At a congressional hearing last fall, Frank Raiter, a former Standard and Poor's executive, described the financial system as if it were a train on tracks: "The engine was powered by the low interest rates that prevailed after the turn of the century," he declared. "The conductors were the lending institutions, and investment bankers who made the [subprime] loans and packaged them into securities, and the rating agencies were the oilers who kept the wheels of the train greased."
And the passengers? "Investors. And it was standing room only."
With low interest rates, money was cheap, so everybody, from homeowners-in-waiting to bankers, borrowed massively, often beyond their means. Confident that the value of housing would only go up, the train rode off the edge of an exploding credit bubble that didn't just pop, but burst, in 2008. The train hit a wall when the financial meltdown reached a fever pitch in September: Lehman Brothers crumbled, the feds bailed out AIG the next day, and the Dow Jones Industrial Average received its worst beat-down since 1931. Then came TARP, the auto bailouts, and the economic stimulus. After all that, Bear Stearns's bailout this past March seemed like nothing more than a bad day on the road to serfdom.
But what was the cause of all of this? Who was running this train off the rails? Nicole Gelinas tells the story of the financial meltdown, but traces its genesis to 1984, when the federal government radically changed the rules of the finance game. That year the country's eighth largest commercial bank, Continental Illinois, was on the brink of collapse; lenders rushed to pull their funds out of Continental, which sparked a global run on other banks. Gelinas explains that, in order to avoid a major financial crisis, the Reagan administration nationalized Continental Illinois, and subsequently told "Congress that none of the nation's top eleven banks would be allowed to fail."
That was the debut of "too big to fail"--and that policy is the villain of After the Fall. Big banks were no longer disciplined by the normal rules of the market: With government-insured risk for the next two decades, banks borrowed more and more against each dollar they had on hand--Bear Stearns was leveraged $35 to every dollar it actually held--which amounted to speculation to turn a profit. During that time total debt "doubled as a percentage of" Gross Domestic Product, yet debtors didn't feel the full brunt of their risk. By nationalizing Continental Illinois in 1984, Washington socialized risk for the next quarter-century.
Gelinas, a fellow at the Manhattan Institute, argues that if the government does not scrap its too-big-to-fail policy, and devise clear and consistent regulations on the market, the "next time the markets try to correct our unsustainable financial system, as they brutally have tried in this crisis, Washington may not be able to pull us back from the brink of depression."
Unraveling the intricacies of the current mess and how we got here, Gelinas lays out her case with skill, citing parallels between the speculation-mad 1920s and the easy-money 2000s to support her argument. After 1929 gave way to the Great Depression, regulators imposed sound and consistent rules to dampen the effect of volatile, risky speculation on the overall economy. But three-quarters of a century later, regulators either forgot or outright ignored those principles for fear of squelching profits and prosperity in the financial markets.
Of course, as we now know, such lax policies and enforcement ended with hundreds of billions of dollars being pumped into a financial system that could have, and should have, self-corrected had too-big-to-fail not ingrained itself into the landscape. What we need, Gelinas argues, is not more bailouts but more regulation of the financial system. If banks know that they actually face the possibility of bankruptcy they will presumably correct their own reckless behavior as a hedge against such stark reality. And even if they do take excessive risks to turn a profit, but fail, there will be a clear, ordered, and consistent way for banks to liquidate their remaining holdings without causing real damage to the global economy. (On the "what" and "how" of this last point After the Fall could use a little more flesh on the bones.)
Most important, Gelinas does not believe that such close regulation would threaten capitalism; instead, it would invigorate the market. Looking back on the recent crisis, she observes:
Capitalism didn't fail; companies did--after having adopted the idea, en masse, that any loan, bond, or other bank asset, could be sliced up and turned into an instantly liquid, priceable, and tradeable security, with all its risk quantified and distributed scientifically to parties willing and able to bear it.
If those companies had been left to die, their bad ideas would have been buried with them. As it is, the ideas still live and are being recycled as banks continue to take opaque risks, reap the short-term benefits, and expect the feds to catch them when they fall.
Emily Esfahani Smith, a Collegiate Network fellow, is an editorial assistant at THE WEEKLY STANDARD.