One Thing We Learned from the Crisis

Ten years ago this month, the Federal Reserve Board made a mistake.

By August 2007, when the research conference at Jackson Hole ended, insiders recognized that some sort of crisis had begun (the Bear Stearns sub-prime hedge funds, Bank Paribas, and all that).  So Federal Reserve Chair Ben Bernanke, FRB New York President Timothy Geithner, and Vice Chair Donald Kohn began discussing emergency measures.

In the coming weeks, plans were drafted to offer troubled institutions short-term loans through auctions at “market rates,” instead of overnight loans at ominous “penalty rates.” The idea was to disguise the emergency nature of such loans and diminish the fear that news of them inevitably spread. In the event, they could be offered, not just to commercial banks, but to investment banks as well, under the broad authority to lend to virtually anyone in need under of Fed’s obscure section 13 (3) .

Envisaged, too, was a series of currency swap lines with European central banks. These derivative transactions would permit distressed European banks to borrow dollars from their home institutions, rather than appealing directly to the Fed, suffering the attendant stigma.  The Fed kept both plans on the shelf in case they were needed.

By December, the arrangements were called for. Reporters had been speculating about them for days. But when the Fed’s Federal Open Market Committee failed to mention them in its communique after its regular meeting, the Dow Jones Industrial Average fell nearly 300 points. Markets concluded that no announcement meant there were no new plans.

In fact, the announcement had been postponed for only a day, to oblige European Central Bank president Jean-Claude Trichet’s wish that the announcement of the Term Auction Facility (TAF) should overshadow news of the new swap lines. Calm was restored – for a time.

By March, when the Fed extended TAF lending to the twenty primary dealers in government securities routinely doing business with the New York Fed – Bear Stearns among them – and then added mortgaged-backed securities to the list, it was clear that emergency measures were working.  The film The Big Short ends just as the Fed was gaining (temporary) control.

And in September, four days after the full-fledged panic finally began when Lehman Brothers was allowed to fail, the Fed’s foresight proved equal to the task.  Some $250 billion in emergency lending of one sort or another, plus another $700 billion vouchsafed by Congress under the Troubled Asset Relief Program, was sufficient to win the day. (All this is from Bernanke’s memoir, The Courage to Act.)

The cost of the small mistake of the announcement in December 2007 underscores the magnitude of the eventual success. Three hundred points on the Dow versus, say, twenty-five percent of world product for a year or two in the case of a global depression. The authorities’ foresight – and attention to the details of making monetary policy – indicates the intricacy of the task . One thing we know about the crisis is that the Federal Reserve Board came through.

It is, of course, possible to argue alternative scenarios. Suppose the Fed had tightened in 2004?  Suppose Bear Stearns had been allowed to fail in March? Suppose the panic had been allowed to run its course?  There are plenty of topics for the hot stove league.

Ten years after crisis, much about its origins remains out of focus.  Amid the rush to globalization, countries piled up large foreign currency reserves, the better to stave off sudden currency swings.  The resulting “savings glut” fueled the boom in sub-prime mortgage lending. Various relationships didn’t become apparent until almost too late.

Since then, however, central banks have distinguished themselves in coping with the the downturn that followed the panic.  The expansionary monetary policy known as “quantitative easing” slowly returned the United States to near full employment; and unemployment is finally falling in Europe, even in Spain, Portugal and Greece

As the Financial Times editorialized yesterday, no news was good news when three major central banks met last week and world financial markets didn’t budge: “[I]nvestors no longer hang on central bankers’ every word because, after the greatest firefighting operation in generations, most major economies are in decent health and monetary policy of late has become more predictable.”

Three cheers, then, for retiring Fed chair Janet Yellen, ECB chief Mario Draghi, and Mark Carney, governor of the Bank of England. Those who manage the global banking system aren’t perfect. But they know a lot more than they used to. See Lords of Finance: The Bankers Who Broke the World, by Liquat Ahamet, if you doubt it.


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