Jared Bernstein was Vice President Joe Biden's chief economist and was the strongest economic voice within the Obama administration opposing inflicting austerity on the nation in response to the Great Recession. His August 28, 2013 column is entitled "Summers and the Banks." He begins by acknowledging that Obama had dreadfully "misplayed" the choice of Ben Bernanke's successor as Fed Chair.
Bernstein writes because he is upset that "Larry Summers views on financial market oversight, a critical part of the job of Fed chair, have been misrepresented in some accounts." In that sentence, Bernstein joins the chorus of economists emphasizing (for the first time in the Fed's history) that effective supervision of banks led by the Fed Chair is "critical." It is good that economists are finally realizing and stating publicly this point. It would be even better if they understood the causes of financial crises and what it means to be an effective financial supervisor. I am hopeful that we can use the newfound willingness of economists to consider effective supervision to induce them to think seriously about supervision and to be open to the perspectives of those with a track record as effective regulators.
The essential requisite of effective financial supervision is an understanding of "control fraud" mechanisms so one can detect, investigate, and intervene to terminate such fraud schemes, to remove the profit from such schemes, and to hold the officers who control the bank accountable for the frauds. The essential requisite of being an effective financial regulator is to minimize the perverse incentives that produce the criminogenic environments that drive epidemics of accounting control fraud. I write to show that Bernstein's column presents no evidence that Summers has ever fought to install effective supervisors as regulatory leaders and to support them when they take on powerful financial interests. Worse, Bernstein simply ignores the evidence that Summers was a leader of the fraud-friendly attacks on effective supervisors.
I also write to show that Bernstein argues that Summers supported one measure, greater bank capital requirements, to reduce the perverse incentives to engage in accounting control fraud. However, because neither Summers nor Bernstein understand control fraud the one regulatory measure Summers supported was inherently incapable of being sufficient. Worse, Bernstein gets the facts wrong because he does not understand effective supervision and ignored the actions of the FDIC and the banking examiners who were right about the more important perverse incentives well over a decade before Summers finally supported increased capital requirements. Overall, Summers was a strong proponent of the criminogenic policies of the Clinton administration that sowed the seeds for the crisis by creating intense, perverse incentives.
Bernstein advises us to ignore Summers' professional lifetime of advocating and implementing the criminogenic policies that led to our three modern financial crises with this breezy sentence: "I am well aware of mistakes he made in the Clinton years in this regard, but he learned from those mistakes, and frequently quoted Keynes' line: 'When the facts change, I change my mind.'" But when Bernstein seeks to convince the reader of Summers' extraordinary transformation it turns out that "there is no there there."
"Regarding the proliferation of securitization and hedging through derivatives, [Summers] wrote in late 2006 that '...innovations that contribute to risk spreading in normal times can become sources of instability following shocks to the system as large-scale liquidations take place.'"
This is the best that Bernstein can muster. Credit default swaps do not spread risk "in normal times." They concentrate risks in the most fraudulent firms such as AIG. They are the sources of instability that cause large-scale liquidations. Note that the regulators could do nothing about derivatives - even get the facts about them - because the Commodities Futures Modernization Act of 2000 that Summers championed produced a deliberate, massive regulatory black hole. Summers did not call for the repeal of the CFMA in his December 27, 2006 article.
If one reads Summers' December 27, 2006 article in full, it also becomes clear that Summers demonstrated no prescience about the crisis. The housing bubble had already burst at the time Summers was writing and there had been copious warnings about the twin epidemics of loan origination fraud (appraisals and "liar's" loans). It did not take prescience for Summers to understand the mounting disaster, it simply took paying attention to the facts and understanding control fraud. Summers did not see the mounting disaster and ignored fraud - even past epidemics of control fraud. The word "fraud" and the concept disappear in Summers' article. The Savings and Loan debacle and the epidemic of accounting control fraud that drove it and the Enron-era scandals disappear in Summer's article even though he talks about market problems in 1987 (the heart of the S&L debacle) and 9/11 - contemporaneous events with the control fraud epidemics and resultant financial crises that he ignores even though they were far worse crises than those that Summers discusses.
Summers' selective blindness is the product of the neoclassical dogmas he continues to hold dear and that continue to enrich him. Recall that he was writing over five years after George Akerlof was made a Nobel Laureate in 2001. Akerlof is the leading economist studying control fraud. His "lemons" article focused on anti-purchaser control frauds in which the deceit was about product quality. His 1993 article with Paul Romer focused on accounting control frauds. The title of the article captured their thesis -- "Looting: The Economic Underworld of Bankruptcy for Profit." Akerlof and Romer demonstrated how such frauds drove the S&L debacle. Summers ignored not only the criminologists and the regulators but also two of the world's top economists.
The overall Summers article is one long "on one hand; on the other hand" piece that never takes a position on whether we are facing a crisis. He is mystified by the fact that while risk was growing massively spreads were falling to "historic lows." Akerlof and Romer's article (or my articles and my book) explained why accounting control fraud epidemics produce this result when they hyper-inflate bubbles.
Bernstein's only other example of Summers' supposed learning the importance of supervision occurred in a January 27, 2008 article. Bernstein stresses the passage in which Summers calls for banks to raise capital, but the overall thrust of the article is Summers urging broader bailouts of financial institutions - including public bailouts. Summers describes a paltry $150 billion stimulus program as "substantial."
Bernstein portrays Summers' suggestions that banks raise capital as an act of unusual prescience and hostility towards banks.
"About a year later, when neither the Fed and nor other bank regulators were acting, Larry was insisting on the need for measures to protect the system and the flow of credit, arguing for something that ultimately became, from my perspective, one of the more important pieces of the Dodd/Frank reforms: increased capital buffers in lending institutions."
Summers' article did use the word "insisting" in connection with increased capital: "A critical element of regulatory policy should be insisting on increased capital in existing financial institutions." But Bernstein and Summers failed to ask the question of how the regulators were supposed to "insist" on "increased capital" at the end of January 2008 (and how "insisting" was supposed to produce "increased capital"). Summers and other neoclassical economists who advised the Clinton and Bush administrations had made such an action a practical impossibility. Recall that Bernstein said "I am well aware of mistakes he made in the Clinton years...." Did Bernstein and Summers think those mistakes had gone away? Did Summers even try prior to 2008 to undo those mistakes?
Basel II emasculated bank capital requirements in Europe and would have done so in the United States but for the heroic rearguard defense of the Federal Deposit Insurance Corporation (FDIC). U.S. capital requirements were "merely" crippled as a result of the FDIC's efforts. Basel II began under Clinton and it followed each of the destructive patterns of "Reinventing Government" that Summers and Rubin so enthusiastically championed. The regulators were ordered to treat the banks as "customers" and to "partner" with them on any rules. The biggest banks were brought inside the regulatory tent (but not public interest representatives) that created the travesty that was Basel II. The Clinton Treasury Department under Rubin and Summers was a strong supporter of weaker capital standards. Summers did not favor greater capital requirements years before the regulators - the FDIC warned and fought against Basel II's assault on capital requirements for at least five years before Summers' 2008 article. The FDIC fought without any aid from Summers. Basel II was not a case of the Fed failing to act - the FCIC report and Spillenkothen memorandum make clear that the Fed's contingent of theoclassical economists led the effort to use Basel II to virtually eliminate capital requirements and treated the opposition of the Fed's supervisory staff as further evidence of their economic illiteracy.
The investment banks, hedge funds, SIVs, and mortgage banks had no meaningful capital requirements and the federal banking regulators had no authority to set capital requirements for them - so how exactly were they supposed to "insist" that these entities (who made and purchased most of the fraudulent loans) raise their capital? Basel II took over five years to develop and adopt - how were the banking regulatory agencies supposed to settle on a new higher capital standard in time (starting in February 2008) to prevent a crisis that was about to destroy Bear Stearns in April 2008 and gather momentum rapidly after that point?
The FDIC was the only federal banking regulator that might have been prepared to act aggressively to increase capital levels. The FDIC, however, was a hollowed out shell by the time Summers wrote his article because the "Reinventing Government" effort he championed (compounded by Bush's analogs) had cut the FDIC staff by over three-quarters. The OCC and the OTS (two bureaus within Treasury) were locked in a "regulatory race to the bottom" that the Clinton Treasury run by Rubin and Summers encouraged. The Clinton Treasury reinventers had taken credit for slashing OTS' staff, which was supposed to regulate some of the largest fraudulent lenders (Countrywide, WaMu, and IndyMac). By 2008, the OTS staff had been cut by more than half and the regulatory race to the bottom had ruined the OCC and OTS - and preempted state efforts against the fraudulent lenders. It takes some special degree of chutzpah for Bernstein to praise Summers as ahead of the regulators when he is one of the most culpable people on the planet for destroying regulatory effectiveness.
I remind Bernstein and Summers that we (OTS) got "liar's" loans right in 1990-1991 when we listened to our examiners and supervisors' warning that only fraudulent lenders would make such loans. We drove the lenders making those loans (which were not yet called "liar's" loans in that era) out of industry. It was the Clinton administration, at the demand of the Treasury reinventers implementing Rubin and Summers' embrace of the three "de's" (deregulation, desupervision and de facto decriminalization) who destroyed the OTS' vital loan underwriting rule that stopped liar's loans and replaced it with a deliberately unenforceable and useless "guideline."
In his January 27, 2008 article, Summers called for the opposite of stringent supervision - he favored gimmicking the accounting rules so the banks did not have to recognize their losses or establish adequate loss reserves. In an extraordinary passage Summers favored continued accounting fraud by the banks: "more capital permits more recognition of impairments...." No. "Impairments" meant losses on bad loans and investments. "Recognition" means that the bank financial statements tell the truth - they admit the losses. A bank has a legal duty to recognize its losses whether or not it has "capital" sufficient to continue in business despite those losses. It is a felony to fail to do so. Summers recognized that banks and hedge funds were engaged in pervasive accounting and securities fraud for in another portion of the article he purports to recognize that it is essential to "ensure transparent and fair valuations." Summers' article, however, actually endorses accounting and securities fraud by claiming that banks can and should wait to recognize losses until they have enough reported capital to survive their losses. Note the consequences of Summers' endorsement of accounting and securities fraud:
- The banks engaged in control fraud were allowed to claim that transactions (e.g., making and buying liar's loans or engaging in appraisal fraud) that actually generated losses were booked as if they produced enormous gains(and overstate their capital) during the expansion phase of the bubble
- This transmuted real losses into what Akerlof and Romer termed the "sure thing" of fictional profits
- Which maximized the officers' compensation and promptly made them wealthy
- After the bubble burst Summers would allow the controlling officers to continue to refuse to recognize the losses on the bad loans and investments, which
- Created fictional profits and minimized real losses, which
- Massively overstated bank capital and allowed them to escape TARP limits on executive compensation
- Which made the officers even wealthier because they made terrible loans and because they covered up the losses on those terrible loans
Bernstein ignores fraud as fully as Summers does so he gets his analytics wrong on Summers supposed conversion to favor stringent supervision. Bernstein argues:
"[Summers] suggested the regulators push banks to increase their capital by diluting the shares of current owners.... Again, his advocacy of this position is quite inconsistent with those who believe he would place the banks or their shareholders' interests above that of the broader economy."
Shareholders rarely control banks - CEOs do. "Banks" are almost always controlled by their CEOs. The CEOs often run banks to maximize their personal interests and a substantial number of CEOs do this at the expense of the shareholders and the bank. CEOs decide whether banks will make political contributions, fund academic chairs, and hire economists as consultants and speakers. The CEOs typically spend the banks' money and the amount of money they use to fund politicians and economists represents "chump change" from a large bank's perspective - but a fortune from the perspective of the politician or economist. What I am describing are basic incentive structures that every neoclassical economist purports to believe - except when it comes to them and their donors. Then they suddenly believe that their luncheon speeches are really so brilliant that the CEO paid $50,000 to them to deliver a canned speech because the speech will transform the way the firm operates. The self-deception is pathetic.
Summers' critics may often use the shorthand expression that Summers has served the interests of the "banks," but if those critics are at all astute they really mean that Summers has served the interests of the banks' CEOs. He sought to do that in his January 27, 2008 article, particularly his ode to accounting and securities fraud led by bank CEOs. Bank CEOs have made Summers a very wealthy man and are now trying to make him the Fed Chairman. The bank CEOs don't simply look forward to Summers' continued favor - they are desperate to block Janet Yellen.
Bernstein's piece ends with this damning indictment of Obama: "Larry was a strong ally in arguments for continued fiscal stimulus when others on the team were ready to pivot to deficit reduction." In plainer English, a supposedly progressive President chose a team of economic advisers who should have had all the benefits of a profession that has known for 75 years that austerity in response to a severe recession was insane. The team saw austerity throw the Eurozone back into a gratuitous recession (and much of the periphery into a second Great Depression). Nevertheless, it was necessary to fight a furious rear guard action to prevent the "terrible trio" of Timothy Geithner (a Republican with a fig-leaf conversion to Independent to get the job), Bill Daley, and Jacob Lew - three non-economists - from fully convincing Obama to endorse austerity and gut the safety net as part of a "Grand Bargain." That rearguard action continues today and has only slowed and limited the insanity rather than prevented it even though the "bargain" is economically self-destructive and would constitute the "Great Betrayal" of the Democratic Party's great economic successes and Americans who are most in need. It is the Republican Party's extremism rather than the rearguard fight that has (so far) blocked Obama's effort to commit the Great Betrayal. Still, Bernstein is correct that Summers is far superior to the terrible trio that Obama chose as his economically illiterate economic advisors.
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