Lawrence Summers. (photo: Getty Images)
Say what you will, the combative Harvard economist Larry Summers is a brilliant apostle of John Maynard Keynes and a strong advocate of using government spending to stimulate faltering economies and create jobs. He also understands -- and has shown mathematically with Berkeley economist Brad deLong -- why inflation does not become a threat in a severely depressed economy.
But, for all his smarts, Larry Summers has one major crime on his rap sheet. He helped orchestrate the Clinton-era deregulation that ended up fueling the crash of 2008, killing economies, jobs, growth, and hope across the globe. President Obama should not name him to head the Federal Reserve, which would only encourage him to kill again.
Like it or not, the Fed remains Washington's most powerful regulator of the financial sector. As one of the most destructive deregulators of our time, Larry Summers is exactly the wrong fox to guard the henhouse. Close to Wall Street, for whose firms he sometimes works, Summers also profited personally from the deregulation, but he is far more dangerous than a hired killer. He believes in what he does.
This comes through clearly in an October 2009 Frontline documentary called "The Warning." It is available online, as are the transcript and full-length interviews, from which I've taken most of what follows.
"The Warning" takes us back to the Bill Clinton boom of the late 1990s and tells of a very personal clash over how best to manage America's rapidly expanding financial sector. Should we stick to the regulatory approach that had guided the American financial system with relative safety since the New Deal? Or should we let the "free market" -- or to be more precise, Wall Street -- regulate itself, even in the case of fraud?
Backing self-regulation stood Summers, who had become deputy secretary of the Treasury, along with two financial titans -- his mentor and former head of Goldman Sachs, Treasury Secretary Robert Rubin, and the long-time Fed chairman Alan Greenspan, a disciple of the uber-capitalist Ayn Rand and an ideologue with an almost mystical faith in free markets. Summers was the youngster on the team, and the mild-mannered Rubin used him as his chief enforcer.
Supporting at least a minimum of government regulation stood a very clever woman called Brooksley Born, a veteran securities lawyer whom Clinton named in 1996 to chair the little known Commodities Futures Trading Commission. CFTC regulated agricultural futures and oversaw complex "financial derivatives" like credit default swaps and collateral debt obligations, which derive their notional value from underlying indexes, securities, commodities, mortgages, and other items of worth. Banks and insurance companies sold them as tools to help governments and corporations manage and minimize risk, but they were little more than wagers on future outcomes.
Having practiced derivatives law for some 20 years, Born knew the field first-hand, and she grew increasingly worried as a regulator that the vast majority of derivatives traded in private over-the-counter (OTC) transactions beyond even the minimal regulatory supervision and transparency of recognized options and futures exchanges. As a result, the world was flying blind, since no one could know the true extent of risk to the global financial system, or how much individual banks, insurance companies, hedge funds, and sovereign wealth funds stood to lose.
Lack of transparency opened the door to outright fraud, as a scandal involving Bankers Trust showed at the time. As we subsequently learned, Enron went even further, using price-swap derivatives, credit derivatives, and accounting fraud to inflate asset values, hide billion-dollar losses, and keep soaring liabilities off the books in bogus reports to investors, creditors, and employees. Derivatives also greatly increased economic risk, and could, Born feared, drag down the entire financial system if anything went wrong.
"You have one big institution that fails, it can't pay its obligations, it forces somebody else into dangerous territory who can't pay their obligations, and pretty soon, it's a falling domino effect through the economy," explained Born's aide Michael Greenberger. The derivatives are "hidden like land mines in a battlefield and nobody wants to give money to anybody else because they don't know."
To avoid all this, Born proposed to regulate OTC derivatives. But the free marketeers -- Greenspan, Rubin, and Summers -- immediately balked. Summers, the enforcer, called and read Born the riot act. He claimed to have 13 bankers in his office. All of them demanded that she stop. "You're going to cause the worst financial crisis since World War II," he warned.
The bankers and their lobbyists wanted no regulation of OTC derivatives. "They were totally opposed to it," said Born. "That puzzled me. You know, what was it that was in this market that had to be hidden? Why did it have to be a completely dark market? So it made me very suspicious and troubled."
Born went ahead and prepared a "concept release" describing her proposed regulations. Rubin reacted by calling a meeting of his "president's working group," where Summers and the others all tried to shut her down, often in a condescending way. Characteristically, they dismissed her as "irascible, difficult, stubborn, [and] unreasonable." She was, in their eyes, only a woman and not a member of their Wall Street club.
Born persisted and two weeks later she published her concept release. For Rubin and Greenspan, this was the final straw. They openly called on Congress to stop her and any regulation of the OTC derivatives. Summers joined in testifying before Congressional committees. "The release has cast a shadow of regulatory uncertainty over a thriving market," he said. Republicans and Democrats all seemed to agree, and four hostile committees turned on Born with a vengeance, accusing her of a bureaucratic grab for power.
"My question again is what are you trying to protect," demanded Alabama congressman Spencer Bachus. Born's reply went right to the point. "We're trying to protect the money of the American public, which is at risk in these markets," she said.
Even as the political momentum against her grew, the fates intervened. Many of the new derivatives were so mathematically complex and confusing that they could fool even the most sophisticated insiders. In 1997, two financial economists -- Myron S. Scholes and Robert C. Merton -- won the Nobel Memorial Prize for devising the mathematics to determine the value of derivatives. The next year, following Russia's default on government bonds, a hedge fund that Scholes and Merton co-founded and on whose board they sat -- Long Term Capital Management (LTCM) -- discovered it had lost $4.6 billion on derivative holdings with a notional value of over $1 trillion. Faced with bankruptcy and threatening contagion across Wall Street, LTCM was forced by the Fed to accept a private bail-out deal. If the failure embarrassed the Nobel laureates, it also proved that Brooksley Born knew far better than the titans the dangers that lay ahead.