The Great Unwinding Begins -- And So Does The Selling

The moment that changed the world, that humbled the United States economy, can be pinpointed to a span of a few hours on the afternoon of September 16, 2008. The buck broke. The Reserve Primary money market fund, which held a significant percentage of assets that were considered rope-tied secure, began to trade for less than a dollar. The culprit was the $785 million in bonds that Lehman Brothers, which had just declared bankruptcy, had invested in the fund. It was now worthless.


Rarely is history so neat. At that moment, panic became Wall Street's currency. The credit industry, which relied on the grease provided by the money market fund market, froze. The private markets did not function. Capitalism had collapsed. For two days, the Treasury Department tried to figure out what to do. Finally, they decided to guarantee the buck -- to insure funds and backstop them. That the government needed to stand behind the money market is one of the biggest wows of the financial crisis. That they did is a credit to the Bush administration and the joined hands of Hank Paulson, Ben Bernanke, and Sheila Bair. In political terms, the bar separating the American system from socialism was set higher.

Although the public appreciates the span of the economic crisis, one element is understated, or misstated, or misunderstood. When the Obama administration took over the economy, the credit markets were barely functioning. The goal, from day one, of Obama's economic team -- centrist Democrats and Republicans, with nary a liberal in sight -- was to get the private markets functioning again. That was the goal of the much-derided "stress tests" -- pushing the banks to raise private capital to avoid a government takeover. That was why the administration continued -- and expanded -- the Bush administration's bank and auto bailout programs. Now, the mechanisms used to execute these decisions, the language used to sell them, the stimulus package, the prioritization of health care, the errant economic forecasting by (well, everyone and) the administration, the threat of hyperinflation, TARP, the enormous expansion of the Fed's power and balance sheet -- all these things are between the knees and the shoulders. But the argument that the financial interventions were designed to scale the binary -- that is, transform them from a capitalist system to a socialist system -- just falls down.

As of September 18, the government will no longer backstop money market mutual funds. (The Treasury estimates that it has collected about $1.2 billion in new fees.) They are unwinding this intervention. And the system is rebounding in other ways: the various "facilities" created to bail out banks and lenders are giving out fewer and fewer loans and getting back more and more of their money. We're not quite there yet, but borrowers can usually find private sources to lend them the money now, at the government's encouragement.

In David Wessel's excellent book about the economic collapse, he points to a metaphor that Paulson once used to argue for expanded emergency powers for the Federal Reserve. He said that if the Treasury Secretary has a bazooka, and people know about it, it will influence behavior in such a way that the secretary never has to use the bazooka. Of course, the public acknowledgment of the bazooka's existence, so to speak, incited panic, as Wessel explains. Paulson got the idea right but screwed up the politics.

Barack Obama's speech today kicks off a months-long campaign by the administration to re-regulate the financial system, which they see as recovering but impaired. There are plenty of proposed bazookas, and the Fed is going to store many of them. Up until now, the nature of the administration's financial policies has been defensive -- and they worked -- or, they didn't prevent other mechanisms from not working. Given that the defensive policies -- bailouts, acronym-ed new government programs -- proved confusing and unpopular, and fueled some of the populist agita that's now hurting the administration's health care reform plans, I'll be watching to see how they sell their offense. My guess is that they will try, once again, to bring in the institutional stakeholders and build consensus. It helps that Sen. Chris Dodd remains chair of the banking committee. For the sake of his re-election, he needs a populist victory against Big Finance, but he knows enough about Big Finance to overreach. Same with Ken Feinberg, the special adviser for bonuses.

As I see it, the big policy challenges involve the Federal Reserve. Unquestionably, the government wants more authority in the form of adding more break-glass stations at the nodes of the economy. The elites are OK with a bigger Fed; the public barely knows what the Fed does, and will probably find a way to be against it. The pre-decisional period will be important -- who frames the Fed and how? The Republicans are already (and weirdly, given history) staking out an anti-Fed position.

The easiest part of the reform package to pass will be the new consumer lending protection agency. Republicans will argue that it stifles innovation, but I don't think the public will care that much. The credit card industry will fight tooth and nail against it, which is one reason why having Chris Dodd at the helm of the banking committee is good from the administration's standpoint; his successor would have been Sen. Tim Johnson (D-SD), whose state is reliant on Big Credit.