If Barack Obama is victorious on November 4th, someone on his transition team should send inauguration tickets to Richard Fuld, the chairman and chief executive of Lehman Brothers. For months, Obama had struggled to promote the sense—which was not altogether confirmed by the official statistics—that the economy was in real trouble. Back in March, in New York, he gave a thoughtful speech, tracing the sub-prime crisis to lax oversight, and calling for a major overhaul of regulatory policy. The serious newspapers reported the event, and that was that. By Labor Day, the McCain campaign had managed to reframe the economic debate—in as much as there was one—around gas prices, offshore drilling, and Obama’s purported plan to raise taxes on ordinary Americans. (Actually, his tax plan would leave more than ninety per cent of households paying less money to the government.) Some polls even showed John McCain outscoring Obama on economic issues.
Enter Fuld. The trouble began during the summer lull on Wall Street, when he neglected to find an outright buyer for his faltering firm. That mistake was followed by the news, on September 9th, that a Korean bank that had considered investing in Lehman was withdrawing. Three days later, the government informed Wall Street that it would not bail out Fuld’s firm. Coming less than a week after the U.S. Treasury’s takeover of the mortgage giants Fannie Mae and Freddie Mac, the sight of the venerable investment bank filing for Chapter 11 protection spooked the markets, which experienced their biggest drop since 2001. Then, on September 16th, the Federal Reserve extended an eighty-five-billion-dollar loan to American International Group, the largest insurance company in the country, sparking panic on Wall Street. The economy was suddenly at the center of the campaign, which is where it should have been all along.
In the past few days, Obama has had the demeanor of a man who fell out a window and landed on a trampoline; McCain has looked like someone who thought he had won the lottery only to discover, en route to the prize ceremony, that he had been sold a phony ticket. The epizootic in the financial markets resurrected doubts about the wisdom of McCain’s decision to pass over the business-minded Mitt Romney as his running mate, a choice that left him to face alone tough questions about economics—his least favorite subject. Last week, McCain restated his belief that the fundamentals of the economy were strong and flip-flopped on the regulation of Wall Street. “How is it supposed to reassure people to hear Mr. McCain intone, as he did yesterday, the words ‘derivatives’ and ‘credit default swaps’ as if it’s the first time he’d ever heard of them?” the editorial page of the Wall Street Journal wondered.
No matter who wins the election, the economy has undeniably entered a new phase. John Kenneth Galbraith’s comment that in America the only respectable type of socialism is socialism for the rich has never seemed more apt. The Treasury Secretary, Henry Paulson, and the Fed chairman, Ben Bernanke, had good reasons for nationalizing Fannie Mae and Freddie Mac, which help provide mortgages to tens of millions of American families. The rescue of A.I.G. was more questionable, but Paulson and Bernanke feared that letting it fail would cause chaos in the global financial system; hidden inside the insurance company was a financial-products division that had sold other firms all manner of exotic derivatives, including credit-default swaps, which guaranteed the value of bonds. Had A.I.G. gone under, those swaps would have been practically worthless.
Whatever the merits of saving A.I.G., many financial experts agree that the Bush Administration’s policy of buying more time for the financial industry to fix itself (at the Fed, this is known as the “finger-in-the-dike strategy”) needs supplementing with a direct attack on the slumping property market—the source of all the losses. It was in this context that, last Friday, Paulson announced a plan to have the government relieve the banks and investment banks of their most distressed mortgage assets. The sums involved would be huge—perhaps as much as two trillion dollars, according to Harvard’s Kenneth Rogoff, a former chief economist at the International Monetary Fund. (That amount is more than triple the cost of the Iraq war so far.) Marketing such an enormous bailout to the American voters will not be easy, but history demonstrates that often the only way to resolve a collapse in the banking system is for the government to step in and socialize the losses. That is what happened during the savings-and-loan crisis of the late nineteen-eighties, when the government set up the Resolution Trust Corporation to dispose of the assets of insolvent thrifts. The total cleanup cost to the taxpayers, in today’s dollars, was nearly two hundred billion.
If Congress goes along with Paulson’s plan—and the early indications are that it will—the quid pro quo, at least for a time, will be more oversight of the financial industry and a witch hunt for the Wall Street chiefs who got us into this mess. The hunt has already begun. Last week, McCain proposed an investigation modelled on the 9/11 Commission, and congressional Democrats scheduled hearings for as early as this week. Many details remain to be uncovered about how firms like Lehman and A.I.G. operated, but McCain and the other lawmakers should also investigate their own roles.
Beginning in 1978, when the Carter Administration abolished government restrictions on airline routes and fares, both parties began to espouse the doctrine of unfettered free markets. In some industries—airlines and telecommunications, for example—deregulation delivered lower prices and more choices, with few downsides. Then the Reagan Administration relaxed parts of the Glass-Steagall Act, a Depression-era law that restricted the activities of big financial firms. This facilitated innovation and growth but also made the system more fragile. A few years later, the Clinton Administration—after heavy lobbying by Wall Street, and vigorous encouragement from Alan Greenspan, then the Fed chairman—removed the last vestiges of Glass-Steagall. (Phil Gramm, the former Texas senator—and a McCain adviser, until he recently referred to Americans as “a nation of whiners”—co-sponsored the key piece of legislation.)
Commercial banks, such as Chase Manhattan, merged with investment banks, such as J. P. Morgan. The remaining Wall Street firms, grappling with new competition in their traditional businesses, increased their borrowing and made riskier bets. Last year, Bear Stearns, Lehman Brothers, and Merrill Lynch had more than thirty dollars of investments on their books for every dollar of capital. Having borrowed so heavily, the firms were hostage to a withdrawal of credit on the part of their lenders. After the sub-prime-mortgage market collapsed, that was precisely what they faced.
As Obama noted last week, it is no accident that the country is confronting its worst financial crisis since the Depression. Gullibility and greed caused this latest calamity, but what allowed those basic human traits to combine to such catastrophic effect was a legal and institutional framework that resulted from deliberate policy actions. Something new, from a new Administration, is needed. A new deal, you might say.