Midway through Timothy Geithner’s Stress Test, the former treasury secretary describes a late-2008 conversation with the then president-elect. Obama “wanted to discuss what he should try to accomplish.” Geithner’s reply was that his accomplishment would be “preventing a second Great Depression.” And Obama shot back that he didn’t want to be defined by what he had prevented.
It’s an ironic tale for Geithner to be telling, although it’s not clear whether he himself realizes just how ironic. For Stress Test is meant to be a story of successful policy—but that success is defined not by what happened but by what didn’t. America did indeed manage to avoid a full replay of the Great Depression—an achievement for which Geithner implicitly claims much of the credit, and with some justification. We did not, however, avoid economic disaster. By any plausible accounting, we’ve lost trillions of dollars’ worth of goods and services that we could and should have produced; millions of Americans have lost their jobs, their homes, and their dreams. Call it the Lesser Depression—not as bad as the 1930s, but still a terrible thing. Not to mention the disastrous consequences abroad.
Or to use one of the medical metaphors Geithner likes, we can think of the economy as a patient who was rushed to the emergency room with a life-threatening condition. Thanks to the urgent efforts of the doctors present, the patient’s life was saved. But while the doctors kept him alive, they failed to cure his underlying illness, so he emerged from the procedure partly crippled, and never fully recovered.
How should we think about the economic policy of these past seven or so years? Geithner, while acknowledging the disappointments, would have us view it mainly as a success story, because things could have been much worse. And the middle third of his book, a blow-by-blow account of the acute phase of the financial crisis, carries the implicit and sometimes explicit message that things would indeed have been much worse but for the heroic actions of a handful of high officials, himself included.
But this still leaves open the question of whether things could and should have been considerably better, whether preventing a complete economic meltdown was all that could have been accomplished. Here Geithner implicitly says no—or at least that there was nothing more that he himself could have done.
I’ll return to the questions about Geithner’s role later. First, however, let’s examine the nature of the economic crisis we experienced, and why emergency treatments haven’t produced a full return to health.
Something went very wrong with the US economy in 2008. But what?
Quite early on, two somewhat different stories emerged about the economic crisis. One story, which Geithner clearly preferred, saw it mainly as a financial panic—a supersized version of a classic bank run. And there certainly was a very frightening panic in 2008–2009. But the alternative story, which has grown more persuasive as the economy remains weak, sees the financial panic, while dangerous in its own right, as a symptom of something broader and deeper—mainly a large overhang of private debt, in particular household debt.
What’s the difference? A financial panic is above all about confidence, or rather the lack thereof, and the overriding task of policy is to restore confidence. And one way to think about policy in the crisis is to say that people like Tim Geithner and Ben Bernanke dealt forcefully and effectively with the urgent task of restoring confidence in the financial system.
But confidence in itself is not enough to deal with the broader consequences of a debt overhang. That takes policies that go well beyond saving financial institutions—policies like sustained fiscal stimulus and debt relief for families. Unfortunately, such policies were never forthcoming on a remotely adequate scale, which is why true recovery has remained so elusive. And although Geithner denies it, one contributing factor to the inadequacy of policy was surely the fact that he seemed uninterested in, and maybe even hostile to, the policies we needed after the panic subsided.
So, about the panic: Geithner offers a very good and clear explanation of what financial panics are all about. As he says, they’re basically the bank run from the movie It’s a Wonderful Life writ large. Banks are, more or less by definition, institutions that promise their creditors—depositors if they’re conventional banks—ready access to their funds; but they invest in assets that are relatively illiquid, that is, can’t be converted into cash on short notice. The reason this works is that under normal conditions, only a small fraction of a bank’s depositors will try to pull their money out on any given day.
But the risk of a run is always there. Suppose that for some reason many depositors do decide to demand cash at the same time. The bank won’t have that much cash on hand, and if it tries to raise more cash by selling assets, it will have to sell those assets at fire-sale prices. The result is that mass withdrawals can break a bank, even if it’s fundamentally solvent. And this in turn means that when investors fear that a bank may fail, their actions can produce the very failure they fear: depositors will rush to pull their money out if they believe that other depositors will do the same, and the bank collapses.
Now, we have an answer to this danger: federal deposit insurance, which has made old-fashioned bank runs obsolete by assuring depositors that they won’t lose their money. The problem, it turned out, was that by the mid-2000s much of the US financial system—more than half of it, by Geithner’s reckoning—consisted of “shadow banks,” which didn’t rely on traditional deposits but instead raised money through various forms of short-run borrowing. Lehman Brothers, for example, relied heavily on “repo”—short-term loans, mainly overnight, with assets like mortgage-backed securities as collateral. What became apparent in 2008 was that shadow banks were every bit as vulnerable to runs as conventional banks, but lacked any kind of public safety net.