The Journal of Economic Perspectives is a general-interest publication of the American Economic Association, designed to make the results of economic research more accessible to non-specialists and policy makers. I got to take part in its symposium on “Financial Regulation after the Crisis,” which is available here compliments of the AEA. When 11 different economists write five different articles, there is usually going to be a wide range of views. However, I feel somewhat lonely with my contribution, “A Year of Living Dangerously: The Management of the Financial Crisis in 2008.”
In the essay, I argue that U.S. financial authorities took some serious missteps that worsened the crisis. Chief among them was the decision to lend to Bear Stearns in mid-March to facilitate its resolution. This was a bad precedent that left a large footprint. I take this as a cautionary tale about government intervention.
Andrei Shleifer and Robert Vishny (professors, respectively, at Harvard University and the University of Chicago Booth School) give a clear explanation of their earlier work on “fire sales.” The term was used often in 2008 and refers to the possibility that troubled firms’ sales of financial assets would drive down asset prices and exacerbate balance-sheet strains. And, indeed, the Shleifer-Vishny framework implies government intervention can sometimes be justified.
They make the case of that possibility very forcefully. But what I find most fascinating is the main metaphor of the entire discussion. Shleifer and Vishny explain that the expression “fire sale has been around since the nineteenth century to describe firms selling smoke-damaged merchandise at cut-rate prices in the aftermath of a fire” (p. 30).
This prompts me to make three observations.
First, as any insurance agent can relate, most of the monetary damage from a fire comes from the water used to put it out. How a crisis is handled matters.
Second, how much does the low price of a smoke-damaged good owe to its forced sale and how much to the fact that it is damaged? In a crisis, this inference is critical to determining whether the government is helping an illiquid or an insolvent firm. In retrospect, the authorities were too optimistic in 2008 about the underlying value of mortgage-related assets. Three years later, the national unemployment rate is 9 percent, house prices are about 25 percent lower on average, and one-fifth of household mortgage holders have obligations of higher cost than their home’s value.
Third: after the fact, a fire marshal can usually trace the origin and propagation of the event. The forces shaping the contours of a crisis are harder to discern. As with a fire, the response of the authorities matter. Unlike a fire, there can be a self-fulfilling aspect in a crisis, partly as the consequence, as Justice Holmes related, of “shouting fire in a theater and causing a panic.” The understandable efforts of financial authorities to convince a recalcitrant Congress of the need to act, first on the government-sponsored enterprises in the summer and then on the Troubled Asset Relief Program in the fall, probably heightened public anxiety and contributed to the deterioration in confidence.
2008 was a year of living dangerously for financial authorities. The pity is that we have yet to learn all of the appropriate lessons.
The focus of financial markets is squarely upon stress tests for almost 100 European banks. European politicians and financial authorities are already predicting that the results will be judged a success.
The Senate’s passage of the Dodd-Frank financial reform bill is an event too discouraging to comment upon at length. What does it suggest we have learned as a nation from the past few years of financial turmoil?
The Federal Reserve’s policy setting group, the Federal Open Market Committee (FOMC), provides a documentary record of their deliberations in the form of lightly edited transcripts that are released with a five-year lag. The latest installment, all transcripts from 2004, was released last week. The transcripts are a goldmine for historians and serious analysts of monetary policy. Unfortunately, it is also possible to cobble together a controversy from more than a thousand pages of text that few people will consult directly.
So, it had to happen one day. Donald L. Kohn, vice chairman of the Federal Reserve Board of Governors, 
Congratulations are in order to Federal Reserve Chairman Ben Bernanke on his confirmation this afternoon by the Senate on a vote of 70 yeas and 30 nays. Unfortunately for him, commiserations are also in order because he has to lead an institution that is currently held in low esteem by the public and will almost surely see some of its independence eroded by a hostile Congress.
