Let's get this part out of the way: Don't read the Squam Lake Report. The book is the muddled product of 15 experts recommending financial reform. It's mercifully short, but reads like overly collaborative documents do—I shudder to think of the endless word massaging and negotiation writing this thing by committee must have required. The result is an overly formal and tepid work with few novel or particularly lucid insights not already covered elsewhere. And to MarketMinder's view, this group fundamentally misunderstands the causes and consequences of the panic. Skip it.
Instead, pick up the equally pithy but vastly wiser Senseless Panic, by William M. Isaac. As former FDIC chairman and close collaborator with Paul Volcker through some truly rough financial times like the Penn Square/Continental Illinois banking crises of the early ‘80s, and the S&L crisis of the late ‘80s, this guy is a regulatory veteran with real world experience to give us important perspective about today.
It's a great thing to see the 2008 crisis contrasted with these events—something that's been almost wholly neglected until now. The situations weren't the same, but the basic lessons about public policy vis-à-vis banking are vital. Basic lessons about getting broad participation from banks for emergency programs, dealing with moral hazard, being decisive and transparent for the markets, showing the "bazooka" of commitment to backstop vital institutions, recognizing the interconnection of banks, and much else, were all experienced here...less than a generation separated from 2008. Back then, at least, they staved off a true panic.
The first part of Isaac's book is a memoir of his career as FDIC chair, which is surprisingly lively and light—he turns out to be quite a gifted communicator. This is a very readable book. His anecdotes about the Butcher banks of Tennessee, for instance, hold great lessons about how banking stress tests work, and are entertaining without being overly wordy or bogged in detail.
And it's from this authoritative viewpoint of experience that Isaac launches the second part of the book, which unequivocally states: This panic didn't have to happen. It's a breath of fresh air to read Isaac make some basic empirical observations about the subprime mortgage market and its magnitude (it was far too small to create a global recession and market panic), and ask the basic question: So how did a manageable situation like this turn into such a disaster? Answer: The devastating mark-to-market accounting rule and inept response from our government. Simply, this is the best breakdown of FAS 157 published so far.
There's only a little to be critical of in this book. I couldn't shake a sense of "apologia" in the same vein of Henry Paulson or Alan Greenspan's memoirs. Much of the first half of Isaac's book reads almost like a justification for his decisions 30 years ago. This is understandable because free markets proponents (such as these fellows) would normally feel ambivalence about public policy in the first place. But it's tedious to continually justify one's existence.
Isaac is most upset because in 2008 the Feds didn't get out in front of the problem and instead handled it in a cobbled, hodgepodge fashion. This, truly, is the best advice for a public official—to be consistent and transparent. But at times this lesson becomes overwrought. The hope is for regulators in these positions to realize their powerful, but often limited, ability to truly anticipate and contain all financial ills. Unfortunately, too often such folks are addled with the political disease of believing they are capable of more than is realistic.
For example, Isaac describes the need to enact reforms and policies that detect and/or fix future ills before they happen. That is, instead of being reactive, they ought to be more proactive. Some of this good: Filling the FDIC insurance coffers in good times rather than imposing higher fees in bad times (as happened in ‘08 and ‘09) is a fine enough thing. But, Isaac simply isn't skeptical enough of his own powers, or those of who might serve in the future. There's far too much talk of "there's a proper way to do this" and "we can make sure a panic never happens again" via sound public policy. This is hubris. So long as we continue to have free markets, there will be more panics. There's only so much any elite group can anticipate and appropriately act upon. And, every situation will be unique and require context to make the best decisions—no rigid playbook will work. So, it's disappointing to hear Isaac support notions of a Systemic Risk Counsel (SRC)—a regulatory body designed expressly to monitor risks in the system and recommend circuit breakers for them in the future. (Which is now a reality, by the way, thanks to the new financial reform bill.)
Oh! If only it were that simple. The fact is some of our best, most learned financial minds simply botched this episode. The lesson is not to further strive toward a quixotic utopia of regulation to prevent future breakdowns. Regulation should evolve with the quick-moving capital markets, but sound regulation realizes its limitations—it is by definition reactive and will remain so as long as capitalism remains dynamic. That means recognizing the fantasy of making rules that prevent all future ills. We boom and bust. This lesson is particularly poignant now that we can view the US financial reform, which mostly ended up a jumble of politicized goo that proved wholly unable to produce solutions to the true problems of the era.
In some fashion, though, this is quibbling. Isaac has produced one of the best analyses about the 2008 crisis, and we'd do well to heed the lessons of his well-articulated experience. As the regulators begin to interpret and act upon the new reform bill over the next many years, let's hope they keep his work in mind.