In the preface to Transparency Games, I asked why did the US surrender to Wall Street on September 23, 2008.  It has taken almost a decade, but the answer has finally leaked out.

Originally, I thought the US policymakers lead by Hank Paulson, Ben Bernanke and Tim Geithner might not have known there were two policy models for responding to a financial crisis.

One policy model was the Swedish Model.  Under this model, banks absorb losses.  This model was used in Sweden in the 1990s to deal with its financial crisis.  It was originated in the US during the 1930s to deal with the Great Depression.  Iceland showed how this model could be used in 2009.  It made its banks write down their loans to the greater of what a borrower could afford to repay or what an independent third party would pay for the collateral.

Why is this model attractive?

It holds creditors responsible for making bad loans and it protects the real economy, particularly the middle class.  In fact, writing down debt boosts the real economy as money that was previously being used for debt repayment can now be used to purchase goods and services.

Finally, history has shown this model always successfully ends a financial crisis.

The second policy model was the Japanese Model.  Under this model, banks are protected at all costs.  This model has been used in Japan since its financial crisis started almost 3 decades ago.  Bank loans are not written down.  Rather, interest rates are reduced to try to make the loans more affordable to the borrowers.  While technically this helps, debt in excess of the borrower’s capacity to repay will not be repaid.  However, lowering interest rates reduces savings which in turn reduces the purchase of goods and services.  In effect, the cost of protecting the banks is to place a huge economic drag on the economy.

Please note, this model has never been shown to successfully end a financial crisis.

There is one other factor in favor of choosing the Swedish Model over the Japanese Model when responding to a financial crisis.  Our financial system is designed to support this choice.  Specifically, the combination of deposit insurance and a central bank acting as a lender of last resort means banks can absorb losses on the bad debt in the financial system AND continue in operation supporting the real economy.

So why did the Committee to Save the Banks choose the Japanese Model and save the banks rather than the middle class?  Because it fit at least one member of the Committee’s view:

The financial system must be stabilized at all costs, as the only way to heal the economy so real people benefit.

This particular member of the Committee actively undermined ever using the Swedish Model.

Obama wasn’t exactly gunning for bank retribution, as his dismissal of the Swedish option showed, but he approved the order that night and tasked the Treasury Department with nailing down the details.

Geithner simply didn’t follow the request, failing to produce any proposal for the unwinding of Citi …

Geithner and his bank regulator colleagues made sure a breakup wouldn’t be needed by using Federal Reserve loans, guarantees, and a third bailout to save Citi. Little was asked from the company in return. Geithner had devised “stress tests” to judge how large banks would handle another downturn, and Citi’s initial test estimated that the bank would need $35 billion in additional capital to reassure markets that it was safe. But Citi haggled with regulators, dropping their capital requirement to $5.5 billion, about the same as what the bank paid out in bonuses that year.