David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more. The book gives us an inside view of how policy making took place in response to the striking events. Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded. In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process. Here, we emphasize three serious flaws in the policy-making process that Wessel describes: the consistent lack of a plan and short-time horizon of the decisions, the insularity of the decision makers, and the apparent disregard for FOMC information-security rules governing meetings and associated documents. We conclude by noting some oversights in Wessel’s account of the Great Depression and the Panic of 1907.
Lack of a Plan
The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded. It is not a pretty picture. His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed.
The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them. The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency. The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not. The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences. For example, the problems of exiting from many of the policies are now significant and have yet to be addressed.
Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted. This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing. It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008. That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem.
By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis. Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available. Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated. This was long before the problems in Lehman Brothers emerged. Market participants’ concerns, as subsequent events proved, were well-founded. It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans. Most of the largest financial institutions – both domestic and international – proved to have inadequate capital. Some failed, and many were bailed out by their respective governments.
Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time. The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved. And lacking a plan, it is harder to see if and when a decision was wrong.
Delegated and Concentrated Decision Making
The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC. Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information.
Why did it happen? Under what authority did this happen? One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies. Let us explain. Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions. According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and, at a minimum, an agenda must be provided,. For this reason, only three governors can get together in the same room without it constituting a “meeting” and invoking the provisions of the Sunshine Act. But during the entire crisis there have only been five governors on the Board, with two vacancies. (David Kotok has written extensively on this issue in previous commentaries.) Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions. Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared. It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative. Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs.