Geithner agreed that we need to deal with the problem of moral hazard, which is caused by private shareholders being able to count on government subsidies and taxpayer bailouts. But being a former NY Fed President (2003-2008), he stopped short of acknowledging the Federal Reserve’s causative role in the economic crisis.
Location: House Financial Services Committee
Ron Paul: Today, we’re talking about reforms in the housing financial markets which I think is crucial, very, very important. My concern is that there hasn’t been a full explanation or understanding of how we got into the mess, and so far what I hear, and the little bit we do hear, is that we will deal with problems with more technical solutions and more regulatory solutions rather than looking at the fundamental causes.
To me the fundamental causes are well-understood by the Austrian free-market economist because they predicted early on what was going to happen and it did. They put the blame on three things: fixing interest rates (price fixing) too low for too long, and also the line of credit that was with the Federal Reserve, which was something that Congress did even though it was $2 billion, it created a lot of moral hazard because even Greenspan admitted that there was probably about a $14 billion indirect subsidy to Fannie Mae and Freddie Mac which also encouraged the distortion. And on the books it was legal for the Federal Reserve to buy mortgage debt, and of course there were no restrictions because it was done in secret about exactly how much credit exactly will be created.
And because of my concerns and understanding of what was happening in July of 2002, I was convinced that we were working on a financial bubble and I introduced legislation that would have moved the line of credit from the Treasury as well as prohibited the Fed from buying mortgage debt which most people would object to, “No we need them for the emergency.”, but that’s what caused all the moral hazard, and I think also existed for the benefit of us selling debt overseas, this encouraged foreigners to buy, knowing the Treasury stands behind this, and the Federal Reserve stands behind this, and the whole cycle continues.
But when I introduced that legislation back in 2002, I said:
Ron Paul: “By transferring the risk of widespread mortgage default the government increases the likelihood of a painful crash in the housing market and the system could stave off the day of reckoning by purchasing GSC debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary but painful market corrections will only deepen the inevitable.”
Now that’s not so much my statement, coming about that on my own but becaue I endorse free markets and I endorse Austrian economics. And I don’t see any understanding of that coming from our leadership in the Congress, or the Fed, or the Treasury, and I think it is so crucial that there is this understanding.
So my question is, are you familiar with the explanation of the Austrian economists, of the business cycle, how bubbles are formed and what we should do, and you shake your head yes, and if so, if you do understand that, which part of it don’t you like? And why don’t we look more carefully at those economists? They were right 10 years ago, I believe they’re right now. Why aren’t they consulted?
Tim Geithner: Congressman, I agree with much of what you said and as you and I have talked before in this hearing, I think you’re right to point out that a long period of low real interest rates around the world played a major role in contributing to this financial crisis, this real estate boom, this credit boom. You’re also right that moral hazard played a very important role, most dangerously in Fannie and Freddie and those institutions were allowed to grow to enormous size, take on enormous risk without capital to support those commitments because of the expectation the government would come in and protect them from the failures. I completely agree with you. Completely agree with you.
Ron Paul: My time is running out, I want to see if I can get one answer. My bill that was suggested years ago, would that be a proper thing to do now to make sure that that line of credit and this inevitable purchase of this kind of debt from the Fed, we should restrict that or remove it, would you agree that was a good suggestion back then?
Tim Geithner: I have to go back and look at your bill, but as I said in my statement, if you think about what system should replace our current system, a critical part of that is to make sure you don’t have institutions with private shareholders taking advantage of a subsidy from the government that leaves the taxpayer exposed to the risk of substantial loses. So I agree that a centerpiece to future reform would be dealing with the moral hazard in the current framework.
Ron Paul: But doesn’t the monetary system breed into the system of moral hazard? The Fed is designed to be the lender of last resort. That’s what it says. They’re there to be there to pick up the pieces.
Tim Geithner: GSCs were different as you said because there was a credit line, and because these expectations built up over time the government would be there. That had nothing to do with the Fed. In fact the Fed…
Ron Paul: Our concerns bore out because that’s what exactly happened, the government did pick up the pieces and now we’re in a bigger mess.