In “After the Music Stopped”, Alan Blinder offers a very comprehensive narrative of the 2008-2009 crisis – the worst economic crisis in postwar American history. Blinder’s motivation for writing the book comes from the fact that many Americans still do not understand why we got into this mess and why the government did what they did. So he wants to explain to the public in simple terms what caused the crisis, where policy makers succeeded or failed and what lessons we have learned from this painful episode. I find that the book resonates quite well with what we have covered in class and it puts a lot of focus on analyzing the rationale and effectiveness of the government’s response.
Causes of the Financial Crisis
Blinder starts the book by identifying the “seven villains” that contributed mainly to the crisis – “inflated asset prices”, “excessive leverage”, “lax financial regulation”, “disgraceful banking practices”, “the crazy quilt of unregulated securities and derivatives”, “abysmal performance of rating agencies”, and “perverse compensation system in many financial institutions”. 1 He argues that each villain created a vulnerability that could and should have been avoided and the Fed’s loose monetary policy was not the primary cause of the housing bubble (agreeing with the Financial Crisis Inquiry Commission 2). When homebuyers believed that house prices would keep on rising at 10-15% annually, a half percentage point increase in mortgage interest rate would not make a difference.
However, unlike the FCIC report, the book does not put a strong emphasis on bad behavior as a major cause of the housing boom and bust. Instead, Blinder seems to agree with Professor Shiller that the first and foremost cause was “we went a little crazy about housing.” 3 In Chapter 2, he looks at the evidence from Shiller’s research in more detail. A survey conducted by Case and Shiller in 2005 shows the average house price increase expected over the next decade in San Francisco was 14% per year (22% in Los Angeles). The belief that house prices will always rise spread like an epidemic, reinforced by observations of actual price increases and ‘hype’ stories told by the media. 4
One thing missing from Blinder’s analysis is the Global Savings Glut hypothesis. Ben Bernanke proposes that the demand for safe assets came from emerging-market and commodity-rich countries (with large current-account surpluses). By 2007, financial firms were running out of safe assets to sell and because of this excess demand, they responded by manufacturing assets through securitization. 5 However, Blinder does discuss the bond bubble (including MBS backed by subprime mortgages) and investors’ “reach for yield”. 6 In his opinion, the increased demand for riskier assets started with the Fed’s low interest rate policy. The mistake of holding interest rate too low for too long is somewhat excusable, as the economy was still recovering from the mini-recession in the early 2000s.
In contrast, Blinder holds the bank regulators responsible for three mistakes – their permissive attitudes toward subprime lending, ignorance of external and internal warnings, and failure to grasp the complexity of the shadow banking system. He also blames the reckless banks and mortgage originators for making inappropriate loans for consumers (telling a story of two Mexican American strawberry pickers in California who were egged on to take out a $720,000 mortgage to buy a $720,000 house by the agent who made a big commission). The credit rating agencies were guilty as well, for showering AAA ratings on MBSs and CDOs (as they were paid by the issuer of the securities). The entire system was rigged with perverse incentives. A lot of this is in line with the FCIC report and what we have learned in class, as these factors all contributed to the crisis (although Blinder seems to put more emphasis on the first and second “villains”, bubbles and leverage).
The Government’s Reponses to the Crisis
This is the key area that the book focuses on. If Blinder had to assign a grade for the government’s responses to the crisis, it would probably be a ‘poor’ grade in the period before and right up to Lehman’s collapse, and a ‘good’ grade after that. In the time leading up to the crisis, policy makers underestimated the impact of the housing bubble, under-regulated the financial system, and exacerbated market turmoil by treating the failures of Bear and Lehman so differently. In Blinder’s view, letting Lehman go burst was a catastrophic decision. The Fed held the position that “saving Lehman with a loan from the Fed was illegal.” Early on, Bernanke and Paulson expressed the wrong belief that six months after Bear, “the market had ample time to prepare” for the possible demise of Lehman. 7
Nevertheless, the author acknowledges that after Lehman, the government did a decent job of preventing the economy from falling into deep depression and getting it back on its feet. Not all of their policies were effective, but as a whole, the government’s response was a success. Without it, we might have experienced a “Great Depression 2.0”. The stress tests introduced by Secretary Geithner in early 2009 really worked – it restored market confidence with very little public spending and within a few months after the US financial system collapsed, it was up and running again. Obama’s fiscal stimulus also helped end the recession, although it remains one of the biggest and most controversial policies during his terms in office. The logic behind it is quite straightforward: while businesses and households stop spending, the government steps in by temporarily increasing its own spending and/or cutting taxes to induce businesses and households to spend more. After a big stimulus was passed in February 2009 (it barely passed Congress on a party line vote), job losses started to abate immediately, and the recession was officially declared ‘over’ in June 2009. 8
However, up to this day, the government does not get much credit from the public. Interestingly, a theme that Blinder keeps bringing up in the book is communication failures by leading government officials, including the President, who “has rarely taken the time to give a speech of explanation – far less time than the American people need and deserve.” Paulson and Geithner, the two Secretaries of the Treasury, “have between them barely given a single coherent speech explaining what happened and – perhaps most important – why they did what they did.” 9 As a result, the American people felt angry and lost trust in the Obama administration – the Republican party had major wins in the House and governorship in the 2010 election.
This theme has indeed come up in our classes several times. Many people still feel like American taxpayers’ money was unjustly used to bail out big corporations, while millions of people lost their jobs or their homes. It is not obvious why the government chose to spend money on saving Bear or AIG instead of the struggling homeowners. The lack of communication led to the lack of understanding. There is a widespread false notion that “the government gave away money to the banks” but in reality, it was lending money to these big banks through various programs like the $700 billion TARP. Not many people (including myself) know that the financial rescue ultimately netted a profit to American taxpayers as the firms returned to health and repaid what they owed.
Another area where the government could have done more was stopping “the great foreclosure train wreck”. Losing a home is an extremely painful experience and Blinder argues that the government deserved a C- or a D grade for their half-hearted efforts on this front. It could have established a large refinancing program for homeowners – the “up-to-date version” of the Home Owners’ Loan Corporation from the 1930s. It could have persuaded banks to take some haircuts on troubled mortgage loans (lowering the interest rate or principal owed) to let people keep their homes. Various programs supposed to help homeowners (HARP, HAMP, HAFA, HHF, HAUP, etc.) fell short of both expectations and needs. 10
Lessons from the Crisis
Blinder ends the book with a new version of the Ten Commandments for the future of finance. The first one stresses on the fact that “unlike elephants, people forget”, sometimes very quickly (which seems to be happening already). Banks are now lamenting about excessive regulation and try to lobby their way out of any financial system reform. Recently, a bipartisan group of Senators has proposed to loosen up some of the regulations that were put in place after the financial crisis. The new proposal would, among other things, raise the asset threshold for a bank to be treated as “systematically important” from $50 billion to $250 billion. The proposal also contains other “community bank relief” measures such as an exemption from the Volcker rule (which aims to prevent banks from making certain types of speculative investments) for banks with less than $10 billion in total assets and limited trading assets. 11
Blinder does not believe in self-regulation – it’s like setting the fox to guard the henhouse – and he advocates for more government regulation and supervision than we had before the crisis. He is also in favor of the Dodd-Frank Act of 2010 – although it will not prevent the next crisis from happening, it should reduce the costs and severity of future crises. However, compared to Secretary Geithner’s playbook which focuses more on the policymaker’s point of view 12, Blinder actually calls on corporations to do a better job of self-regulation in several of his Commandments (e.g. 3 – honor the shareholders, 4 – better manage risk, 5 – use less leverage, 8 – keep things on the balance sheet, 9 – fix perverse compensation systems). Regulators cannot be everywhere while the private market has lots of talent and will always come up with innovations. It is fine if policy makers are one or two steps behind the market. Problems only emerge when policy makers are ten steps behind the market, which was what happened in the years leading up to the crisis.
Last but not least, it is also important to watch out for consumers – “failure to protect unsophisticated consumers from predatory financial practices can actually undermine the entire economy”. 13 In this area, Blinder believes the Consumer Financial Protection Bureau founded in 2011 should help.
Conclusions
“After the Music Stopped” shows Blinder’s sympathy with Secretary Geithner’s opinion that “we saved the economy, but we kind of lost the public in doing it.” 14 One of the main takeaways from the book is that overall, the government response to the 2008-2009 crisis was effective, albeit imperfect. However, Blinder finds it concerning that many Americans still do not understand exactly what happened, and strongly feel that the government fails to do its job of protecting the economy and the people. This results in a loss of confidence in the government (driven by public ignorance), which can have hamper the government’s response the next time a crisis comes along.