‘Stability’ leads to one crisis after another
Must the government rescue the system when huge crises occur?
Former US treasury secretary Timothy Geithner discusses his new book ‘Stress Test, Reflections on Financial Crises’. Photo: Getty Images
Are financial crises an inevitable feature of capitalism? Must the government rescue the system when huge crises occur? In his book Stress Test , Timothy Geithner, president of the Federal Reserve Bank of New York and US treasury secretary during the 2007-09 crisis, answers “yes” to both questions.
Yet these answers also harm the legitimacy of a market economy. It is bad enough if capitalism is crisis-prone. It is worse if the state feels obliged to rescue those whose folly or criminality caused the damage, to protect the innocent.
Mr Geithner argues not only that crises are sure to recur but that governments must react with overwhelming force. The only way to stop a crisis is to remove the circumstances making it rational to panic.
That means the government must borrow more, spend more and expose taxpayers to more short-term risk – “even if it seems to reward incompetence and venality, even if it fuels perceptions of an out-of-control, money-spewing, bailout-crazed big government”. This is a bald statement of an unpopular view.
Sheila Bair, head of the Federal Deposit Insurance Corporation during the crisis, has given an opposing view, arguing that, if Wall Street believes the government will always pick up the tab, instability will inevitably result. Mr Geithner’s justification of the bailouts only makes sense, she says, once you accept a false dilemma: “That our only choices were either to do nothing or to pursue the over-the-top measures which we did.”
The view that capitalism is crisis-prone seems compelling. It is, Mr Geithner suggests, human to take on risk during a prolonged period of prosperity. That happened in the leverage cycle which preceded the crisis. People did not take on leverage because they expected to be bailed out. They did so because they expected to gain.
Credit bubble Yet there also exists what I call “rational carelessness” – the fact that bailouts were likely if the worst came to the worst surely comforted creditors and so increased the risk of a destabilising credit bubble.
Once Lehman Brothers failed, a new depression seemed to be on the way. In response finance ministers and central bankers promised to “take decisive action and use all available tools to support systemically important financial institutions and prevent their failure”.
They did and it worked. Panic – as measured by the spread between rates on unsecured interbank lending and expectations of future official interest rates – fell. In the US the economy started to stabilise after two quarters of contraction. Mr Geithner’s view is that the correct response to such a crisis has three elements: massive monetary and fiscal support; guarantees for the liabilities of systemically important institutions; and harsh stress tests. If an institution fails to raise capital, the government must inject it.
The conditions of the time – above all, the limited legal authority of the US (and other) governments – made a more tailored approach almost impossible to adopt. The value of assets was so uncertain, capital buffers so tiny, the reliance on short-term borrowing from fickle sources so ubiquitous and the mechanisms for resolving complex financial institutions so inadequate that governments had no reasonable alternatives. They could not risk the economic results.