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January 18, 2013, 4:57 p.m. ET
When the Rain Came Down
A masterful account of how the housing crisis and credit crunch nearly brought down the economy
By DA V ID R. HENDERSON
Alan S. Blinder is one of America's leading economists. One of the few economists who write really
well, he is also a master storyteller. In "After the Music Stopped," Mr. Blinder, previously a vice
chairman of the Federal Reserve Board and, before that, a member of President Clinton's Council
of Economic Advisers, gives his interpretation of the events leading to the U.S. financial crisis, the
financial crisis itself, and the Bush and Obama administrations' response. It is one of the best
books yet about the financial crisis.
Mr. Blinder, a professor at Princeton and a regular
contributor to the Journal's editorial page, tells the
By Alan S. Blinder
story in basically chronological order, gives citations for
The Penguin Press, 476 pages, $29.95
almost all the important facts he marshals and,
refreshingly, tells the reader when he sees himself as
making judgment calls in controversial cases.
Unfortunately, he also makes judgments on
controversial issues that he does not see as (or concede
to be) controversial. He also minimizes the role of the
government in creating the crisis, omitting important
facts that contradict his argument. He describes the
financial industry as an example of laissez-faire, though
in reality it is highly regulated. The latter claim allows
EPA
him to blame on the private sector what was really the
pendant le delugeA display of stock market
joint responsibility of a regulated industry and its
indexes, including the Dow Jones at top left, in
Tokyo on Oct. 10, 2008—the end of a week in
regulators. Finally, and most strikingly, Mr. Blinder has
which the Dow fell 18%.
faith in government's power to make things better
despite his own exposition of a series of government
actions that he himself admits were mistakes.
After the Music Stopped
Let's begin with the most important of the relatively uncontroversial points that Mr. Blinder
makes about the financial crisis. It began with the housing price bubble between 1997 and 2006
and the subsequent collapse of housing prices over the next few years. A major cause of the
bubble was that many mortgage lenders lent to people whom anyone with common sense would
have seen to be really bad risks. In addition, mortgages had been sliced, diced and repackaged into
securities, so that a given person's mortgage was not held by one individual or one firm, making it
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hard for borrower and lender to come to terms after the house's value fell. Finally, the creditrating agencies failed spectacularly to do their job. Had the three major firms that rate bonds—
Standard & Poor's, Moody's and Fitch—assessed various mortgage-backed securities accurately,
many bond buyers would have been prepared for the risks they were taking and some would not
have bought the bonds at all. These facts are all pretty much agreed on, and Mr. Blinder does an
excellent job of laying them out in the first third of his book.
A somewhat more controversial claim Mr. Blinder makes (but one I agree with) is that the turning
point in the financial crisis was the federal government's refusal, in September 2008, to bail out
Lehman Brothers. "The Lehman decision," writes Mr. Blinder, "abruptly and surprisingly tore the
perceived rulebook into pieces and tossed it out the window." Now market participants began to
think that the federal government would let large financial firms fail. Mr. Blinder sees this as so
important a turning point that he refers frequently to Sept. 15, the day Lehman filed for
bankruptcy, as "Lehman Day." Had the feds bailed out Lehman, he argues, the panic that hit Wall
Street would have been less extreme.
But Mr. Blinder omits a crucial fact about Lehman, one that, by itself, explains why the huge drop
in value of Lehman's mortgage-backed securities led to its collapse: the effect of changes in federal
bankruptcy law. Thanks to the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act,
when Lehman went bankrupt it could not simply, as in earlier days, pay holders of derivatives as
much as possible with its assets. Instead, it had to give each derivative holder a new contract
identical to the one it had signed with Lehman, but with a different counterparty. Lehman would
also have to pay the transaction cost of the new contract. Such costs are typically about 0.15% of
the contract's total value. That's small, right? No. When Lehman went bankrupt, the face value of
Lehman's derivative contracts was $35 trillion—with a "t." The transaction costs alone were $52.5
billion. That is what sank Lehman.
Mr. Blinder also points out that Reserve Primary Fund, the "world's oldest money market mutual
fund," had 1.2% of its assets invested in commercial paper—that is, short-term bonds—issued by
Lehman. With the value of Lehman's bonds falling after it went bankrupt, Reserve Primary Fund
had to "break the buck." Until then, most people thought that the value of each share in a moneymarket fund (MMF) would always be $1. Depositors thought that if they had, say, 1,000 shares in
the fund, they could redeem them for $1,000. Yet the value could actually fall if the underlying
assets lost enough value.
When depositors tried to withdraw their funds, Reserve started paying them 97 cents for shares
that depositors expected to be worth $1—thus "breaking the buck." Investors in other moneymarket funds, fearing something similar, started redeeming their shares. In just one week in late
September, depositors withdrew $350 billion from MMFs. As other MMFs sold commercial paper
to generate the funds to redeem their customers' shares, the value of commercial paper fell
further. One Federal Reserve economist quoted by Mr. Blinder recalled that "we were staring into
the abyss" and "there wasn't a bottom to this." That led Treasury Secretary Henry Paulson to get
President Bush's permission to set up insurance for MMF depositors. It worked, and the outflow
from MMFs stopped.
This bailout, according to Mr. Blinder, was "sorely needed" to stem the fire sale of commercial
paper. But that's highly debatable. Had the Treasury made clear that it would not bail out MMFs,
then many of them would have also had to "break the buck." Once depositors knew there was no
gain from getting their funds out early, the run on MMFs would have ended, thus stopping, or
dramatically slowing, the plunge in value of commercial paper.
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Mr. Blinder is a strong believer in the ability of government regulation to solve problems and even
prevent them in the first place. He sees the private sector as mainly to blame for the housing and
financial crises and criticizes "laissez-faire" economic policies adopted by the Clinton and Bush
administrations that supposedly contributed. But I do not think that term means what he thinks it
means. Laissez-faire has traditionally meant that the government keeps its hands off the economy
and allows for economic freedom. But at times, Mr. Blinder applies the term to cases in which the
government, once its hands were already all over the economy, didn't take the additional steps he
favored.
At other times he does use the term in its traditional sense but fails to establish that it applies.
Consider, for example, three major forms of government intervention that helped cause the
housing bubble: (1) the Federal National Mortgage Association (Fannie Mae) and the Federal
Home Loan Mortgage Corp. (Freddie Mac); (2) the 1977 Community Reinvestment Act, which
requires banks to lend mortgage money to people who are bad risks; and (3) federal deposit
insurance. During the years when the housing bubble developed, Fannie Mae and Freddie Mac
contributed by relaxing their mortgage lending standards so that they were buying subprime
mortgage-backed securities (MBS). Mr. Blinder himself notes that, by 2004, Fannie and Freddie
owned a third of all subprime MBS. This figure was down to 17% by the summer of 2007, but, as
Mr. Blinder admits, 17% is still a large number.
Part of the reason for the size of these holdings, Mr. Blinder notes, is that Fannie and Freddie were
pressured by the "affordable housing goals" of the Department of Housing and Urban
Development. Interestingly, although the Community Reinvestment Act, whose enforcement Mr.
Blinder's previous boss, President Clinton, beefed up in 1995, was part of the "affordable housing
goals," Mr. Blinder never names that legislation. In any case, this does not sound like laissez-faire.
Finally, consider the role of deposit insurance. By insuring 100% of bank deposits up to $100,000
(and, later, $250,000), the federal government substantially weakened depositors' incentives to
monitor their banks' lending practices. Even Franklin D. Roosevelt, whose administration
introduced deposit insurance in 1933, spoke eloquently of this downside. And the $250,000 limit,
moreover, is not really a firm cap. Wealthy people can legally avoid it with the help of firms such
as Promontory Interfinancial Network, which divide deposits held in one bank into smaller
deposits in many banks. Mr. Blinder well knows this; as he reveals in a footnote, he is a part owner
of Promontory. Again, this is not laissez-faire. Banking is one of the most heavily regulated
industries in the United States.
None of this is to say that the financial crisis would not have happened without these three
interventions. The private sector had a large role, and unjustified optimism is not limited to the
government sector. It is to say, though, that the financial crisis would not have been as bad had
the government been truly laissez-faire.
So once the financial crisis happened, what was to be done? Mr. Blinder devotes the bulk of his
book to the immediate response to the crisis as well as to ways for avoiding a repeat. He praises
the Troubled Asset Relief Program and points out that the net cost of TARP to taxpayers is not
the $700 billion that was budgeted for but, rather, a much more modest $32 billion. But there was
another way to go, the way Alan Greenspan handled the 1987 stock market crash, the Y2K
episode in 1999 and 2000, and the post-9/11 economy. That way was to have the Fed purchase
Treasury bills through open-market operations to make sure the economy had ample liquidity. In
all three cases, it worked.
Many people think that that's exactly what Federal Reserve Chairman Ben Bernanke did when
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the crisis hit, but he did not. Mr. Blinder, to his credit, recognizes this, pointing out that, although
the Fed changed its composition of assets, it had little effect on the money supply. He makes this
point briefly, but in a 2011 article San Jose State University economist Jeffrey R. Hummel
provides chapter and verse, noting that Mr. Bernanke took on extensive discretionary power to
favor some financial assets over others. As Mr. Hummel puts it, under Mr. Bernanke "central
banking has become the new central planning." Mr. Blinder seems to sense this but, unfortunately,
does not pursue the point.
Mr. Blinder is a Keynesian, that is, someone who believes that the federal government should use
fiscal policy—changing taxes and government spending—to stabilize the aggregate demand for
goods and services. He therefore favored the stimulus policy that President Obama adopted his
second month in office. Mr. Obama had the government increase spending in order to create more
demand for goods. But Mr. Blinder is relatively unconcerned about whether the money was spent
on valuable items. He has what I call the "GDP fetish"—the belief that increases in GDP are good
whether or not they represent increased production of things that people actually value. If the
government spends $100 billion digging holes and then filling them back up, then GDP can rise by
$100 billion or more even if the $100 billion is totally wasted. Some stimulus projects, in fact, are
little better than hole-digging. One example I noted on a recent visit to Detroit is the tearing up of
sidewalk corners to make them wheelchair-friendly, even though the sidewalks themselves have
so many craters that people in wheelchairs use the roads instead. With his faith in government
intervention, Mr. Blinder sees the corners but not the craters.
—Mr. Henderson is a research fellow with the Hoover Institution and
an economics professor at the
Naval Postgraduate School in Monterey, Calif.
A version of this article appeared January 19, 2013, on page C5 in the U.S. edition of The Wall
Street Journal, with the headline: When the Rain Came Down.
Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved
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