Why History May Be Unkind to Tim Geithner

Why History May Be Unkind to Tim Geithner

By Arnold Kling - January 28, 2013

In “Timothy Geithner's Legacy,” Steven Rattner argues that history has vindicated the response of policy makers to the financial crisis. In my view, it is too soon to make that judgment.

Many years ago, a friend of mine advised me that when your bicycle gets a flat tire, never replace just the inner tube. Chances are, there is still something sharp stuck in the tire, and if you do not replace the tire you are just setting yourself up to have another blowout.

At this point, we do not know whether the financial system has been fixed or whether it has just been set up to have another blowout. It appears that TARP and other post-crisis interventions have enabled several large financial institutions to return to profitability. Whether this is going to be good for the economy in the long run only time will tell.

One thing we can say about our financial system in the wake of the crisis is that our biggest banks have gotten bigger. In an article published by the Federal Reserve Bank of St. Louis in November-December 2011, David C. Wheelock pointed out that the ten largest banks in the United States now hold nearly fifty percent of all deposits.

Writing in a publication for the Federal Reserve Bank of Minneapolis, economist Robert DeYoung pointed out that the three largest U.S. banking firms (Bank of America, J P Morgan Chase, and Citigroup) each now have assets in excess of $2 trillion. It is not clear that these banks are any more efficient than banks that are one-tenth the size, or even less. What is clear is that banks of this size are impossible for regulators to monitor effectively or to resolve quickly in the event they turn out to be insolvent. As DeYoung points out, these banks do not face a market test, because their status as too-big-to-fail acts as a subsidy, lowering their borrowing costs.

In my opinion, Timothy Geithner's approach relied on short-term thinking, focused on the health of Wall Street and the largest banks. He has shown little understanding of history and little inclination to think deeply about the interaction between regulation and the financial industry.

Back in 2008 and 2009, the attention of policymakers was focused on the sudden deterioration of financial conditions. Many pundits and politicians leaped to the conclusion that financial deregulation and an outbreak of extreme private-sector greed had allowed dangerous risks to build up without regulators catching on in time.

As more information becomes available, that narrative is looking increasingly suspect. Peter J. Wallison and Ed Pinto of the American Enterprise Institute found that Freddie Mac and Fannie Mae, in an effort to meet political mandates, purchased the majority of the subprime loans that were originated in the peak years. Although many defenders of Freddie and Fannie attacked this analysis, a lawsuit initiated by the SEC late in 2011 alleged that Freddie and Fannie bought even more high-risk loans than Wallison and Pinto had estimated originally. (Peter J. Wallison, Bad History, Worse Policy, p. 168)

I believe it is likely that eventually the economic history will stress how poorly both regulators and financial industry executives understood the structure of the system that had evolved. The political advocates of home ownership had no idea how badly they were setting up their constituents for failure. The regulators who saw themselves as fine-tuning capital regulations had no idea how badly their rules were distorting bank behavior. (See my paper, “Not What They Had in Mind”)

Short-range thinking allows officials like Rattner and Geithner to rejoice at having replaced the inner tube on tire of the financial bicycle, so that Wall Street can ride almost as comfortably as it did in 2007. However, Rattner and Geithner have not learned the true lessons of the financial crisis. In my view, one of the key lessons is that regulators have too much confidence in their ability to monitor and regulate large financial institutions.

There is no such thing as a financial system that is too regulated to break. And if it cannot be made too regulated to break, then your best hope is a system that is easy to fix when it does break. From that perspective, enormous banks, with many hundreds of billions in assets, are inherently harmful. There is no easy way to fix the system when such a large, complex institution becomes insolvent. We would be better off breaking up the large banks. (See here) 

This is where history may judge Tim Geithner very poorly. In 2009, at the height of the financial crisis, there was widespread public and political support for making serious changes to how Wall Street and the financial sector operated. Presented with an opportunity to break these too-to-big-to-fail banks down to a size where an institution could be allowed to fail without threatening the entire national economy, Geither instead attempted to restore the status quo. This was a win for the biggest banks, but the nation as a whole may eventually come to regret his policies. 

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center.

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