How do you resolve a crisis: Theories vs Reality

Phillip Swagel, formerly U.S. Treasury Department has presented a wonderful paper at recent Brooking Conference. The paper title is really fitting – ‘The Financial Crisis: An Inside View’. It is a longish paper (50 pages) and am still reading it. It is so full of insights that skimming does not work at all.

He makes a confession upfront:

Notwithstanding these criticisms with regard to the Treasury, a paper such as this will inevitably be seen as defensive, if not outright self-serving. Since this is unavoidable, I simply acknowledge it at the front.

He says simply suggesting an idea to resolve the crisis is not good enough. It has many constraints when applied in real time

Legal constraints were omnipresent throughout the crisis, since Treasury and other government agencies such as the Federal Reserve must operate within existing legal authorities. Some steps that are attractive in principle turn out to be impractical in reality—with two key examples being the notion of forcing debt-for-equity swaps to address debt overhangs and forcing banks to accept government capital. These both run hard afoul of the constraint that there is no legal mechanism to make them happen. A lesson for academics is that any time the word “force” is used as a verb (“the policy should be to force banks to do X or Y”), the next sentence should set forth the section of the U.S. legal code that allows such a course of action—otherwise, the policy suggestion is of theoretical but not practical interest. Legal constraints bound in other ways as well, including with respect to modifications of loans.


New legal authorities can be obtained through legislative action, but this runs hard into the political constraint—getting a bill through Congress is much easier said than done (we were all misled as children by the simplicity of the legislative process in the animated television short feature “I’m just a bill”). The difficulty of getting legislation enacted was especially salient in 2007 and 2008, the first two years after both chambers of Congress switched from Republican to Democratic leadership. A distrustful relationship between the Congressional leadership and President Bush and his White House staff made 2007 an unconstructive year from the perspective of economic policy,

A final constraint was simply time. Decisions had to be made rapidly in the context of a cascade of market events. Certainly this was the case by the week of September 14 when Lehman and AIG failed, the Reserve Fund money market mutual fund “broke the buck” by having its value per share fall below the $1 par level and this sparked a panicked flight from money market mutual funds, and commercial paper markets locked up, with major industrial companies that relied on CP issuance telling others at Treasury that they faced imminent liquidity problems……Time constraints meant that sometimes blunt actions were taken, notably guarantees on the liabilities of AIG, of money market mutual funds, and several weeks later of banks’ qualified new senior debt issues.

Apart from the constraints he points there were departmental issues within Treasury and lack of coordination. This led to improper communication leading to finger pointing at Paulson.

It was too easy—and wrong—to believe that Secretary Paulson was looking out for the interests of Wall Street rather than the nation as he saw it, or of one particular firm. Whatever the reason, such communication gaps led to natural skepticism as Treasury’s approach to the crisis evolved in the fall with the switch from the original TARP program of asset purchases to capital injections. There were valid reasons behind the initial plan to purchase assets (even if many people found them inadequate) and also valid reasons for the switch to capital injections. But the insufficient explanations of these moves led to skepticism and growing hostility in Congress and beyond to the rescue plan actions.

He further adds when Paulson came at Treasury he actually was worried of the global imbalances and very low volatility in financial markets. He asked the Treasury staff to identify potential fin market challenges. However all this was not enough. Though he does not really explain why these exercises did not work, I can immediately say reality is different. It is much like the exams we take. We all try and prepare for our exams (in our own capacity). Some of the questions which we prepare even come in the exam. But there are seldom cases of doing as well as we did in preparations.  

Apart from this he also points that quite a few ideas being presented by Team Obama were suggested by then Treasury team in 2007-08. We all know that TARP-I was to do with buying toxic (sorry legacy) assets. Swagel adds that the recent Treasury proposed Public Private Fund to buy these assets was also thought then but was not applied because of the constraints.

This is a great read. Indirectly, it asks economists to be more methodical and back their policy recommendations with whether it can be done or not. You just can’t suggest something which looks good in theory but cannot be applied in policies. I think this applies to all aspects of economics. It needs to be backed with practical reality.

I am still reading the paper. Will point if anything more interesting crops up.


2 Responses to “How do you resolve a crisis: Theories vs Reality”

  1. An insight into US Treasury fire-fighting policies « Mostly Economics Says:

    […] insight into US Treasury fire-fighting policies By Amol Agrawal I had earlier pointed to a must read account into US Treasury operations in this crisis. It was written by Phillip Swagel formerly U.S. […]

  2. Thinking about Ministry of Finance/Treasury « Mostly Economics Says:

    […] usually get literature on MoF/T as an autobiography of some insider (Swagel points to some ideas) but not much like the research we get on central […]

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: