Chip Somodevilla/Bloomberg/Getty Images

President Barack Obama, Senator Christopher Dodd (center left), and Representative Barney Frank (right) at the signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Washington, D.C., July 21, 2010

On Wall Street, the Great Recession didn’t last very long. Having sustained losses of $42.6 billion in 2008, the securities industry generated $55 billion in profits in 2009, smashing the previous record, and it paid out $20.3 billion in bonuses. In the spring of 2010, the Wall Street gusher continued to spew money. Between January and March, Citigroup’s investment banking division made more than $2.5 billion in profits. Goldman Sachs’s traders enjoyed their best quarter ever, generating an astonishing $7.4 billion in net revenues.

Barely a year and a half after the collapse of Lehman Brothers, Wall Street was once again doing well for itself—obscenely well, it seemed to many people. “For most Americans, these huge bonuses are a bitter pill and hard to comprehend,” noted Thomas DiNapoli, the comptroller of New York State, whose office tracks Wall Street profits. “Taxpayers bailed them out, and now they’re back making money while many New York families are still struggling to make ends meet.” In other parts of the country, Americans weren’t merely resentful; they were fiercely angry at the Wall Street bonus recipients and the politicians who had rescued them. (“Hank, the American people don’t like bailouts,” Sarah Palin, John McCain’s running mate, had warned Treasury Secretary Henry Paulson in October 2008.)

And yet, judged purely in economic terms, the Bush-Obama rescue program had proved fairly successful. Since July 2009, the Gross Domestic Product had been expanding steadily, confirming the predictions of recovery that Timothy Geithner and Ben Bernanke had made. The rate of growth was modest rather than spectacular—about 3 percent on an annualized basis—but it belied the doomsters’ prognostications. Measured by the economy’s overall output of goods and services, the recession had ended more quickly than expected. In May 2010, the Organization for Economic Co-operation and Development, an economic research body based in Paris, said that the world economy would grow by 4.6 percent in 2010 and 4.5 percent in 2011. Despite widespread fears of a “double dip” recession, the global recovery appeared to be continuing.

Aside from allowing Lehman to collapse, policymakers had avoided the mistakes of the 1930s. By injecting taxpayers’ money into struggling financial institutions and guaranteeing their debts, they had arrested the vicious cycle of falling prices of stocks and other assets, panic selling, and further falls in prices. By reducing short-term interest rates virtually to zero, they had halted a similar downward spiral in the real estate market. (With the cost of mortgage loans at historic lows, bargain seekers entered the market, putting something of a “floor” under prices.) And by introducing tax cuts and additional public spending programs, governments had counteracted the economy-wide vicious cycle in which tumbling demand for goods and services prompted firms to reduce their workforces, unemployment rose, and demand slipped further.

In Washington and other capitals, the authorities had demonstrated that at least for one year, Keynes had been right: economies suffering from a speculative bust didn’t have to be left to nature’s cure or, more accurately, to the markets’ cure, which Andrew Mellon, Herbert Hoover’s Treasury secretary, famously described as “liquidate, liquidate, liquidate.” But while the aggressive use of fiscal and monetary policy could be labeled “Keynesian,” other elements of the rescue program didn’t fit neatly into any model. The Fed’s innovative liquidity programs harked back to Walter Bagehot’s edict that central banks should lend freely in a crisis. Its resort, in order to bring down long-term interest rates, to buying up Treasury bonds and mortgage securities—so-called quantitative easing—was akin to the “helicopter drop” of cash that Milton Friedman had advocated as a cure for deflation.

The bank bailouts and other less visible subsidies to the financial sector weren’t associated with a particular economic creed: they were emergency measures that had been adopted reluctantly. Rather than relying on a particular theory of the crisis or a single policy tool, policymakers had adopted a flexible and pragmatic approach, trying a number of things together and adjusting the mix as they went along.

Only on Wall Street was the recovery palpable, however. In September 2010, 9.6 percent of the US workforce was still out of work, and that didn’t include more than eleven million people who had stopped looking for jobs or who had been forced to accept part-time employment. Taking account of these people, the September 2010 rate of “underemployment” was 17.1 percent—about one in six. Even for those fortunate enough to be working, worries remained. Many households were saddled with mortgages bigger than the value of their homes. In Miami, real estate prices were about 50 percent below their 2006 peak; in Las Vegas, they were down 55 percent; nationwide, the decline was about 30 percent. Rather than going out and spending, many households and firms were hoarding cash and rebuilding their savings. In the second quarter of 2010, the annualized growth rate of US GDP fell back to 1.6 percent, raising more fears of a return to recession.


Across the Atlantic, meanwhile, the financial crisis had never really gone away. In the fifteen-country euro bloc, GDP fell 4.2 percent in 2009, compared to a decline of 2.4 percent in the United States. Modest growth returned during the first quarter of 2010, but another blowup in the markets quickly overshadowed it. As the recession deepened, many countries, the United States included, had run up huge budget deficits, which were starting to spook investors in government bonds. In early May, the European Union, together with the International Monetary Fund, completed a €110 billion (about $155 billion) lending package for Greece, where government spending exceeded tax revenues by about 13 percent of GDP. Far from calming the markets, the Greek bailout created fears of similar problems emerging in Spain, Portugal, and other heavily indebted European countries. With speculators continuing to short the euro, the EU hastily created a s750 billion stabilization fund, which could be used to aid other member governments that ran into difficulties funding their operations.

If this was a recovery, it was a fragile and embittered one. While the authorities’ response to the crisis had prevented a wholesale economic collapse, it had failed the political test of winning popular support—something Timothy Geithner freely admitted. “My basic view is that we did a pretty successful job of putting out a severe financial crisis and avoiding a Great Depression or Great Deflation type of thing,” the Treasury secretary told me in early 2010. “We saved the economy, but we kind of lost the public doing it.”

Given the nature of the policies that the Bush and Obama administrations had adopted, public anger was inevitable. By the end of 2009, almost all the big banks had repaid their TARP bailouts, but they continued to be the recipients of official largesse. With the Fed holding short-term interest rates at virtually zero, firms like Citigroup and Goldman Sachs could borrow money from one arm of the government (the Fed) or from investors (by issuing short-term commercial paper) for next to nothing and, by purchasing US bonds, lend it to another arm of government (the Treasury) at an interest rate of 3 or 4 percent. By playing “the spread,” any moderately competent Wall Street trader could generate large returns for his desk and a big bonus for himself without actually doing what banks are supposed to do: furnishing money to firms and funding capital investments. While bank profits were soaring, many businesses and individuals were still finding loans hard to come by.

The other losers in this game were those who had cash stashed in a savings account or money market mutual fund. “What we have right now is a situation where every saver in the country is, essentially, paying a huge tax to bail out the banking system,” noted Raghuram Rajan, the University of Chicago economist who, back in 2005, had issued a fateful warning about the dangers of a financial blowup. “We are all getting screwed on our money market accounts—getting 0.25 percent—and the banks are making a huge spread on nearly every asset they hold, because they are financing them at pretty close to zero rates.”

The Obama administration didn’t come out and say so, but enabling the banks to make big profits was one of its policy objectives. Rather than seizing control of sickly institutions, such as Citi and Bank of America, it had settled on a policy of allowing them to earn their way back to sound health, while also encouraging them to raise money from private investors. This was the rationale behind the controversial “stress tests,” which the Treasury Department and the Fed carried out in the spring of 2009; they were intended to find out how much new capital the banks needed to survive a deep recession.

In May 2009, when Geithner announced that the ten biggest US banks needed to raise just $75 billion, many economists had accused him of understating the banks’ remaining holdings of toxic assets. In fact, the official loss estimates were similar to those produced by independent analysts. But the government stress testers were assuming that other parts of the banks’ businesses, particularly their trading operations, would record greatly enlarged profits in 2009 and 2010, which would help them withstand big losses in real estate and commercial lending. Buried in the Treasury’s official report on the stress tests was the prediction that Citigroup’s net revenues in 2009 and 2010 would exceed by $49 billion its provisions for losses through bad loans. For Bank of America, the projected profit figure was $75.5 billion. For Wells Fargo, it was $60 billion.


When these enormous profits duly materialized and the banks distributed some of them to their employees, the public was outraged. Critics accused the Obama administration of overlooking less offensive options for stabilizing the financial system. One idea, widely canvassed in early 2009, would have been to seize control of troubled firms, move their tarnished assets into a state-run “bad bank,” and eventually refloat them on the stock market as smaller, healthier institutions. Twenty years previously, during the savings and loans crisis, this approach had been adopted successfully. Theoretically, it would have enabled the government to fire reckless bank managers, wipe out bank shareholders, and impose a “haircut,” i.e., a reduction in repayments, on bank creditors, thereby punishing the guilty rather than rewarding them with a bailout. “While the Obama administration had avoided the conservatorship route, what it did was far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses,” the Nobel-winning economist Joseph Stiglitz wrote in his 2010 book, Freefall: America, Free Markets, and the Sinking of the World Economy.

Members of the administration countered that its critics had greatly underestimated the practical difficulty of pursuing the nationalization option. If the government had seized Citigroup, one senior Treasury official told me, it could well have created creditor “runs” at other banks suspected of being on the government target list. The only way to prevent this from happening, the official said, would have been to spend $3 trillion and take over all the big banks. That figure may be an exaggeration, but the fear of sparking another financial crisis was a real one, and so were the political concerns of the White House and the Treasury Department. Neither President Obama nor Geithner had any appetite for a policy that smacked of radicalism and big government.

Paul Volcker
Paul Volcker; drawing by John Springs

From an economic viewpoint, the most serious problem with the rescue programs was not that they further enriched the loathed bankers but that they exacerbated some serious incentive problems at the heart of the financial system. By extending trillions of dollars in loans, capital injections, and debt guarantees to troubled firms, the US government and its counterparts overseas had greatly extended the public safety net for banks and other financial entities. Left unchecked, this expansion will surely lead to more blowups, followed by even bigger bailouts.

The problem is one of rational irrationality. Once people in the financial sector come to believe that the government will cap their losses, they have an incentive to step up their risk-taking, what is called “moral hazard.” Simply announcing that there won’t be any more bailouts won’t solve the problem, a point noted by two Bank of England economists in an important paper published in November 2009. Policymakers may say “never again,” wrote Andrew Haldane and Piergiorgio Allesandri,

but the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.1

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed in July 2010, while containing many worthwhile individual measures, didn’t really get to grips with this problem. Taken overall, the reform effort amounts to tinkering with the existing system rather than fundamentally reforming it. Any comparison with FDR’s regulatory response to the Great Depression is specious. By the end of Roosevelt’s first term, the financial system had been transformed. The House of Morgan and other big banks had been split up into their investment banking and commercial banking components; through the newly founded SEC, the government was exercising close supervision of Wall Street; through the Reconstruction Finance Corporation, which had acquired and kept equity stakes in many big financial firms, it was forcing reluctant bankers to extend credit; and through the Justice Department, it was prosecuting a number of prominent financiers. Today the financial system looks overall pretty much the same as it did in 2007, even though at the end of 2010 there are fewer independent Wall Street firms than there were a few years ago, and the survivors have a bit less freedom to maneuver than they used to have.

Overseas, the same is true. For all their attacks on American free-market dogmatism, European and Asian governments have shown little inclination to clean up their own financial systems. The big European countries, in particular, which have a lot of big multiservice banks, lobbied strenuously against any attempt to break them up. On the torturous issue of bank capital requirements, something similar happened. By September 2010, when new capital standards were announced, they were so modest that many big banks, having replenished their coffers, already satisfied them.

Here in the United States, after all the mergers that the government had orchestrated during the crisis, six huge firms—Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo—now dominate the financial industry, wielding enormous market power and political influence. Together, their assets come to about 63 percent of GDP, some $9.2 trillion. The ratings agencies remain unreformed, and so do some of the myopic compensation packages for Wall Street traders and CEOs that helped bring on the crisis. The one really innovative idea that the administration had was to impose a hefty “pollution tax” on the risk-taking of financial institutions, which would have increased in proportion with their balance sheets. But it didn’t feature in the Dodd-Frank reform bill and has faded from view.

After all that had happened, the measures actually taken—forcing financial institutions to maintain more capital, shifting derivatives trading onto exchanges, and setting up a new agency to protect consumers from predatory lenders—were the least that could have been done. And even in those matters, the Dodd-Frank bill contained a number of sops to the financial lobby. The big US banks still don’t face any hard limits on the amount of debt they can take on; neither do their international competitors, such as Barclays, Deutsche Bank, and UBS. A significant but undetermined amount of derivatives trading is exempt from the new regulations, and the issuance and trading of naked credit default swaps—bets that a certain company or country will go bankrupt—remain perfectly legal. The new consumer protection bureau, rather than operating as a stand-alone body, in the manner of the Food and Drug Administration and the Environmental Protection Agency, is housed inside the Fed, an institution that failed abjectly in overseeing the mortgage market. (Confirming the old adage that nothing succeeds like failure, the Fed was also given new power to act as a “systemic risk regulator,” overseeing the activities of the biggest banks.)

During the debate on Capitol Hill, it is true, some steps were taken to toughen up the reform bill of Christopher Dodd and Barney Frank, notably the inclusion of the so-called Volcker Rule, which prohibits banks from proprietary trading and places limits on how much money they can invest in hedge funds and private equity funds. Depending on how this directive is enforced, it could prompt Goldman and Morgan Stanley to give up the commercial banking licenses they acquired in 2008 and revert to being investment banks. Bank of America, Citi, JPMorgan, and Wells, which are much more invested in commercial lending, will have to scale back their proprietary trading desks. Citi has already done so. (As of now, both Goldman and Morgan Stanley appear determined to keep their banking licenses. To that end, they have been letting go of some proprietary traders and reassigning others.)

Former Fed chairman Paul Volcker’s laudable idea, which the White House adopted at the start of 2010, was that nondepository institutions shouldn’t be allowed to shelter under the government safety net, and, legally, at least, they won’t be able to. The US government now has the power, during a crisis, to take them over and close them down. (At the time of the collapse of Bear Stearns and Lehman Brothers, this authority was lacking.)

However, it is one thing to empower the Treasury and the Federal Deposit Insurance Corporation to fire senior bankers, wipe out stockholders, and impose losses on creditors. It is quite another thing for the authorities to exercise these powers. If Goldman, say, was to run into serious trouble shortly after giving up its banking license, it is hard to believe that the Treasury and Fed would shut it down and let the dominoes fall where they may. If markets were plummeting and creditors, depositors, and other counterparties were rushing to liquidate their positions, the authorities would come under enormous pressure to prop up the firm, or find a healthier rival to take it over. Then we would be back to September 2008.

Despite the best intentions of Volcker and others, the big six banks and an undetermined number of other financial firms are almost certainly still too big to fail. Taxpayer rescues of systemically important institutions can’t be legislated away: the real issue is what can be done to reduce the likelihood that such measures will be needed. Apart from regulating individual lines of business that involve big risks, a tricky enterprise in the best of times, the options are either to greatly reduce the leverage that banks can take on or to break them up, so the failure of any one of them would no longer pose an insurmountable risk to the system.

Neither of these ideas is exactly revolutionary. Practically everybody agrees that excessive leverage played a key role in the crisis, and the idea of splitting up the largest banks has won the support not just of progressive economists but of the British Conservative Party, which formed a coalition government in May 2010; of Mervyn King, the governor of the Bank of England; and even of Alan Greenspan, the former Fed chairman. If the banks are “too big to fail, they’re too big,” Greenspan said in October 2009, and he went on to say, “In 1911, we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

But far from insisting on drastic reductions in leverage and smaller banks, the Obama administration connived against measures designed to bring these changes about. Senator Susan Collins, of Maine, and Senator Blanche Lincoln, of Arkansas, both proposed amendments to the Dodd-Frank bill that would have forced the biggest banks to hold substantially more capital—and real capital, not hybrid securities that are more like debt. After the Senate passed the Collins and Lincoln amendments, the White House and Treasury pushed Congress to drop them from the final legislation. A move to break up the biggest banks, such as Wells Fargo and Bank of America, which was sponsored by Senator Ted Kaufman, of Delaware, and Senator Sherrod Brown, of Ohio, didn’t even get that far. The Democratic leadership in the Senate joined with Republicans to kill the amendment, which was voted down 61–33. “If we’d been for it, it probably would have passed,” a senior Treasury official told New York magazine. “But we weren’t, so it didn’t.”

Utopian economics is on the defensive, just like it was in the 1930s, but it is too early to hail the triumph of reality-based economics. For one thing, the political environment is very different from the one that Roosevelt and Keynes operated in. During the Great Depression, many of the unemployed went hungry, and there was real desperation: it was widely accepted that free-market dogma had failed and that the authorities should step in to put things right. Despite its global scope, the Great Recession doesn’t really compare with the Great Depression, and many ordinary people remain suspicious of government interventions to correct market failures.

Indeed, the summer of 2010 saw a powerful reaction against Keynesian deficit spending. On both sides of the Atlantic, there were calls for an end to stimulus programs; in Germany and Britain, the center-right coalition governments of Angela Merkel and the newly elected David Cameron moved to cut public spending and raise taxes. Partly a reaction to the Greek debt crisis, this policy turnaround also resurrected the “Treasury view” of the late 1920s and early 1930s, which saw the main threat to economic recovery not as a shortage of overall demand but as a dearth of confidence in the public finances on the part of businessmen and investors. With the triumph of Keynes’s “General Theory,” this argument had seemingly been consigned to history, but here it was again, modified hardly at all, on the lips of conservatively minded economists, commentators, and policymakers. “Germany has never agreed to an austerity package to this extent, but these cuts have to be made in order for the country to establish a stable economic future,” Chancellor Merkel said in announcing the German budget cuts.

To be sure, budget deficits equal to 10 percent of GDP or more, which some countries, such as the United States and Britain, were running, couldn’t be sustained indefinitely. (Germany’s deficit was much smaller: less than 5 percent of GDP.) But the best way to bring down deficits is to get the economy going again, which leads to higher tax revenues and lower spending on unemployment benefits. Shifting to retrenchment in the form of major budget cuts during the early stages of a recovery would smack of the mistake that the second Roosevelt administration made in 1936–1937, when, giving in to Wall Street orthodoxy, it slashed spending and raised taxes to balance the budget, only to see the US economy plunge back into recession.

The economists advising President Obama tried to resist the shift toward austerity policies. In an article in the Financial Times last July, Lawrence Summers, the outgoing head of the National Economic Council, pointed out that reviving growth and reducing the deficit were complementary rather than competing objectives. “Reducing the spectre of prospective deficits will enhance near-term growth,” Summers wrote. “And ensuring adequate growth in the near term will reduce long-term deficits.” In September 2010, the US administration proposed another round of tax cuts and infrastructure spending. But as the midterm elections approached, this initiative went nowhere.

Without the original $787 billion stimulus program passed under Obama, the public finances and the overall economy would certainly have been even weaker. Persuading the public to take account of what might have happened is far from easy, however, and opinion polls showed that most Americans agreed with conservative economists who said that the stimulus program had failed. The economic arguments put forward against the stimulus, such as the claim that increases in government spending generate offsetting falls in private spending, were largely specious; but they jibed with the ordinary American’s feeling that many, if not most, tax dollars are wasted.

After the Republicans’ big gains in the midterm elections, the prospects for a second stimulus package seem grim. For the embattled White House, one option that has been mooted is to propose new measures in the lame-duck session of the 111th Congress, which sits until January 2011, and to invite the Senate Republicans to oppose them with a filibuster. For example, the President could continue to insist that the Bush tax cuts for the rich should be allowed to expire at the end of this year, and to propose offsetting that tax increase with a big cut in the payroll tax, which is a tax on jobs.

Another option, which might have a better chance of succeeding, would be to offer the Republicans a deal under which a new stimulus package—a combination of tax cuts and spending increases—would be coupled with a temporary extension of the Bush tax cuts. To say the least, the politics of any such arrangement, which would increase the budget deficit on a short-term basis, would be complicated.

One thing is clear, though: the economy needs more help. In the third quarter of 2010, the overall level of demand for goods and services produced in the United States expanded by just 0.6 percent on an annualized basis. (A surge in accumulation of inventories—goods prepared for sale that are still sitting in factories and stores—boosted the GDP growth rate to 2 percent.) In plain English, the economic recovery has faltered badly. Relying on Ben Bernanke and his colleagues at the Federal Reserve to get it going again is a very risky strategy—akin to asking the pilot of jetliner that has stalled in the middle of the Atlantic to fly the rest of the way on one engine. Things might just work out. But if the other engine can also be restarted—and it can be—why take the risk?

—November 10, 2010

This Issue

December 9, 2010