Lessons from History to Apply to Future Financial Crises
Review of Financing Failure: A Century of Bailouts, by Vern McKinley, The Independent Institute, 2012, 400 pages, ISBN 978-1-59813-049-2
Vern McKinley’s Financing Failure offers a compelling inquiry into the roots and consequences of our latest financial crisis, along with lessons for the future.
McKinley’s academic and professional experience in law, economics, and finance prepared him well to develop historical context in a rigorous way. Among other impressions, including a sense close to outrage about the refusal to learn from history, a reader can be left with admiration for McKinley’s care with detail and data. This is a dense read with some difficult material, but McKinley pulls it off.
In the introduction, McKinley identifies a ‘tripartite coalition’ of large banks, regulators, and politicians. This coalition tends to practice what he calls cafeteria capitalism—choosing when capitalist principles are most expedient and taking other things from government, such as bailouts, when it serves their interests.
Officials’ Sweeping, Dubious Claims
McKinley’s introductory chapter includes some basic conclusions from his reading of the history of bailouts, which can be described in these terms:
- During and after a crisis, public officials regularly make sweeping claims about the value of government intervention and legislative changes but without significant supporting analysis.
- Public officials and market participants tend to describe pre-bailout market conditions in terms such as “unprecedented stress” and “once-in-a-lifetime event,” but history shows “unprecedented” conditions keep happening.
- After each crisis, protected participants get bigger and more threatening in the long run, along with their servants in the public sector.
- Regulators shield the privacy of their own actions as well as the actions of those they are regulating.
- Our latest crisis was rife with regulatory breakdowns.
McKinley’s next chapter is a blow-by-blow description of the events that led up to the bailout of Bear Stearns in early 2008. That experience reinforced other historical lessons illustrating how liquidity is liquidity until it isn’t, and how quickly a ‘liquidity pool’ can dry up when a highly leveraged institution becomes sensitive to whims in market confidence.
The absence of good real-time analysis of systemic threats from a Bear Stearns failure before its bailout, as well as some curious ex post staff justification offered as analysis, suggest the claims of potential widespread calamity underlying the Fed’s exercise of extraordinary lending authority likely were scare tactics. In later chapters McKinley makes a good case that the Bear Stearns bailout took an important leg out of the stool of market and regulatory stability.
After this look at the Bear Stearns story, McKinley lays the foundation for a more thorough historical review. He provides a ‘Bailouts 101’ chapter, taking good care to define terms such as ‘run,’ ‘failure,’ and ‘bailout’ with appropriate precision—in light of the strategic use of those terms by regulators and market participants in real-time crisis/bailout management.
McKinley’s next three chapters are devoted to banking crises in the 1930s, 1980s, and 2000s, respectively. At the outset of each chapter he sets up useful “Legal Scorecards” giving readers some anchoring for the long chain of legislative action and reaction leading up to our latest debacle. Things with different names but similar means and ends—such as the Reconstruction Finance Corporation in the 1930s and the TARP program in the 2000s—help underscore McKinley’s depressing message that we keep repeating history without learning from it.
We learn a great deal from this, but greater discussion of the Panic of 1907 and the subsequent work leading to the Federal Reserve Act in 1913 could have been useful here.
Government’s ‘False Narratives’
McKinley’s next chapter, on the actions of the Fed and the Treasury in the 2000s crisis, is the longest and strongest in the book. McKinley identifies useful “false narratives” of the government’s justification for its actions. They include:
- “The clear evidence is that a contagion would have resulted if Bear Stearns were allowed to file bankruptcy.”
- “The big mistake during the financial crisis was to let Lehman Brothers file bankruptcy.”
- “AIG exploited a huge gap in the supervisory system and new powers are needed for a systemic risk supervisor to fill that gap.”
In each case McKinley provides a reasonable argument pointing to the opposite conclusions—with a particularly original and compelling take on the Lehman Brothers situation. This chapter is followed by two supplementary chapters on the 2000s crisis looking at the actions of the FDIC and the TARP program, respectively.
The final chapter stresses that history stubbornly repeats itself. For anyone concerned about the massive dislocation, economic consequences, and undermining of market principles associated with our latest meltdown, this reading of the history offers a bleak outlook.
McKinley closes with a case, and a plea, for government to abandon short-run stabilization and replace it with sometimes painful but necessary disciplinary solutions. He doesn’t suggest government shouldn’t have a role to play in resolving such crises, and in fact he suggests faster action than the 2000s crisis received.
For some, however, the government role carries the stated or strategically unstated implication of a need for bailouts. McKinley, by contrast, argues government’s role is to close insolvent financial institutions quickly, with costs for those who were associated with them.
William Bergman (firstname.lastname@example.org) is an economist who writes from Chicago.