The 2008 Financial Crisis as Seen From the Top

The New York Times
By Paul Krugman

For a few months in 2008 and 2009 many people feared that the world economy was on the verge of collapse. They had good reason to be afraid. Financial markets were virtually frozen, with credit almost unavailable to anyone except the safest of borrowers. The real economy was in free fall: Over the winter America was losing 700,000 jobs a month, while world trade and industrial output were falling as fast as they did in the first year of the Great Depression.

In the end, however, the worst didn’t happen. The financial crisis caused huge, lasting damage. But the bottom didn’t fall out completely. What saved us? There were multiple factors. But one element was that key public officials didn’t stand aside while the world burned. Instead, they acted — not always soon enough, not always forcefully enough, not always wisely, but pretty effectively all the same.

“Firefighting” is a brief account of that crucial moment by three of the most important actors. Ben S. Bernanke was the chairman of the Federal Reserve Board, then and now the most influential economic position in the world. Henry M. Paulson Jr. was George W. Bush’s Treasury secretary. Timothy F. Geithner was president of the Federal Reserve Bank of New York — another key position in the Fed system — then became Paulson’s successor under Barack Obama.

There are a number of forms a book by central players in a historic episode can take. “Firefighting” could have been a juicy tell-all; it could have been an exercise in boasting about how its authors saved the world; it could have been a litany of excuses, explaining why none of what went wrong was the authors’ fault. And the truth is that there’s a little bit of each of these elements — but not much, considering.

What Bernanke et al. — I’m going to call them BGP for short — have given us, instead, is a primer on why the crisis was possible (and why, even so, almost nobody saw it coming); a ticktock on how the crisis and the financial rescue unfolded; and a very scary warning about the future.

Much of what BGP have to say here is familiar to economists, but perhaps less so to the general public. Fundamentally, they argue, what happened in 2008 was a “classic financial panic,” of the kind that has happened again and again ever since the dawn of modern banking. (Even Adam Smith called for financial regulation, having seen a banking crisis firsthand.)

So why didn’t people see it coming? Part of it was hubris: “Serious economists were arguing that financial innovations like derivatives … had made crises a thing of the past.” (How serious were these economists, actually?) And the reality was that financial innovation made things worse, not better: Most of “the leverage in U.S. finance” — debt that was vulnerable to panic — had moved to “shadow banks” that, unlike conventional banks, were largely unregulated and lacked a financial safety net.

Also, as they say, “it’s hard to fix something before it breaks.” As long as the housing bubble was still inflating, defaults were few and everything seemed sound. A few Cassandras warned about the risks, but like the original Cassandra, they went unheeded. And BGP, to their credit, acknowledge their own failures to recognize the danger, including Bernanke’s notorious declaration that problems in subprime lending were “contained.”

Then it all fell apart. Most of the book is concerned with the increasingly desperate efforts of BGP and other officials to prop up financial dominoes before they could topple and collapse the whole system. It’s an intricate story, one whose details probably seem a lot more interesting to those who were involved than they will to a broader readership. And I don’t think there are any shocking new revelations.

There is, however, a unifying theme to all that complexity: Containing this crisis was so hard precisely because of all that financial innovation. Conventional banks are both overseen and guaranteed by the Federal Deposit Insurance Corporation, which has the power “to wind down insolvent banks in an orderly fashion while standing behind their obligations.” But “the federal government had no orderly resolution regime for nonbanks.”

So BGP and company had to engage in frantic innovation. For example, the Fed funneled money through conventional banks into the hands of nonbanks, in effect lending to institutions they weren’t really supposed to support. This exposed the Fed to new risks; Paulson effectively indemnified the Fed against those risks, apparently without real legal authority to do so. At another point, when a run on money-market funds — which would have been a complete catastrophe — seemed imminent, Paulson guaranteed those funds using money legally earmarked for a completely different purpose, defending the dollar’s foreign exchange value.

Sometimes all these efforts fell short. In a section that will no doubt cause a lot of controversy, BGP argue that there was nothing they could legally have done to prevent the bankruptcy of Lehman Brothers, the event that nearly broke the world. Was this true? I’m not enough of a lawyer to tell.

Still, by the late spring of 2009 the storm seemed to have passed. Recovery was slow, but at this point we are back to an economy with low unemployment and seemingly stable financial markets.

But should we be worried about another crisis? Yes, the authors say, in a final chapter that is downright scary.

Banking, they argue, is actually less risky than it was, thanks to financial reforms that, while far short of what should have been done, have nonetheless led to safer practices. But crises will still happen, and when they do, the firefighting abilities of policymakers will have been gravely compromised. Interest rates are too low for cutting them further to do much good. Fiscal stimulus, which BGP agree was crucial, will be much harder to sell given high levels of debt. And Congress has taken away much of the authority that made extraordinary measures possible in the crisis. In other words, it’s hard to imagine BGP’s modern successors carrying out the kind of rescue operation the authors managed a decade ago.

And it’s not even clear whether they would try, or at any rate have any idea what they’re doing. The authors are too nice to say this, but today’s top economic officials seem to be systematically drawn from the ranks of those who got everything wrong during the crisis. The failure of Bear Stearns was the first solid indication of how much trouble we were in; Donald Trump has just chosen David Malpass, Bear’s chief economist at the time, to head the World Bank. Larry Kudlow, now the administration’s top economist, ridiculed “bubbleheads” who claimed that housing prices were out of whack, then praised Paulson for refusing to bail out Lehman — just hours before financial markets went into full meltdown.

In other words, we seem to have learned the wrong lessons from our brush with disaster. As a result, when the next crisis comes, it’s likely to play out even worse than the last one. Isn’t that a happy thought?

Ben S. Bernanke, Timothy F. Geithner, Henry M. Paulson
Firefighting: The Financial Crisis and Its Lessons