Is it time to start freaking out? Former senior Treasury Department official Ted Truman says that despite the turmoil in the financial markets, the fundamentals of the U.S. economy are indeed strong.
Foreign Policy: U.S. Treasury Secretary Henry Paulson has clearly decided that Lehman Brothers is where he wanted to draw the line in the sand, refusing to put U.S. taxpayers on the hook for another bailout. Given how the world stock markets have reacted in the past two days, was that a mistake? Should Treasury and the Federal Reserve have bailed out Lehman Brothers as they did Bear Stearns, Fannie Mae, and Freddie Mac?
Edwin Ted Truman: I think its important to distinguish between bailing out Bear Stearns or Lehman Brothers and bailing out the financial system. Even if Lehman Brothers had been treated similarly to Bear Stearns, it would only be some of the creditors of Lehman Brothers that wouldve been bailed out, not the institution as a whole.
The circumstances surrounding Bear Stearns and surrounding Lehman Brothers were sufficiently different that a different approach was justified. Bear Stearns, had it been thrown into bankruptcy, wouldve been a huge shock to the system. It was bigger and more involved in the financial system than Lehman Brothers was. The system had months to adjust to the prospect that Lehman Brothers was going fail or be substantially damaged.
FP: Do you think the U.S. government will have to bail out other firms such as insurance company AIG, the American International Group?
ET: Let me once again say, its not a matter of bailing out the firms. In most cases, its the implications for the financial markets and the economy as a whole [that matters]. It is incidental that the firm might be saved or some creditors of the firm might be saved in the process.
I think Secretary Paulson was wrong to draw as firm a line in the sand as he has done in his comments [Monday] because in this business, you never say never. On the other hand, its important to send a message to markets that taxpayers are not standing behind an infinite number of these rescues in the interest of the financial system.
FP: President George W. Bush and Secretary Paulson stressed in their public comments that the fundamentals of the U.S. economy remain sound. Is that your view?
ET: Yes. I think the remarkable thing is that youve had more than a years worth of financial turbulence, and the impact on the real economy has been minimal. The stock market is down 25 percent, house prices are down 15 percent, and the real economy is flat. The capacity of Americans to produce goods and services has been maintained. Unemployment has gone up; thats true. [But] incomes are holding up. We actually are producing at the same rate, maybe a little higher, than we were a year ago. And thats certainly quite different from saying the economy is contracting and that the economy is in a spiral and needs a fundamental reconstruction.
The financial system is taking a bigger hit than it has at any time since the Great Depression, but the real economy is now nowhere close to that. If you look at the Great Depression, the unemployment rate went up to 25 percent and real GDP dropped substantially. Were not close to that, and were not going to be close to that.
FP: That said, should average people be worried? How might whats happening on Wall Street affect people on Main Street, if you will?
ET: Credit is going to be tighter, and it is tighter. Businesses and individuals that are normally creditworthy will have a harder time getting credit. Credit-card lines are being cut. Some of them probably should be cut, by the way. There are a nontrivial amount of people losing their jobs in the financial system. But again, were not in a situation like in the 1930s when stockbrokers were selling apples on Wall Street. The economy has its ups and downs. One of the problems weve had in recent years is the notion that economic policy should prevent all downs. Thats created a one-sided bet.
FP: What do you think the government should do to prevent more large-scale failures in the coming days, weeks, and months?
ET: Youre going to have some additional bank failures, which is inevitable when the economy slows down. Theres not much policy can do, even monetary policy, to reduce the risk that there will be other accidents. Theyve done quite a lot in terms of providing liquidity to the market and encouraging this self-help operation among some of the major financial institutions. But theres not a lot more that public policy in general can do in these circumstances.
One thing that the secretary and the president were trying to do was say dont panic, which I think was right. The economy is basically in good shape, meaning our capacity to develop goods and services. Although a lot of people have lost a substantial amount of financial wealth, thats a paper loss, and doesnt really impact the economy as a whole. It would be wrong for everyone to start panicking.
FP: Who can we hold responsible for the present crisis?
ET: Im not much for finger-pointing. I dont think its very constructive. [But] I think macroeconomic policies were to blame; U.S. fiscal policy was to blame; U.S. monetary policy and the monetary policies of all the other major countries were to blame. We had easy money for too long in the world. The financial system had overdone it and was collectively underpricing risk.
FP: Are you seeing any substantive differences from the U.S. presidential candidates on the financial crisis?
ET: The major difference has to do with the regulatory side. And although Senator McCain is now saying he favors appropriate regulation, in some cases that may involve deregulation, which is having it both ways. The penchant to deregulate, which has been around Washington for the past eight years and was not particularly strong in the previous eight years [to that], is partly to blame here. Senator McCain and his party tend to be more on the side of deregulation than regulation. The Democratic approach to regulation is to provide a framework, whereas the Republican penchant has often been to wipe away regulations and let the market decide.
But I think its very difficult to generalize. The truth of the matter is, administrations are constrained. Even in the Fannie and Freddie case, they wiped out the [common] shareholders and suspended the dividend on the preferred shares, which I think was the right thing to do. I suspect that [former Treasury Secretaries] Bob Rubin and Larry Summers would have done the same thing on their watch.
Edwin M. Ted Truman, a senior fellow at the Peterson Institute for International Economics, was assistant secretary of the U.S. Treasury for international affairs from December 1998 to January 2001.