Stressed Out: Geithner’s Stress Test

Stress-Test-BookThis is a review of former US Treasury Secretary and Chair of the New York Federal Reserve Bank Timothy Geithner’s explanation of the financial crisis and its subsequent management (also posted at Amazon).

Though full of interesting perspectives, Geithner’s exposition seems more of a desire to preempt the writing of history with a rationalization of his policy choices than provide any insight into the reality of the crisis or how it has reconfigured the financial landscape for the worse. Not surprisingly, fellow liberal Paul Krugman’s critical review is not cited by the publishers.

Geithner’s view of the economy and the role of finance is colored by the myopic banker’s view of the credit system, but I guess we should have expected this from a Treasury Secretary whose only preparation for the job was as head of the NY Federal Reserve Bank.

Geithner believes the financial crisis was a liquidity crisis akin to a bank run. Geithner’s solution was calibrated to the Federal Reserve stepping in as the lender of last resort, a role which it performed admirably. But the payments breakdown was merely the symptom of the problem, not the cause. The cause was (and still is) insolvent balance sheets across the financial sector. And this insolvency can be traced back to bad policies: easy credit by Greenspan, Bernanke and Co. and the lack of banking oversight, by, well, guess who? Timothy Geithner at the head of the NY Fed.

A housing bubble fueled by easy credit and securitized mortgages led to balance sheets with mispriced assets for financial intermediaries the world over. In other words, the AAA-rated MBSs they were holding as capital reserves were only as good as the value of the underlying collateral: all those ridiculously priced houses leveraged on cheap credit. When people began to realize this, the run was on and the repo market froze, cascading across all the credit markets. This was an insolvency crisis reflected in a payments freeze. The Fed needed to stand in as lender of last resort and did so, with Geithner’s full support.

But then Geithner’s solution to the post-liquidity financial de-leveraging has been to make bankers whole and push the mispricing costs onto taxpayers, savers, homeowners, and lenders. AIG went into receivership, but all the counter parties from Goldman Sachs to European banks were paid back at par on their credit default swaps. This not only enriched, but sheltered bad actors like Goldman from accountability. This served Geithner’s Wall Street constituency rather well (not exactly the constituency of the US Treasury Secretary, which is a bit broader). This was “heads we win, tails you lose,” on a grand scale. Now the banking system is more concentrated than ever with systemic risk of another shock even more threatening. Meanwhile, Main Street business struggles to obtain credit to grow the real economy. Hence anemic job creation. I doubt the Stress Test assures an all-clear, except for certain favored banking actors who now have a virtual government guarantee as TooBigToFail.

Instead, the Fed and Treasury should have managed the deleveraging of the historical credit bubble until asset prices again reflected fundamental values rather than false confidence in monetary engineering. Like AIG, failed banks should have been restructured by the government and then sold off to profitable buyers.


Despite the self-congratulatory tone of the author, we are nowhere near writing the end of this story. The Fed has expanded its balance sheet by $3.5 trillion and is holding much of that in overvalued MBSs that it has purchased through Quantitative Easing. The policies have tried to inflate housing values in order to return these mortgages back to nominal face value, but the prices of houses are artificially being pumped up by Fed credits while housing fundamentals (median incomes) remain in the doldrums. The bubbles in financial markets are also a direct manifestation of Fed policy. The Fed knows that it can cover its bad assets by merely creating more credit liabilities. The final reckoning will likely be the depreciation of the US$ and the loss of real value to savers, lenders, and working people.

Krugman is right, Geithner and the Fed saved the world from a Great Depression (of their own making – thank you very much), but have invited even greater economic disaster in lost opportunity for the middle class.


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