Value of being connected to Timothy Geithner during 2008 crisis..

This is easily one of the nastiest papers one can read. It is written by top econs like Acemoglu, Simon Johnson and so on. So cannot even ignore it.

The paper actually targets Timothy Geithner’s appointment as Treasury Secretary during 2008. They show how firms which were connected to him gained as news of his appointment streamed in:

The announcement of Timothy Geithner as nominee for Treasury Secretary in November 2008 produced a cumulative abnormal return for financial firms with which he had a connection. This return was about 6% after the first full day of trading and about 12% after ten trading days. There were subsequently abnormal negative returns for connected firms when news broke that Geithner’s confirmation might be derailed by tax issues. Excess returns for connected firms may reflect the perceived impact of relying on the advice of a small network of financial sector executives during a time of acute crisis and heightened policy discretion.

What could be the reasons?

There are at least three reasons why market participants may have expected benefits for Geithner-connected firms. First, they may have expected that some form of explicit corruption could take place. In countries with weak institutions and much policy discretion in the hands of politicians, such as Indonesia, Malaysia, or Pakistan, potential corruption is a reasonable interpretation of stock price movements for politically connected firms. But corruption is not plausible as an explanation for what happened in the United States. Econometric results that show large effects for political connections are typically based on data from countries with weak institutions. In contrast, by most measures and at most times, the United States has fairly strong institutions. Moreover, Geithner is widely regarded as an honest public servant who is very unlikely to have acted on the basis of personal financial gain. Studies of policymaking under the Obama administration by Suskind (2011) and Scheiber (2011) and firsthand accounts by Bair (2012) and Barofsky (2012) — none of which are particularly sympathetic to Geithner — contain absolutely no suggestion of corruption. Geithner has also never run for public office and seems unlikely to ever do so, making political contributions irrelevant.

Second, market participants may have believed that Geithner’s policy preferences were generally consistent with the interests of the financial institutions with which he was connected. This might have represented a type of “cultural capture” of key official decision-makers and thinkers byWall Street (Bhagwati (1998), Johnson and Kwak (2011)). According to this theory, instead of favoring firms because he had connections with them, Geithner’s prior connections had already shaped his perspectives on the financial sector and on the crisis that was still unfolding. In particular, his close connections to large, complex, Wall Street banks might have persuaded him that broader economic prosperity required rescuing those banks on relatively generous terms (for shareholders, as well as executives and creditors). Our results, however, are not based on a comparison of financial to non-financial firms or of large relative to small financial firms.3 Rather, as already noted, they are driven by a comparison of connected to non-connected firms of similar size. Even if Geithner took the worldview that Wall Street  banks were “too big to fail”, this cannot directly account for our results.

Third, the market may have subscribed to a “social connections meets the crisis” hypothesis: that connections would matter during a time of crisis and increased policy discretion. It was perhaps reasonable to suppose that immediate action with limited oversight would have to be taken, and that officials would rely on a small network of established confidantes for advice and assistance. Powerful government officials are no different from the rest of us; they know and trust a limited number of people. It is therefore natural to tap private sector friends,associates, and acquaintances with relevant expertise when needed — including asking them for advice and hiring them into government positions. Even with the best intentions, beliefs are presumably shaped by self-interest, particularly when the people involved were, are, or will be executives with fiduciary responsibility to shareholders. These tendencies can be checked during ordinary times by institutional constraints and oversight, but during times of crisis and urgency, social connections are likely to have more impact on policy.

Thankfully and being kind to Geithner perhaps, their results suggest importance of social connections:

Our findings show a stronger effect for connections than is standard in most related research on the United States.5 In part, previous studies have examined different kinds of connections, focusing on the legislature, where the impact of a single individual is likely to be limited. For example, the so-called Jeffords Effect — named after a Senator who switched parties unexpectedly,causing a change of control in the U.S. Senate — was found to be worth around 1% of firm value (Jayachandran (2006)). Roberts (1990) found statistically significant but small effects on connected firms from the unexpected death of a U.S. Senator.

Further,

We lean towards this interpretation because our results cannot be explained by the idea that Geithner just brought a safe pair of hands to the management of the economy, or by the notion that Geithner and his advisors solely favored large, complex Wall Street firms at the expense of other financial institutions. Our results control flexibly for firm size, profitability, and leverage, and are based, therefore, on differences between connected and non-connected financial institutions of roughly the same size. Consistent with this interpretation, Geithner’s Treasury initially hired key personnel from financial institutions with which he was connected, and some of the decisions of his department can be interpreted as being, at the margin, favorable to connected firms (in particular for Citigroup, on which we have the most detailed anecdotal
evidence).

If our interpretation is correct, benefits to connected firms are temporary — and very much related to the crisis atmosphere of November 2008. Once policy discretion declines and the speed with which important decisions have to be taken slows down, these connections should become less important. This is consistent with Querubín and Snyder’s (2013) findings from the Civil War era, where the excess wealth gains of congressmen disappear after the end of the large government expenditures and discretion. Whether this is in fact the case in the modern U.S. context remains an area for further research.

Phew..it is one-thing to write a paper on crony capitalism..completely another to show the role of one such important individual in the build-up..

WSJ Blog says:

Want to boost your stock prices during a financial crisis? Build ties to the nextTreasury secretary

Not sure how Geithner will react to this..It is really hitting below the belt kind of paper..Expect some lashback from Geithner…stay tuned..

Policymakers need to be really careful these days…If your appointment leads to tanking of markets you are doomed…and if markets rise then researchers like Acemoglu et al could probe deeper and show the connections…

Wish we had research like this on India too. As only thing that happens in the name of reforms and appointment of certain key economics related positions is stock markets going up (or down)…

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