By HOLMAN W. JENKINS JR.
Originally published in the Wall Street Journal on Sept. 30, 2016
Hillary Clinton in Monday’s debate attributed the 2008 financial crisis to “trickle down” economics and Republican tax cuts. That’s one explanation you won’t find in a widely hailed new book about the financial meltdown by Harvard Law School’s Hal S. Scott,“Connectedness and Contagion.”
Too bad Mr. Scott’s scholarly approach cannot be dismissed so readily. One reason right now is Deutsche Bank.
A long acknowledged expert, Mr. Scott dispenses with the idea that the crisis flowed as the necessary result of a housing correction or bad mortgages, or because Lehman Brothers (which held such mortgages) was too connected to other banks such that they would fail if Lehman could not honor its debts.
The problem wasn’t connectedness, but contagion, more colloquially known as panic. Example: The Reserve Fund, a money-market fund, “broke the buck” because it held a small amount of Lehman IOUs. Yet the run quickly spread to other money-market funds that held no Lehman IOUs, only stopping when the money-fund industry was enfolded in a general government bailout of the financial system.
Unfortunately the Dodd-Frank law treated connectedness, not panic, as the problem, especially with its focus on higher capital standards. While these have their uses, Mr. Scott says, capital “is all gone in a heartbeat if there is a panic.”
Worse, savoring the sound bite “no more bailouts,” Congress deliberately erected political obstacles to regulators acting swiftly in the inevitable next crisis.
Which brings us to Deutsche Bank, whose troubles have filled the news. Its stock price is down, the cost of insuring against its default is up. Big depositors are withdrawing cash. Murmurs of a “Lehman moment” are worrying markets globally.
Angela Merkel, Germany’s chancellor, didn’t help matters by allegedly ruling out government support. Of course, she didn’t mean it, but even so, bailing out the bank, if necessary, might be to trade one crisis for another. That’s because doing so might unravel the anti-bailout disciplines Germany has been trying to impose to hold together the Eurozone.
OK, Deutsche Bank won’t be allowed to fail. The thing to notice, though, is how thoroughly this crisis stems from our efforts after the last crisis.
Not only has the bank’s ability to meet tougher capital standards been hindered by low or negative interest rates imposed by the world’s central banks. Capital has been drained out of the bank by a uniquely American crisis “solution”—lawsuits. The Justice Department is currently seeking a bank-breaking $14 billion for supposedly defective mortgages sold to investors, including Fannie and Freddie. In another U.S. court, the bank’s own shareholders are suing because the bank bought the same crummy securities for its own account.
Wait, Deutsche Bank knowingly invested in defective mortgage securities? Of course not. The essence of a run is that the market no longer distinguishes solvent from insolvent, and these mortgages were the first victim. These securities were never so crummy as the ubiquitous media description “toxic” implied. They were the same securities the U.S. government acquired in the bailout and later sold for a profit. (Deutsche Bank was actually a buyer.)
Here, in spades, is the circularity of the bailout dilemma. Washington largely spawned the panic that its own heroics were later required to end. Now let it be said that some believe Prof. Scott paints an overly dire picture of the Dodd-Frank reforms. Politicians and regulators will act to stop a future panic no matter what the law says rather than suffer the consequences of failing to do so.
Maybe that’s right, but there’s no doubt the world financial system has become more fragile, not less so, especially in Europe. Here’s why: Italy would like to bail out its banks using taxpayer money fearing runs if depositors must bear losses. But Italy’s government itself arguably is insolvent, propped up only by the European Central Bank, and EU rules stand in the way of Italy’s plan for its banks.
So far the Italian public is not panicking, but Italy is the EU’s third biggest economy and a key member of its currency bloc. We are one political accident away from a crisis that would unravel the euro. Undoubtedly the Obama administration already is scurrying to call off its mortgage witch hunt rather than supply a match to this powder keg. But such an accident is coming sooner or later in a world characterized by slow growth and ever-mounting debt.