I am afraid that my defense of the law’s importance as a constraint in the case of Lehman Brothers, as against Peter’s charge that the Fed’s choice in that matter should be understood solely as a matter of internal institutional discretion, will give readers the misimpression that To the Edge is filled with examples of law proving decisive against countervailing pressures.
The opposite is more nearly true: especially once the crisis escalated following Lehman’s demise, the law was marginalized again and again, with government lawyers’ creative (i.e., highly questionable) interpretations of existing laws used to justify a huge variety of novel policies. I call this pattern of repeated improvisation “adhocracy,” which I hope sounds more than a little disapproving in contrast to our dignified image of the rule of law. One might think that decisions emanating from adhocracy are necessarily illegitimate, and by some lawyerly conceptions of legitimacy that is no doubt the case. But as I explained in my post on legitimacy, my goal is to see what people regard as illegitimate rather than simply pronouncing on it myself. And in fact, many of the adhocracy’s most outlandish actions not only escaped denouncement, they met with hardly a peep of opposition.
The most striking example came on the heels of Lehman’s bankruptcy, as the nation’s oldest money market fund broke the buck (fell below its normally pegged value of $1.00 per share). Money market funds were thought of by investors as akin to risk-free low-yield savings accounts, and they were crucial sources of short-term funding for American corporations. Unfortunately, even in the midst of the growing crisis, the Reserve Primary Fund decided that it could make an easy and sure-fire return by holding $785 million in short-term paper from Lehman Brothers—for the fund’s managers, the idea that the government would allow Lehman’s collapse was unthinkable. As they decided how much of that paper, which represented 1.2 percent of the fund’s holdings, had to be written off, investors made up their own minds about the fund’s future and started a twenty-first century bank run. There were no photogenic lines of desperate depositors, but $10.8 billion in redemption requests on Monday, September 15, and $29 billion more on Tuesday were quite enough to spark a panic for the whole sector. That in turn would imperil blue-chip American firms’ ability to access the cash they needed to operate smoothly, raising the ominous possibility that workers at iconic firms like GE could soon confront missing paychecks.
With bedlam at the door, Secretary Treasury Paulson was desperate for a way to stop the crisis from escalating immediately—which meant that going to Congress (then already in the works) was not considered a viable option for addressing this particular problem. What Treasury came up with was, legally speaking, “cute as a pail full of kittens.” Paulson was so pleased when he heard the idea he “slapped his desk,” according to his memoir.
The maneuver they settled on took a page from the playbook of the Clinton Treasury’s rescue of Mexico, but with amplified legal insouciance. Clinton’s Treasury Secretary Robert Rubin was determined to help Mexico during its mid-1990s currency crisis but found Congress a reluctant partner, and so he arranged a $20 billion loan for America’s southern neighbor to be made from the Exchange Stabilization Fund (ESF). That loan, by far the biggest ever made by the ESF, was already quite a stretch, and inspired angry denunciations of the ESF as a “slush fund that lacks accountability” (p. 75). But its novelty was only in magnitude, rather than in kind, as the ESF had long been used to make loans that were basically tools of U.S. foreign policy, in spite of its (somewhat anachronistic) explicit requirement to be used for currency exchange rate stabilization purposes.
Paulson and his team at Treasury did something far harder to defend as a straightforward interpretation of the law: they pledged $50 billion from the ESF to guarantee the redemption of money market shares at par value, thereby hoping to quell the panic and convince investors that they had no reason to run for the exits. The legal reasoning, such as was, went like this: the ESF was allowed to traffic not only in gold and currency but in “other instruments of credit,” and it could do so in order to “stabilize” the value of the dollar by way of stabilizing the American financial system. Treasury’s General Counsel, Robert Hoyt, would later reflect on this justification, and his explanation shows that the real interpretive work was done by an unspoken premise: after conceding that the main justification was “a bit of a legal stretch,” he noted, “Well, if you knew what would have happened if we hadn’t done this, you would understand” (start around 11:00 of this video).
Wonder of wonders, he was right! It is gobsmacking how little criticism of this decision you can find. My extensive searches did turn up one fellow who explains how the ESF is at the center of a global conspiracy (if you have some time to kill, recommended!), but other than that practically nothing. This isn’t such a mystery: the program was a huge success, stopping the run on money markets and actually making money for the Treasury after it began charging fees to participating funds. To the extent that legal unpleasantness marred this energetic and effective maneuver, perhaps it has helped encourage the use of the ESF to slip into obscurity relative to many of the crisis’s more heavily-debated interventions. And so, alas, we did not get to see William Hurt pound the table in the movie version of this history, as the scene did not manage to make the cut…
One institution did manage to rouse itself against the Treasury’s legal shenanigans: Congress. Although there would be no dramatic confrontations in oversight hearings, when Congress passed the Emergency Economic Stabilization Act in early October 2008, it included § 131, which reads in full:
EXCHANGE STABILIZATION FUND REIMBURSEMENT.
(a) Reimbursement.–The Secretary shall reimburse the Exchange Stabilization Fund established under section 5302 of title 31, United States Code, for any funds that are used for the Treasury Money Market Funds Guaranty Program for the United States money market mutual fund industry, from funds under this Act.
(b) Limits on Use of Exchange Stabilization Fund.–The Secretary is prohibited from using the Exchange Stabilization Fund for the establishment of any future guaranty programs for the United States money market mutual fund industry.
To me, this reads like some sly joke: we are outraged that the ESF was diverted from its true purpose Y, and so it can never be used for purpose X again! (Oh, and never mind about potential purposes A-W.) Rather than a joke, this strange half-measure probably represents the reconciliation of some real outrage over the ESF’s diversion coming from (former Foreign Relations Committee member) Senator Christopher Dodd (D-CT) with staffers’ recognition that an ambiguously-defined ESF provides a useful safety valve in crises.
I find such covert crisis planning quite unfortunate, not just because of its half-heartedness or underhandedness, but because I fear it actually leads to less accountability for crisis responders and that in turn leads to worse legitimacy. That won’t matter much if every tricky use of the ESF is as successful as the money market rescue was. But we should aspire to have a crisis fighting system that can fail well, out in the open, doing what it is supposed to be doing.
Along those lines, I recommend putting such a safety valve out in the open through the establishment of a properly designated financial crisis emergency fund that gives the Treasury Secretary unrestrained discretion over $50 billion or so but couples this unusual grant of spending authority with extraordinary accountability mechanisms. Not just the Treasury Secretary, but America’s one and only plebiscitary elected official, the president, should be forced to back decisions about how this fund would be used, and the decision should receive fast-tracked scrutiny in Congress. In other words: because legal constraint is likely to work so irregularly and badly at the outset of financial crises, we should openly depend on political constraints instead.
That was very far from the approach taken in the Dodd-Frank Act, the major reform law to emerge from the crisis. Indeed, although lots of complaints about Dodd-Frank worry that we are overlearning the lessons of the last crisis rather than effectively preventing the next one, I find the law to be curiously unresponsive to some of the legal shortcomings in our crisis response system exposed during 2008-2010. More on that next time.