Republic, Lost_ How Money Corrupts Congress--And a Plan to Stop It - Lawrence Lessig [35]
Some believed the promise was even more specific than that. Why would sophisticated debt holders take such extreme risk? “The obvious explanation,” Raghuram Rajan writes, “is that [they] did not think they would need to bear losses because the government would step in.”40 Simon Johnson and James Kwak point to at least one case in which the financial executives of one major bank calibrated the risk they would take based upon the government’s decision to expand the bailout capacity of the Federal Reserve.41 They and others have pointed to the discount the market gave big banks for their cost of capital as evidence that the market believed those banks “too big to fail”: “Large banks were able to borrow money at rates 0.78 percentage points more cheaply than smaller banks, up from an average of 0.29 percentage points from 2000 through 2007.”42
Harvey Miller, the bankruptcy counsel for Lehman Brothers, was even more explicit than this: As he told the Financial Crisis Inquiry Commission, hedge funds “expected the Fed to save Lehman, based on the Fed’s involvement in [previous crises]. That’s what history had proved to them.”43 Again, Rajan: “[T]he problem created by the anticipation of government intervention is that the bankers, caught up in the herd’s competitive frenzy to cash in on the seemingly lucrative opportunity, are not slowed by more dispassionate market forces.”44
The executives knew this. The pressures of the competitive market, however, made it impossible for them to do differently. As one CEO put it, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”45
Either of these accounts would explain the second condition that Posner described earlier: “complacency about asset-price inflation.” It’s easy to be complacent when you believe the government has your back—and especially when the market confirms that belief by giving you a break on the interest rate it charges.
In this sense, the story here is thus the story of both too little regulation and too much regulation.
Too little, since by relaxing the regulatory constraints, the government left the banks vulnerable to the constraints of competition. Those constraints forced the banks to take on more risk than was socially sensible, even if privately rational. In the terms of chapter 5, it forced the banks to ignore the externality of the risk their gambles would produce for the economy as a whole.
Too much, since the implicit guarantee of a bailout encouraged the banks to be “complacent about asset-price inflation.” As Rajan writes, “the institutions that took the most risk were those that were thought to be too systemic to be allowed by the government to fail.”46 The implicit promise to socialize the risk, as Paul Krugman put it,47 while allowing the banks to privatize the benefits was the consequence of an intervention by the government—certainly among the silliest in the history of finance, but an intervention nonetheless.48
The combination was deadly—for us, at least, if not for the banks. For, after the collapse, of course, the government did effectively bail out all but one investment bank, Lehman Brothers. The surviving banks, however, are ever larger and more profitable than they were before. Indeed, as Jamie Dimon, chairman and CEO of JPMorgan Chase, boasted about 2009, “This might have been our finest year ever.”49
It is for these reasons that I believe the decision by our government to deregulate derivatives was foolish. When combined with the implicit and explicit promise to bail out failure, it encouraged a radical increase