Short-term stability can be dangerous
We now have Timothy Geithner’s 528-page memoir of the financial crisis and its aftermath. Called Stress Test, it’s full of fascinating details of a frightening time. For me, the most striking incident involves a call between Geithner and Lloyd Blankfein, the head of Goldman Sachs.
This is September 2008. Lehman Brothers has just failed. Many huge financial institutions are threatened. Confidence is shredding. Events seem to be spinning out of control. Geithner sees Blankfein as one of Wall Street’s “calmer, stronger, smarter” voices but also finds him “shaken.” Geithner lectures him:
“Lloyd, you cannot talk to anyone outside your firm, or anyone inside your firm, until you get that fear out of your voice,” I said. “You can replace it with anger or you can cover it up. But you can’t let people hear you like that.”
To critics left and right, Geithner is a reviled figure for his part in propping up Wall Street and rescuing many overextended firms. Geithner headed the New York Federal Reserve Bank (2003-09) and was President Barack Obama’s first Treasury secretary (2009-13). His rebuttal is what he calls the “paradox of financial crises.” You have to save the financial system, even if the financial system — through poor lending and reckless speculation — got you in trouble. He writes: “When the financial system stops working, credit freezes, savings evaporate and demand for goods and services disappears, which leads to layoffs and poverty and pain. When investors and creditors start to panic, consumers and businesses follow suit.”
On this, Geithner is correct. It wasn’t certain when the economy would stabilize. It would have been later if, say, Citigroup or Bank of America had failed. We were spared another cycle of panic, imploding stock prices, lost wealth and fewer jobs.
To buttress his point, Geithner provides some convincing data. The economy’s recovery, though slow and disappointing, still compares favorably with many precedents. In the 1930s’ Great Depression, employment did not regain its pre-crisis peak for eight years. By contrast, today’s employment is near its pre-recession peak after six years. For five financial crises in Europe and Japan from the mid-1970s to the early 1990s, the average time to reach pre-crisis employment was 15 years.
Similarly, the government’s financial rescues made money. Most banks repaid with interest the amounts they received; many other subsidies have been recovered (or will be) with interest. Through 2013, these programs were projected to be $166 billion in the black, Geithner says.
But why wasn’t the financial crisis anticipated? Here, Geithner is less insightful. The explanation isn’t that some problems weren’t recognized. As early as 2004, staff at the New York Fed did a study titled “Are Home Prices the Next Bubble?” The conclusion was, no. Prices might fall in some localities, but there would be no nationwide slump because since World War II there never had been. Likewise, Geithner was repeatedly warned (by some Wall Street insiders) that the economy was overdosing on credit.
These problems were regarded as isolated in a basically sound economy.
What was missed was how these problems would interact to create a panic unprecedented since the 1930s. They were missed because (a) a U.S. financial panic was outside the experience of all those in positions of power, making it hard for them to imagine the threat realistically, and (b) mainstream economic doctrines reinforced the bias by treating financial panics in advanced countries like the United States as historical curiosities, eliminated by post-Depression reforms.
We thought we had outgrown panics. This conceit bred complacency. There is a deeper problem to which Geithner alludes only in passing. Prolonged financial “stability can produce excessive confidence, which produces the seeds of future instability,” he writes. Precisely. The boom beginning in 1982 and lasting until 2007 convinced bankers, business leaders, economists and households that economic risk was waning. Practices once thought to be dangerous were less so.
This is the central lesson of the crisis. Success at stabilizing and stimulating the economy in the short run can destabilize it in the long run. This also happened in the 1960s, when the belief that economists could control the business cycle led to inflation and instability in the 1970s and early 1980s. But the lesson is not acknowledged because its implications are unpopular (an obsession with short-term stability may backfire) and it’s ignored — or even denied — by the post-crisis narratives, including Geithner’s.