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AFTER T HE M USIC S T OPPE D

THE FINANCIAL CRISIS, THE RESPONSE, AND THE WORK AHEAD

A L A N S . BL I N DE R

t he penguin pr ess New York 2013

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WHATS A NICE ECONOMY LIKE YOU DOING IN A PL ACE LIKE THIS?

We came very, very close to a global financial meltdown.
Federal Reserve Chairman Ben S. Bernanke

Did anyone get the license plate of that truck? Thats how many Americans felt after our financial system spun out of control and ran over all of usalmost literallyin 2008. The U.S. economy was crawling along that summer, with employment drifting down, spending weakening, and the financial markets suffering through a gutwrenching series of ups and downsmostly downs. The economy was hardly in great shape but neither was it a disaster area. It wasnt even clear that we were headed for a recession, never mind the worst recession since the 1930s. Then came the failure of Lehman Brothers, the now-notorious Wall Street investment bank, on September 15, 2008, and everything fell apart. Yes, the license plate of that truck read: L-E-H-M-A-N. Most Americans were innocent bystanders who didnt know where the

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truck came from, why it was driven so recklessly, or why the financial traffic cops didnt protect us better. As time went by, shell shock gave way to anger, and with good reason. A host of financial manipulations that ordinary people did not understand, and in which they played no part, cost millions of them their livelihoods and their homes, bankrupted many businesses, destroyed trillions of dollars of wealth, brought the once-mighty U.S. economy to its knees, and left all levels of government gasping for tax revenue. If people felt as though they were mugged, its because they were. The financial accidents that took place between the summer of 2007 and the spring of 2009 had severe consequences, which Americans experienced firsthand. But most citizens are baffled, and many are extremely displeased, by what their government did in response to the crisis. They question the justice of the seemingly large costs taxpayers had to bear, and they wonder why so many reckless truck drivers are still on the road, prospering while other Americans suffer. Perhaps most of all, they are anxious about what the future may bring. As late as the 2012 election, a strong majority of Americans were telling pollsters that the country was still on the wrong track or heading in the wrong direction. No wonder we heard populist political thunder from both the Right (the Tea Party movement) and the Left (the Occupy movement). The United States recently completed the quadrennial spectacle we call a presidential election with a plainly angry electorate. While President Obama won reelection, no one yet knows what the 2012 election will bring in its wake. But we do know that the last chapters of the story that began in 2007 are yet to be written. So lets start by looking back. What hit us and why?

A Very Brief History of the Fina ncial Crisis a nd the Great Recession
Historical perspective accrues only with the passage of time, and we are still living through the aftermath of the frightening financial crisis and

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the Great Recession that followed closely on its heels.* But enough time has now elapsed, and enough dust has now settled, that some preliminary judgments can be made. Consider this book a second draft of history. There will doubtless be thirds and fourths. It is vital that we reach some preliminary verdicts relatively quickly because Americans well-justified anger is affectingsome would say, poisoningour political discourse. This book concentrates on the what and especially the why of the financial crisis and its aftermath. Its a long and complicated story, but some understanding is essential for the better functioning of our democracy. So before getting enmeshed in the details, here is a very brief history of the financial crisis, the Great Recession, and the U.S. governments responses to each. It will take only four paragraphs. The fourth may surprise you.

The Supershort Version

The U.S. financial system, which had grown far too complex and far too fragile for its own goodand had far too little regulation for the public goodexperienced a perfect storm during the years 20072009. Things started unraveling when the much-chronicled housing bubble burst, but the ensuing implosion of what I call the bond bubble was probably larger and more devastating. The stock market also collapsed under the strain, turning many 401(k)s intoin the dark humor of the day201(k)s. When Americas financial structure crumbled, the damage proved to be not only deep but wide. Ruin spread to every part of the bloated financial sector. Few institutions or markets were spared, and the worst-affected ones either perished (as in the case of Lehman Brothers) or went on life support (as in the case of Citigroup). We came perilously close to what Federal Reserve Chairman Ben Bernanke called a global financial meltdown. Some people think of the financial markets as a kind of glorified
*Economists date the end of a recession as when the economy stops contracting, which came in June 2009. But the public seems to consider recession an approximate synonym for hard times, which are clearly still in progress.

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casino with little relevance to the real economywhere the jobs, factories, and shops are. But thats wrong. Finance is more like the circulatory system of the economic body. And if the blood stops flowing . . . well, you dont want to think about it. All modern economies rely on a variety of creditgranting mechanisms to circulate nutrients to the rest of the system, and the U.S. economy is more credit-dependent and financialized than most. So when the once-copious flows of credit diminished to mere trickles, the economy nearly experienced cardiac arrest. What had been far too much liquidity and credit during the boom years quickly turned into vastly too little. The abrupt drying-up of credit, from both banks and the so-called shadow banking system, coupled with the massive destruction of wealth in the forms of houses, stocks, and securities, produced what you might expect: less credit, less buying, and a whopping recession. The U.S. government mobilized enormous resources to alleviate the financial distress and, more important, to fight the recession. Congress expanded the social safety net and enacted large-scale fiscal stimulus programs. The Federal Reserve dropped interest rates to the floor, created incredible amounts of liquidity, and expanded its own balance sheet by making loans, purchasing assets, and issuing guarantees the likes of which it had never done before. Many of the Feds actions were previously unimaginable. I remember coming into class one morning in September 2008, scratching my head in disbelief and saying, Last night the Federal Reserve, which has never regulated an insurance company, nationalized one! The company was the infamous AIG. Now the surprise: It worked! Not perfectly, of course. But for the most part, the financial system healed faster than most observers expected. (Remember, healing in this context does not mean returning to the status quo ante. We dont want to do that.) And the economys contraction, though deep and horribly costly, turned out to be both less severe and shorter than many people had feared. Only the homebuilding sector, a small share of our economy, experienced anything close to Great Depression 2.0. For the rest, unemployment never quite reached 1983 levels, never mind 1933 levels. That doesnt mean everything was hunky-dory by, say, 2012. Far from it. But the worst, most assuredly, did not happen.

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So thats my capsule history, and it suggests a modestly happy endingor at least a sigh of relief. That said, we are grading on a pretty lenient curve when the good news is that the United States avoided a complete meltdown of its allegedly best-in-class financial system and a second Great Depression. In truth, U.S. macroeconomic performance since the fall of 2008 doesnt merit even the proverbial gentlemans C. It has been the worst in postWorld War II American history. Give it an F instead. Congress rewrote the rulebook of finance in 2010, trying to ensure that nothing like this will ever happen again. But the financial reforms are so newmost not yet even in effectthat no one knows how the redesigned regulatory system will work in practice, especially once it comes under stress. And bank lobbyists are fighting the reforms tooth and nail. To turn Rahm Emanuels famous principle into a question: Did we waste this crisis or use it as a catalyst for much-needed change?* Only time will tell.

Three Critical Questions

Another aspect of the crisis motivates this book: Even today, despite numerous works on the crisissome of them excellentmost Americans remain perplexed by what hit them. They have only a limited understanding of what the U.S. government did, or failed to do, on their behalfand, more important, why. They also harbor several major misconceptions. In consequence, the Tea Party movement erupted in 2009, voters threw the rascals out in the elections of 2010, Occupy Wall Street exploded in 2011, economic issues were central to the hotly contested election in 2012, and trust in government is still scraping all-time lows. This, too, is understandable. As I watched the financial crisis, the recession, and the policy responses to each of them unfold in real time, one of my biggest frustrations was how little explanation the American people 1S 1R 1L

*Emanuel, then the designated White House chief of staff, was widely quoted in November 2008 as saying, You never want a serious crisis to go to waste.

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ever heard from their leaders, whether in or out of government. Sadly, that remains true right up to the present day. We wont restore trust in government until Americans better understand what happened to them and what was done to help. The president of the United States possesses the biggest megaphone in the world. But President George W. Bush virtually dropped out of sight during the waning months of his administration. Can you remember even a single Bush speech on the nations developing economic crisis? President Barack Obama has been vastly more visible, activist, and eloquent than his predecessor. Yet even he has rarely taken the time to give a speech of explanationfar less time than the American people need and deserve. The two secretaries of the Treasury during the crisis period, Henry Paulson and Timothy Geithner, have between them barely given a single coherent speech explaining what happened andperhaps more importantwhy they did what they did. Federal Reserve Chairman Ben Bernanke has done more explaining, and done it better. But his audience is specialized and limited, and he tries to stick to the Feds knitting, not the administrations. So most of the job of explaining has been outsourced by default to the private sector. Even there, however, the supply has been inadequate. For example, while our financial industry is allegedly teeming with brilliant people who understand all this stuff, hardly any industry leaders have stepped up to explain what happened, much less to apologizeprobably on advice of counsel. Journalists, academics, and the like have, of course, penned hundreds of articles and op-eds on the origins of the crisis and the responses to itincluding a few by yours truly. But mass media outlets require such brevity that anything remotely resembling a comprehensive explanation of something as complex as the financial crisis is out of the question. Twelve seconds of TV time constitutes a journalistic essay. While this book tells the story in what I hope is an intelligible manner, its more important goal is to provide a conceptual framework through which both the salient facts and the litany of policy responses can be understood. More concretely, I want to provide answers to the following three critical questions:

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How Did We Ever Get into Such a Mess? The objective here is not to affix blame, though some of that will inevitably (and deservedly) be done, but rather to highlight and analyze the many mistakes that were made so we dont repeat them again. What Was Done to Mitigate the Problems and Ameliorate the Damagesand Why? Were the policy responsessome of which were hastily designed sensible, coherent, and well justified? Again, my purpose is not so much to second-guess the decision makers and grade their performances as to learn from their experiences, so were better prepared the next time around. My big worry is that the policy responses of 20082009 are now held in such ill repute that politics will stand in the way the next time a financial crisis hits. Did We Waste the Financial Crisis of 20072009 in Emanuels Senseor Did We Put It to Good Use? Specifically, were the financial reforms enacted in 2010 well or poorly designed to create a sturdier financial structure? What did they leave out? Has the financial industry cleaned up its act? Perhaps most important, what comes next?

Whats a Nice Economy Like You Doing in a Pl ace Like This?

A well-known series of TV commercials brags that what happens in Vegas stays in Vegas. But the calamities that befell the financial markets in 20072009 did not stay there. They soon had profound ill effects on the real economythe places where Americans live and work, where nonfinancial companies make profits or losses, and where standards of living rise or fall. Indeed, with many Americans desperate to find work or struggling to make ends meet, we are still living with many of those effects.

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