A Crash Course in Crisis Economics*
*Starring (to the extent, for good or for ill, that any of this can come down to one person, which as we’ll see is only so much) Barney Frank.
III. The Limits of Foresight in the Face of a Juicy Sex Scandal and Finite Gross National Attention Span
Frank joined the Financial Services Committee during his inaugural term for the typical reasons a freshman Democrat does: It’s big, and therefore not hard to get a seat on, and also oversees affordable housing policy — one of his passions. (The idea that Frank is a liberal housing activist still has wide currency. An investment banker friend who knew I was working on this article told me to tell the “financial antichrist” to “stop hypocritically murdering America.”) But the fact is that 12 of the years Frank has spent on the committee have fallen under Republican leadership, which has limited how much housing policymaking he’s been able to do. More beneficially, it’s cleared him to focus his intellect on issues in which he has less of an emotional stake.
One thing Frank’s intellect has had trouble squaring is the insularity of the Federal Reserve. By law, the Fed is granted a much-vaunted independence from politics (that’s why it can change interest rates without a permission slip from the White House or Congress). But during the Clinton years, Frank felt that then-chairman Alan Greenspan had the Fed buying so far into its autonomy that it was in its own sort of closet. It was a point Frank drove home with eerie prescience on what was probably his busiest day as a minority member: October 1, 1998.
On that day, one of Frank’s other committees, the Judiciary, was preparing a series of cases for and against President Clinton’s impeachment over the Monica Lewinsky affair. Like most of his colleagues, Frank felt the proceedings were a joke that cheapened the whole institution. But with his own sex scandal having removed the pieties that bound most Democrats, he was the only one willing to say it, and he had been remaking a name for himself lambasting the process in interviews granted to anyone who asked.
Now the committee was in the final stages of entering into the public record a 4,610-page supplement to the 445-page Starr Report. News cameras clogged the halls of the Rayburn House Office Building as the media camped out, waiting for the documents. The assembled reporters, as they’d learned to do, looked to Frank for good sound bites. But Frank had to tear himself away, because a far more important hearing was in session down the hall. The previous week, the Federal Reserve Bank of New York had intervened to organize a bailout of a huge hedge fund, and Greenspan and New York Fed boss William McDonough were there to explain what had happened.
Long-Term Capital Management was legendary for a trading strategy built on arbitrage algorithms that used historical data on the relationships between the price swings of stocks, bonds, currency, and commodities. The strategy had worked splendidly until earlier that year, when a series of emerging markets crashed, the Russian government defaulted on its debt, and conventional economic logic went haywire. This hardly would have sent the shock waves it did but for two things: To increase its profits, Long-Term Capital traded not only the actual stocks, bonds, etc., but also derivative contracts that bet on the movements of their prices, with each bet having a “counterparty” bank on the other side. And to further amplify returns, Long-Term Capital had loaded up each bet with massive amounts of short-term debt, which meant dozens more creditors. No one knew for sure how much money was at stake if Long-Term Capital blew up. The Fed estimated it could be as high as a trillion dollars, which was why it had been moved to intervene.
At the same time, McDonough and Greenspan maintained coolly that the intervention was really not that big a deal. “Not one penny” of federal funds had been put on the line; it was the affected banks that had chipped in on the bailout. Sure, McDonough and his deputies had provided the conference rooms and “were present” at the negotiations, but McDonough hadn’t, he claimed, actually participated. “This was a private-sector solution,” he emphasized, “to a private-sector problem.”
Frank laid into McDonough in a way that can only be appreciated in hindsight. He suggested that for all McDonough’s “passivity” in the intervention, he was most likely “in [his] heart of hearts…quite proud” of his hard work averting financial collapse. More important, Frank pointed out that McDonough, while “a very persuasive man,” could not have done what he did without the “implicit power” bestowed by the New York Fed — which is to say, a part of government. And from one government employee to another, surely McDonough had to understand how bad it looked when the “mistake-makers” were shielded from huge personal losses by the Fed’s actions.
“A consequence of preventing damage to the system was to leave some of the richest people in this country better off than they would have been if the federal government hadn’t intervened,” Frank said. “And that rankles a lot of us…when we’re told we can’t do anything similar for people much needier.” The debate over whether the bailout of Long-Term Capital created moral hazard would occupy economists for years to come, but Frank had put forward the real hazard right there: In insisting that the government-brokered deal was private-sector self-healing, McDonough had forgotten that the Fed and Congress were on the same team.
The chain of events threatened by the implosion of Long-Term Capital is almost exactly the scenario playing out a decade later on a massive scale: A single event unpredicted by the models — then the Russian default, today the foreclosure crisis — gets magnified over and over and over again by a financial system loaded up with complex derivative securities. Ten years ago, there were already people in Washington, some Republicans among them, pushing for the monitoring that would prevent that. As early as 1997, the respected Commodity Futures Trading Commission chair Brooksley Born had argued strenuously in favor of regulating the non-exchange-based derivatives that hedge funds were starting to gorge on, only to be shut down by Greenspan and Treasury Secretary Robert Rubin. The Financial Services Committee’s GOP leaders — including its next chairman, Mike Oxley — would pursue their own fruitless reform efforts (which received from the Bush camp what Oxley succinctly described to the Financial Times as a “one-finger salute”). It was all the product of a legislative landscape rife with asymmetries: Republicans with the deepest intellectual interest in finance — and the most information about its excesses—were coming to favor more oversight, but were hamstrung by the larger body’s generalized suspicion of regulation, coupled with the reflexive bias against it of the Bush administration and the Fed, which also happened to harbor a reflexive disdain for Congress.
During the October 1, 1998, hearing, Frank would have no success in his efforts to rewire that dynamic. “I understand there are those who believe that while democracy is capable of dealing with many, many issues, it really cannot be trusted with matters of high financial policy,” he half-joked to Greenspan and McDonough at one point. “There is an overwhelming tendency, when you come here, to speak to us as if we were adolescents who need to be told some things but who are not ready for the entire truth.” Of course, with the rest of the House consumed with fashioning thousands of pages of documents into a case to impeach the president over a blowjob, treating people like adults was clearly not at that moment Washington’s, or the media’s, or the country’s, highest priority.