We Saw the Crisis Coming

David Ignatius
March 1, 2009

WASHINGTON -- The big mistakes we make in life aren't the ones that sneak up on us, but those we make with our eyes wide open. That bit of wisdom comes from my friend Garrett Epps, a professor of constitutional law at the University of Baltimore. And it's powerfully true about the financial crisis that has enfeebled our economy.

Nothing about this crisis is really a surprise. People have been warning about it for more than a decade, in academic studies, official reports, Wall Street analyses, even op-ed pieces. Our smartest financiers, Warren Buffett and George Soros, saw it coming clear as a bell.

Yet the authorities did too little in the early years, when they could have had some effect. And once the full force of the crisis hit, officials became caught in a reactive cycle of incrementalism -- with each intervention setting up the next one. We have been dragged into the future by the weight of past mistakes, rather than charting a new course.

This failure is especially clear in the case of three prominent people who are shaping the response to the crisis now: They saw the dangers building but failed to take decisive action -- for fear that a new financial architecture would frighten the markets.

The three who saw it coming are Robert Rubin, the treasury secretary during the Clinton administration; Lawrence Summers, Rubin's successor at Treasury and Barack Obama's chief economic adviser; and Timothy Geithner, who served under Rubin and Summers, then headed the New York Federal Reserve and now runs Treasury.

I admire all three, whom I got to know when I was the Post's business editor during the mid-1990s. I am looking backward here not to point fingers, but to argue for breaking the cycle of reactive mistakes.

First, Rubin: During the boom years of the 1990s, he was deeply worried about the risk of systemic failure in the financial markets. He was especially nervous about derivatives, the exotic financial instruments that were being created willy-nilly on Wall Street. Rubin hadn't run Goldman Sachs that way, and he feared the new crowd was taking risks they didn't understand. In the event of a crisis, would the window of transactions be wide enough to maintain orderly markets? Or would liquidity simply disappear?

Rubin pinpointed all the right issues. And yet when pressed in interviews about a new financial architecture to reduce these systemic risks, he would shy away like a skittish colt. Famously, he balked at the recommendation of Brooksley Born to regulate derivatives at the Commodities Futures Trading Commission.

Summers and Geithner had similar worries about systemic risk, and the same phobia about frightening the markets. Their skill was in crisis management -- the Mexican peso crisis in 1994, the Asian financial crisis in 1997, the Russian default and Long-Term Capital Management collapse in 1998. They were deft in nudging the markets away from meltdown, and that reinforced their confidence that ad hoc policies, negotiated privately with Wall Street leaders, were better than clunky regulatory regimes.

The paradox is that many reforms of those years have actually made things worse, by building in pro-cyclical forces that accentuate the downturn. This was true with the so-called "Basel II" capital standards. By requiring banks to maintain high reserves during crises, it forced them to sell assets into a falling market, compounding the downward pressure.

Other reforms had similar unintended consequences. The mark-to-market rules adopted by the accounting profession had the perverse effect of forcing banks to write down their portfolios daily as the market for securitized assets collapsed. These "marks" were often imaginary, since there was no real market. But banks had to take huge write-offs anyway, accelerating the death spiral.

Summers and Geithner now have a unique chance -- the best chance in a century -- to put the casino economy on a sounder footing. They don't have to worry as much about spooking the markets, which are already so traumatized they barely register a pulse. They can break with ad hoc policies.

The Obama team should build around what works, rather than shoring up the status quo: That means encouraging smaller, nimbler banks -- rescue Citigroup, if we must, but then break it up. It means putting technology and innovation at the center of plans to rebuild the auto industry; it means staking risk-takers. Where's the venture fund in the stimulus package? Summers and Geithner (with Rubin in the wings) have the rare chance to get it right, with their eyes wide open.

davidignatius@washpost.com