Stress Test

by Timothy F. Geithner

  “That must have been expensive for you, Bob,” I teased him.

  “Yes,” he laughed. “Very expensive.”

  The President gave me a pretty remarkable parting gift: engraving plates for the ten dollar bill, featuring Alexander Hamilton on the front and the Treasury building on the back. His inscription was gracious: “Thanks for navigating us through a terrible storm; Hamilton would be proud!” He and the vice president came to my official farewell ceremony, as did former secretaries Rubin and Paulson, Ben Bernanke, and a lot of Treasury’s civil servants and political appointees.

  I used the occasion to rehash some of the rules I had adopted since I first arrived at Treasury in 1988, from Be for stuff, not just against stuff to No peacocks, jerks, or whiners. And I tried to express my appreciation for the awesome colleagues who had fought the crisis by my side. It really had been a terrible storm. The world had looked to us for leadership, and despite some stumbles and setbacks and conflicts, we had gotten the job done, even if the world didn’t think so.

  “It was not easy work,” I said. “There was no risk of public affirmation or affection. You were subjected to a lot of second-guessing, but you persevered, and because of your resolve and your creativity and your ingenuity, our economy is stronger, even with all the challenges we still face.”

  “I walked into this building in 1988 a younger man, eager to work on issues that matter,” I continued. “And I leave Treasury so thankful for this opportunity to have worked with such an amazing group of people, so grateful to have been part of something consequential, something larger than ourselves.”

  EPILOGUE

  Reflections on Financial Crises

  In November 2008, when I told then President-elect Obama that his most important achievement would be preventing a depression, he said he intended to do a lot more than that. And he has. He ended the war in Iraq, is winding down the war in Afghanistan, and eliminated Osama bin Laden. His health care reforms are not only expanding insurance protections for millions of Americans, they are contributing to a dramatic slowdown in the medical cost growth that threatens our fiscal future. He has made tremendous strides on issues like gay rights, clean energy, and education reform. History will recognize him as a remarkable and consequential president.

  But his success in preventing a major depression is still at the heart of his broader legacy. It made most of his other achievements possible, because a depression would have been an unimaginable catastrophe, substantially worse than anything we experienced in terms of unemployment, foreclosures, and poverty. When President Obama took office, we were heading that way. The U.S. economy was on a path to lose nine million jobs in 2009. The housing market and auto industry were collapsing. The financial system, despite all our government interventions and guarantees, was still fragile and broken. The five bombs—Fannie, Freddie, AIG, Citi, and Bank of America—were all serious threats to explode, and they were all much larger than Lehman Brothers.

  The U.S. Recovery Has Outperformed the Developed World

  GDP Levels in Major Advanced Economies

  Because of the aggressive fiscal, monetary, and financial force we deployed, the U.S. economy has grown faster than other major advanced economies since the financial crisis.

  Source: Organisation for Economic Co-operation and Development (Q1 2008 = 100).

  They did not explode. And the U.S. economy escaped its death spiral. It started growing again within six months. By the end of 2013, our GDP was 6 percent higher than before the crisis; Japan, the U.K., and the eurozone were still below their pre-crisis output levels. After declining by $15 trillion, U.S. household wealth was also higher than the pre-crisis peak. As I write this in March 2014, we have enjoyed forty-eight consecutive months of private-sector job growth, with 8.7 million private-sector jobs created. Our 6.7 percent unemployment rate is still high, but it is a lot lower than our peak of 10 percent, or the current eurozone rate of 12 percent.

  Worse Initial Shock, but No Great Depression

  Comparison of Market and Economic Indicators

  The shock that preceded our crisis in 2008 was larger than the initial shock that precipitated the Great Depression in 1929, but our outcomes were dramatically better.

  Sources: Federal Reserve Board, Bureau of Economic Analysis, Bureau of Labor Statistics, Council of Economic Advisors, and Historical Statistics of the United States, Millennial Edition.

  By contrast, six years after the start of the Great Depression, U.S. employment was still 10 percent below its pre-crisis peak. Our shock in 2008 was even worse than the shock of 1929, but our outcomes have been much better. If our economy had followed the trajectory of the 1930s, it would be $2.5 trillion smaller today—the equivalent of losing the entire output of both Texas and New York—and 13 million fewer people would have jobs. That would have been a disaster for Main Street, not just Wall Street. The recovery of the stock market—up 175 percent from its bottom in early 2009—has replenished the personal savings of millions of Americans as well as public and private pension funds. The stabilization of Wall Street and the rest of the financial system saved the Main Street economy from the trauma of another depression.

  And while we didn’t design our financial programs with the expectation of making money for the taxpayers, the financial industry paid for the rescue. As late as April 2009, the IMF estimated that we would incur nearly $2 trillion in direct costs saving the financial system, but at the end of 2013, our financial programs were projected to generate a positive return for the taxpayer of more than $150 billion, enough to fund federal cancer research at current levels for the next twenty-five years. But many Americans just remember the initial characterization of the financial rescue as a handout. Jenni LeCompte once sent me a clip of CNN’s Erin Burnett interviewing a young activist from Occupy Wall Street, asking him if he knew that the Wall Street bailouts had been profitable for taxpayers.

  “I was unaware of that,” he told Burnett.

  Would that make him feel differently about TARP?

  “Oh, sure,” he replied.

  That earnest protester also might have been interested to learn about all the money President Obama poured directly into the Main Street economy. In his first term, the Recovery Act and other stimulus initiatives included about $1.4 trillion worth of tax cuts, government investments that boosted employment, and direct aid to low-income and middle-class families. That total does not include the President’s rescue of the auto industry, which resuscitated dying manufacturers and helped prevent a regional depression in the Midwest, or his lifelines for Fannie and Freddie, which kept mortgage rates low and helped revive the real estate market. Jon Stewart used to make the case on The Daily Show that we should have written checks to the American people instead of writing checks to the banks. We wrote a lot of checks to the American people.

  Projected Taxpayer Returns from the Crisis Response

  Projected Returns and Losses from Government Investments (end-2013)

  In early 2009, the IMF estimated that the U.S. government would end up spending nearly $2 trillion rescuing the financial system. In fact, the U. S. government’s crisis response not only prevented the collapse of the financial system and helped revive the broader economy, but as of the end of 2013 it was projected to generate about $166 billion in positive returns for taxpayers.

  Sources: Compiled from Congressional Budget Office, Federal Deposit Insurance Corporation, Federal Reserve Board, Office of Management and Budget, and U.S. Treasury Department.

  Still, the financial crisis left tragic pain and suffering in its wake. Financial crises always do. The economists Carmen Reinhart and Ken Rogoff, my former IMF colleague who played chess in his head during meetings, have calculated that it takes the average country eight years after a financial crisis to reach its pre-crisis income levels. Even though we did much better than the average, and our crisis was much worse than the average, Americans absorbed a terrible blow. Long-term unemployment is still at alarming levels, with a dev
astating effect on workers as well as the economy at large. Poverty is still shockingly high. Income growth for most households is still stagnant. Our housing programs could not prevent millions of foreclosures. And despite the President’s insistence on raising taxes on the wealthy, lowering taxes for the poor and the middle class, and expanding the federal safety net, inequality is still rising, continuing a decades-long trend.

  The U.S. Recovery Has Also Outperformed Historical Comparisons

  Total Civilian Employment

  Recoveries that follow severe financial crises are always slow, but our post-crisis employment growth has been much stronger than other advanced economies that have experienced severe banking crises since World War II.

  Sources: Census Department, Organisation for Economic Co-operation and Development, and U.S. Treasury Department.

  The juxtaposition of the slow economic recovery and the rapid financial recovery has fueled the sense that we cared more about Wall Street than Main Street. That is simply not true. But it is true that the U.S. economic recovery, while strong compared to previous crises or other countries in this crisis, has been weak compared to normal post-recession recoveries.

  WHY IS that?

  It’s mainly the reality of deleveraging after a financial crisis. After a long period of too much borrowing, too much home-building, and too much financial leverage, Americans have been saving more, paying down debts, and working through the excess inventory in the real estate market, while banks have been reining in risk. This is all part of the healing process, but it has slowed our rate of growth. We also had some bad luck with shocks beyond our control, like unrest in the Middle East, the tsunami in Japan, the lingering mess in Europe, and drought in parts of the United States.

  But we also had a serious and frustrating self-inflicted wound: our prematurely tight fiscal policy. The President has been a strong advocate for fiscal stimulus, starting with the Recovery Act, the largest stimulus in history, continuing with several modest stimulus bills and more substantial stimulus proposals even after “stimulus” became a dirty political word. But since 2010, government cutbacks at the federal, state, and local levels have sliced about one percentage point off GDP each year—the difference between the tepid growth we had and the solid growth we could have had. And in March 2013, the blunt across-the-board spending cuts of the so-called “sequester” took effect, chopping another half point off GDP. We didn’t quite repeat the 1937 mistakes to the extent that Europe did, so premature austerity didn’t kill our recovery; but insufficient stimulus definitely sapped its strength.

  The Economy Started Growing Again Remarkably Quickly

  Quarterly Real GDP Growth

  The overwhelming force of the policies we deployed in early 2009 turned an economy contracting at an annual rate of more than 8 percent into a growing economy within six months. Since the end of the Great Recession, the economy has expanded at an average annual rate of 2.4 percent, despite headwinds from the European financial crisis, state and local government cutbacks, and a more recent shift to austerity at the federal level. Excluding government spending, GDP has grown at an average rate of 3.5 percent since 2010.

  Source: Bureau of Economic Analysis (chained 2009 dollars, quarterly, seasonally adjusted annual rate).

  The right has continued to caricature President Obama as an irresponsible big spender who doesn’t care about deficits, which is bizarre given the actual numbers. The $1.2 trillion budget deficit he inherited in 2009 shrank to $680 billion by 2013, the fastest reduction since the demobilization after World War II. On the President’s watch, the deficit will fall from a scary 10 percent of GDP to about 3 percent in just over five years—partly because of responsible policies like the end of the Bush tax cuts for the most affluent Americans, partly because of premature austerity like the sequester, partly because of the stronger economy. Discretionary spending relative to GDP is projected to fall to the lowest it’s been since the Eisenhower administration. Health-care-cost growth since 2010 has been the lowest on record, and a significant part of that seems to be due to the President’s reforms. With interest rates still remarkably low by historical standards, we ought to take advantage of our vastly improved fiscal outlook to increase our long-term investments in education, research, and especially infrastructure, ideally in the context of more fiscal reforms that would make our long-term commitments more sustainable.

  In general, political dysfunction—and the fear that Washington gridlock could lead to disastrous outcomes for the economy—has been a drag on growth. The debt-limit showdown that brought the United States to the brink of default in the summer of 2011 was brutal for business and consumer confidence. Republicans continued to play chicken with the economy in the fall of 2013, refusing to pass a budget unless the President agreed to repeal Obamacare, which obviously wasn’t going to happen; their leaders finally backed down after a pointless two-week government shutdown. Superpowers really aren’t supposed to bumble around like that. But the President again refused to negotiate with Republicans over the debt limit in 2013, and Republicans agreed to extend it into 2015 after failing to extract any concessions. I strongly believe Congress should abolish the debt limit, so political extortionists can never again use the full faith and credit of the United States as a bargaining chip.

  Today, the U.S. economy is still growing modestly. It’s strong enough to create jobs but not to quell the concern that Main Street has been left behind. The Fed has begun to “taper” its monetary stimulus, reducing its bond-buying by $10 billion every month, and there is no additional fiscal stimulus on the horizon. But we are getting stronger. After several years of deleveraging, the average U.S. household is in a healthier financial position, with about 20 percent less debt relative to income. We still have the world’s most innovative, resilient, and diverse economy, and it’s considerably more productive than it was before the crisis. Our divisive and adolescent political culture is still a problem—unable to deliver many policy reforms that could help ordinary Americans, always a threat to make things worse—but most other countries face even more daunting political challenges.

  THE UNDERSTANDABLE sense of disappointment and unease that so many Americans feel about their economic future has been accentuated by an acute sense of resentment and outrage about the rising fortunes of the wealthiest few. The success of our financial rescues and the speed of the stock market’s recovery look like evidence that we sided with the arsonists who burned down the economy, bailing them out of bad bets, protecting their crazy compensation. Even though the prevailing view on Wall Street is that our financial reforms are a tyrannical assault on free enterprise, many Americans believe we helped Wall Street get away with the heist of the century.

  Some of this anger reflects a misunderstanding of what we did during the crisis. For example, our interventions did not shield Wall Street from all financial pain. We let the weakest parts of the financial system fail, and forced many of the survivors to shrink in size or scope. Bear Stearns ceased to exist as an independent firm after its “bailout.” Investors in Fannie, Freddie, and AIG were so upset about the losses they absorbed during their “rescues” that they actually sued the federal government. After all the public furor over our supposed generosity, after all the outrage from moral hazard fundamentalists about the green light we supposedly gave to the excessive risk-takers of tomorrow, it’s been odd to also stand accused of being overly harsh to failing financial giants.

  Through TARP and the stress test, major banks were diluted in proportion to the risks they took: The more capital they needed, the more their shareholders saw their stakes in those firms reduced. An investor or an executive who owned 1 percent of Citigroup’s stock before the crisis would have owned 0.16 percent of the firm by the end of the crisis. That was certainly better than getting totally wiped out through failure, but it was much less generous than our critics suggest. And the CEOs of the troubled institutions that required a majority government stake (Fannie, Freddie, AIG) or a me
rger with a stronger partner (Bear, WaMu, Countrywide, Merrill, Wachovia) all lost their jobs. That ought to help strengthen the incentives of future bank investors and executives to temper their risk-taking. Our financial reforms will tie future compensation packages more closely to long-term performance, with legal authority for clawbacks when firms run into trouble. And because the tax system is now more progressive, a larger share of financial-industry bonuses are helping to finance education, the safety net for the poor, stronger enforcement of new financial rules, and other critical functions of government.

  The perception that Wall Street paid no price for its misbehavior is also inaccurate. By early 2014, the big banks had paid more than $100 billion in fines related to the crisis. Overall, there has been a substantial increase in enforcement penalties for U.S. financial firms, and the new Consumer Financial Protection Bureau and the stronger authorities and resources granted to the other financial regulators will create an even more credible deterrent in the future—much stronger, I believe, than in any other major economy.

  It’s also true that individual Wall Street CEOs haven’t been marched off to jail en masse, as many Americans thought they should be. But this was not a conspiracy of public corruption or ineptitude. Federal prosecutors and state attorneys general had all the right incentives to go after high-profile financial scalps, and they have brought down some insider traders and Ponzi schemers. For the most part, they have simply concluded that the financial activities most responsible for the crisis weren’t illegal, however unethical or dumb they may have been. There was an appalling amount of mortgage fraud during the credit boom; it caused a lot of pain, and it deserved a more forceful enforcement response than the government delivered. But the bulk of the huge boom in borrowing that caused the crisis was between consenting adults who took risks they believed would pay off, risks that did pay off for a long time, risks fueled by genuine but imprudent beliefs that rising real estate values would make future defaults extremely unlikely. When Elizabeth Warren explained her theory of consumer protection to me over that dinner after we passed Dodd-Frank, she made the correct observation that banks did not and could not make money on loans that consumers had no hope of repaying. In any case, federal laws do not prohibit greed or ignorance or excessive optimism or even excessive risk-taking.