The Committee to Save the Banks sat down for a lengthy, friendly interview for the tenth anniversary of the Great Financial Crisis.  What the committee members said is very important as it reveals how unfit they were for the positions they held and how the choice they made to save the banks undermined America.   Due to the length of the interview, I will present the evidence supporting this conclusion across four posts (Part II, Part III and Part IV).

Let me start with a brief summary of who the committee members are and the story they would like us to believe.

“We were dealing with trying to put out a fire without the right tools to do so.” That’s former Treasury Secretary Henry Paulson describing how he, Timothy Geithner, former president of the New York Federal Reserve and former Treasury secretary, and Ben Bernanke, former Federal Reserve chair, were insufficiently armed to deal with the 2008 financial crisis. The three men worked together to coordinate an unprecedented response, often racing to do so against the clock and against public opinion.

The committee members would like to portray themselves as heroes who not only didn’t have the right tools for the job, but had to battle public opinion too.

The only problem with their story is a decade afterwards they are still the only people who believe it.

Why is it unbelievable?  Everyone had and still has reason to think the Crash of ’29 and the subsequent Great Depression were so traumatic policymakers would have taken all the necessary steps to prevent another depression and provide all the tools necessary to deal with a financial crisis.  And policymakers did this.

In the run-up to the Great Depression, the financial system was based solely on the principle of caveat emptor (buyer beware).  Under this principle, there was limited need for government intervention in the financial markets and regulation.  It was assumed investors would do everything necessary to protect themselves knowing they were responsible for all losses on their investment exposures.

The idea a financial system would work based solely on the principle of caveat emptor ended with the Crash of ’29.

So the question became, what to replace it with.  Behavioral Economics helps us to understand the policymakers’ choice for a replacement financial system.

Behavioral Economics teaches us everyone likes a good story.  It is ingrained in us.  When we talk to each other, we tend to use narratives.  And there is no place where the use of narratives can be found more than in the financial sector.

Wall Street is fully aware of our desire to hear a good story.  Not surprisingly, its sales model is built on telling stories.

In the early 1930s, the Pecora Commission examined Wall Street.  What it found was Wall Street used a good story to hide the risk of the investments it sold.  And the investments it sold were opaque.  In effect, Wall Street used stories to suggest how the opaque investments should be valued.

Sound familiar?

It should.  Recall how subprime mortgage-backed securities were valued.  Wall Street provided the valuation story.  Wall Street said use the ratings on these opaque securities as a substitute for your own due diligence as to how risky these investment actually are.

Given Wall Street’s storytelling prowess, the Information Matrix shows why the global financial system is designed the way it is.

Information Matrix

	Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying?		Yes	No
	Yes	Perfect Information	Antique Dealer Problem
	No	Lemon Problem	Blind Betting

If you were going to design a financial system, you would want all of the transactions to occur in the Perfect Information quadrant.  Why?  There is no economic theory supporting the notion Blind Betting yields the same or better allocation of resources than can be achieved with informed decision making.

It is only in this quadrant investors know what they own.

It is only in this quadrant, Wall Street’s storytelling prowess is benign.  Investors can Trust Wall Street’s story, but they can also Verify if the story is true.

Naturally, Wall Street prefers to sell investments which belong in the Blind Betting quadrant.  Why?  Wall Street knows it makes more money on a per transaction basis selling high margin opaque securities than low margin transparent securities.  So if Wall Street is going to spend its time telling stories, it is more profitable to tell these stories about opaque securities.

So how did the policymakers in the 1930s redesign the global financial system to maximize transactions in the Perfect Information quadrant and minimize transactions in the Blind Betting quadrant in the face of Wall Street’s ability to spin a good story?

They combined the principle of caveat emptor with transparency.  They made it the responsibility of government to ensure transparency so investors could know what they own.  Investors had an incentive to use the disclosed information because they were held responsible for all losses on their investment exposures.

But the policymakers didn’t stop there.  They also addressed the issue of bank runs.  They did this in two ways.  They adopted deposit insurance.  They used the central bank as a Lender of Last Resort to ensure liquidity in the financial system.

This solution was ingenious.  It allowed insolvent financial institutions (aka banks) to continue in operation indefinitely as deposit insurance made the taxpayers the silent equity partner of these insolvent firms.  At the same time, it made the deposits a stable source of funding as depositors didn’t have to worry about the solvency of the financial institution.

This solution to bank runs is very important as it effectively ended the disruptions caused by a financial crisis that negatively impact the real economy.  The payment system continues to function.  The banks continue to make loans.  The investors in the banks unsecured debt and equity securities are still held responsible for all losses associated with their investments.  The only issue is the timing of these losses as the government decides when it will step in to close a financial institution.

Perhaps most importantly, this solution uses the banks’ capital accounts to absorb the losses on the bad debt in the financial system.  This protects the real economy in many ways including preventing creation of zombie firms that undermine the profitability of the industries they are in and diverting capital needed for growth to funding the bad debt.

As I was going through a description of the redesigned financial system, I intended to give you a sense for both how comprehensive the redesign was and how each element of the redesigned financial system supports every other element.

The redesigned financial system reflected a very important reality:

Banks like Goldman Sachs and JP Morgan need the U.S., but the U.S. doesn’t need the currently existing banks.

The redesigned financial system protected the payment function and the lending function while letting the banks performing these functions fail.  In 1933, the FDR Administration showed how to implement what has become known as the Swedish Model.  Under this model, banks are forced to take losses on their bad assets.  Then, viable banks are allowed to stay in business and rebuild their book capital.  Non-viable banks are closed.

Policymakers were given every tool necessary to pursue the Swedish Model.

With this background, you can understand why the Committee to Save the Banks is defending the indefensible.  The financial system was redesigned to protect the real economy and not the specific banking entities.  Saving the current roster of banks meant pushing the financial crisis that should have been contained in the banking system onto the real economy.  There is absolutely no surprise that allowing bankers to privatize the gains and socialize the losses was not popular with the public.

Next Part II:  Opacity and Bank Runs