wrong narrative almost three-quarters of a century ago. The most important lesson to draw as we write the new one is that many blows brought us low.

As of now, the draft narrative supports those judgments. We have thus far written a morality play pointing to corporate greed, supervisory incompetence, and misplaced faith in markets. With the outline so distinct in black and white, the policy implications are similarly self-evident.

Before government officials rush to codify the current understanding, they should reflect upon the last time we were in this position. Over the past year, there have been all manner of comparisons to the experience of the Great Depression, the prior episode when global financial markets and economy were so stricken. There is, indeed, an apt parallel to the current stage of our crisis. The narrative first written about the Great Depression was wrong in many important respects.

By the 1940s, the educated consensus was that fiscal stimulus was the only effective means to engineer revival. In particular, this followed because it was believed that the Federal Reserve ran out of effective tools once the policy interest rate fell to zero. The Great Crash was agreed to have followed in part from excessive competition among financial institutions. And restraints on the trade of goods, services, and capital helped to anchor an otherwise unstable system.

Having learned these lessons, fiscal policymakers viewed themselves as given a mandate to smooth the business cycle, as enshrined in the Employment Act of 1946, and the Federal Reserve was pushed to a supporting role. The Congress legislated and regulators promulgated numerous restraints on the baser nature of commerce. Financial institutions were split by function and policed by different agencies. Limits were placed on deposit and lending rates. And tariffs rested near century highs.

We have thus far written a morality play pointing to corporate greed, supervisory incompetence, and misplaced faith in markets. With the outline so distinct in black and white, the policy implications are similarly self-evident.

Over the next few decades, the U.S. economy expanded rapidly, and the gains from this growth were shared relatively equitably. But this owed more to the rewards of winning a world war on foreign land masses. In fact, institutions at home were calcifying around an elaborate regulatory apparatus. The nation was poorly positioned for and too rigid to cope with the energy and environmentalism shocks of the 1970s.

Meanwhile, leading academics, including Milton Friedman, Anna Schwartz, Ben Bernanke, and Christina Romer, pushed back against the prevailing world view. As they won the field and the false lessons of the Great Depression were unlearned, deregulation followed.

Incremental policy change fostered innovation in all aspects of commerce. However, deregulation did not attack the fundamental infrastructure of our post-1930s regulatory framework. As a result, financial institutions stretched into the gaps between regulators’ watch, becoming more complicated and harder to govern. Self-interested lobbying groups made sure that significant subsidies to housing remained inviolate. More generally, the gains from economic progress were not broadly shared. The system as a whole was less resilient and more vulnerable than it could have been.

Greed, no doubt, was an accelerant when a spark struck. However, the critical question is not whether people are greedy. People have been, are, and always will be greedy. Rather, we should ask why restraints on the exercise of that greed did not work.

Perhaps enlightened policymaking at the time of crisis in 2007 and 2008 could have compensated for these underlying fragilities. But we will never know. In the event, the triumvirate of Hank Paulson, Bernanke, and Timothy Geithner failed to identify the solvency problem at the root, acted in an inconsistent manner when resolving institutions that set problematic precedents, and generally inflamed fears.

So here we are, still paying the cost of writing the wrong narrative almost three-quarters of a century ago. The most important lesson to draw as we write the new one is that many blows brought us low.

The critical question is not whether people are greedy. People have been, are, and always will be greedy. Rather, we should ask why restraints on the exercise of that greed did not work.

Under any plausible scenario, finance will get more expensive. Banks will hold more capital. Constraints will be placed on individual choice. How those changes are enacted through supervision and proscription will depend on the lessons we are learning now. And we will live with the results for a long time.

There is an opportunity to help society get the story straight. The Financial Crisis Inquiry Commission was established in a provision of recently enacted mortgage fraud legislation. This bipartisan body is to find “the causes, domestic and global, of the current financial and economic crisis.” The precedent is not encouraging. But as William of Orange admonished, “One need not hope to undertake, nor succeed to persevere.”

Vincent Reinhart is a resident scholar at the American Enterprise Institute and a former director of the Federal Reserve Board’s Division of Monetary Affairs.

FURTHER READING: Reinhart wrote “Is the U.S. Too Big to Fail?” on how the special status of the United States is not likely to dissipate soon, but it is causing growing international resentment, and “Playing Down the Price Tag of the Fiscal Stimulus” on how attempts to downplay the expense of the bailout do harm.

Image by Darren Wamboldt/Bergman Group.

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