Location: HQ1 Atrium, HQ1-1-700
Attendance: Open to all Participants with an Annual Meetings ID badge
This annual lecture series is sponsored by the Per Jacobsson Foundation, to foster and stimulate discussion of international monetary problems. Timothy F. Geithner, President of Warburg Pincus, former Secretary of the US Treasury, and President of the New York Federal Reserve, will deliver this year’s lecture on “Are We Safer: The Case for Updating Bagehot”.
Timothy F. Geithner President, Warburg Pincus, and former Secretary of the US Treasury and President of the New York Federal Reserve
“Are we Safer: The Case for Updating Bagehot”
Contributors: Veronika Sola and Rasheeda Smith Yee
Is the financial system safer today? With the reforms now in place and with the memory of the crisis still fresh, how confident should we feel about the resilience of the financial system and of policymakers’ ability to protect the U.S. economy from a major financial crisis?
- Financial systems are inherently fragile. Periods, like those in the run-up to the 2007 crisis, that combine a large increase in wealth or savings with optimistic beliefs about the economy can be particularly dangerous as this dynamic fuels demand for money-like short-term liabilities, and lowers the perceived risk in financing long-dated illiquid assets. These liabilities are dangerous because they are runnable. Once the run starts and the risk of financial collapse increases, the existential challenge is to break the panic by reducing the incentive for individuals to run from financial institutions and for financial institutions to run from each other.
- There is no way to protect the economy from a failing financial system without deploying public resources. However, politicians often perceive the costs of bailouts as higher than the cost of panic. The initial tendency is to do the exact opposite of what needs to be done. However, postponing action might lead to the necessity to socialize more risk and liabilities.
- To answer whether we are safer now we need to look at: (i) the resilience of the financial system today; (ii) the strength of the Keynesian arsenal; in terms of fiscal capacity to absorb losses and back stop the financial system, the room to use fiscal resources to cushion the fall in private demand, and the scope for monetary policy to lower interest rates; and (iii) the quality of the firefighting arsenal and the available knowledge and skill in deploying those tools.
- On the plus side, the post crisis reforms have produced a more resilient financial system. Capital buffers are able to absorb a much higher level of losses and the system is less prone to runs, with short-term liabilities of the major financial institutions substantially smaller as a share of the total. This mix of stronger shock absorbers should help limit the risk of contagious runs on financial institutions. These achievements, however, need to be considered in the context of the weaker Keynesian policy arsenal and the limitations on the emergency financial authorities.
- The financial reforms “born of the inevitable popular aversion to bailouts” that were implemented in the US do not make us safer. The combination of a more limited lender of last resort, no standing guarantee or broader capital authority, and a resolution regime designed to prevent the use of public resources and impose losses on current creditors leaves the financial system more vulnerable to the most dangerous crisis.
- Should the financial reforms be revisited and refined, it will be important to build in more room for discretion, keeping it as a complement, not as a substitute, for strong prudential safeguards. There is also a case to make a substantial ongoing investment in the practical knowledge of how to break panics and resolve crises.
Selected questions from the audience
- In response to a question on what is the political economy of getting a country, in particular an emerging economy, where it should be in terms of crisis preparedness, Geithner noted the objective should be to maximize the degrees of freedom, in particular in terms of the ability to use the Keynesian policy arsenal.
Reacting to whether monetary policy should be the preferred tool when responding to a financial crisis, Geithner remarked that fiscal policy is usually more constrained and can rarely be used without delays.
“Safety (in the financial system) is a function of the quality of prevention and the quality of decisions you make in the midst of the storm... It's just like in national security. We depend not just on diplomacy and espionage, and the moats and the castles, but on standing armies with weapons.”
“The objective should not be to eliminate the risk of failure of banks or large institutions.
Failure has its merits. It’s important for incentives, for innovation, for efficiency.”
“The incremental room available to policy makers in most “advanced” economies to respond to future crises is dramatically more limited than in 2008. This seems likely to be true for a long time”
“If you limit the ability of governments and central banks to respond ex ante to the unknown, you are choosing to live with a much greater risk of crisis,”
“"(It's mostly fiscal) is true in financial crisis too. Most of what you need in the end requires the broader resources of the state”
Timothy F. Geithner, President, Warburg Pincus, and former Secretary of the US Treasury and President of the New York Federal Reserve