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Stress for Success: a Review of Timothy Geithner's Financial Crisis

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Stress for Success: a Review of Timothy Geithner's Financial Crisis Journal of Economic Literature 2015, 53(4), 975–995 http://dx.doi.org/10.1257/jel.53.4.975 Stress for Success: A Review of Timothy Geithner’s Financial Crisis Memoir † Gary Gorton* Timothy Geithner’s memoir of the financial crisis of 2007–08—Stress Test: Reflections on Financial Crises—is an important historical document offering details of how policies were formed and implemented during the crisis, showing the political constraints, and offering lessons for future crises. Walter Bagehot’s classic rule for fighting crises— that the central bank should lend against good collateral at a high rate—is passive and incomplete. Geithner argues for the use of overwhelming force to reestablish confidence. Also, although the Federal Reserve’s new crisis lending programs needed to be anonymous so as not to reveal weak banks’ identities—“stigma”—the stress tests during the crisis did reveal information that may have been useful in reestablishing confidence. ( JEL B31, E44, E63, G01, G21, G28) 1. Introduction (i.e., the costs to banks from having their identity revealed at emergency lending pro- imothy Geithner’s memoir of the grams), navigating through the politics, the TFinancial Crisis of 2007–08, Stress Test: failure of Lehman Brothers, dealing with the Reflections on Financial Crises, is a valuable policy naysayers, and timing the use of over- historical record of the formation and imple- whelming force. During the crisis, a new tool mentation of the policy responses during the was introduced to reestablish confidence, crisis. Lessons for future crises can be dis- the stress tests of large banks. tilled from his recollections. Geithner’s crisis Events during the crisis were chaotic and response was informed by his direct experi- fast moving. Fundamentally, policymakers ences of the Mexican and Asian crises. In the did not know initially what was actually hap- book, he discusses conducting triage during pening, but had to respond, at first in reaction the crisis, the importance of avoiding stigma to events as they unfolded and then, with the Troubled Asset Relief Program and the stress tests, proactively. Timothy Geithner, like * Yale and NBER. Thanks to Michael Bordo, Lori Ben Bernanke, was there during the entire Gorton, Bengt Holmström, Andrew Metrick, Guillermo Ordoñez, and David Warsh for comments. Gorton con- crisis period, first as president of the Federal sulted at AIG Financial Products during 1996–2008, and Reserve Bank of New York (and coinciden- has consulting relationships with Starr Inc. and Barclays tally, vice chairman of the FOMC) and then Bank. † Go to http://dx.doi.org/10.1257/jel.53.4.975 to visit the as US treasury secretary. “Our response to article page and view author disclosure statement(s). the global financial crisis is still wrapped in 975 976 Journal of Economic Literature, Vol. LIII (December 2015) myth and haze and misperception. And I was is important; it cannot come too early, as that in the middle of it from start to finish . .” may signal that the situation is worse than (p. 12).1 “We lived through months of terror” the market thinks. And it cannot come so late (p. 19). His book is a record of this. as to be ineffective. It was largely Geithner Pretty much from the beginning, who had to get the timing right. Bernanke and Geithner spoke of the cri- Economics enters the memoir only with sis as a bank run. Then FOMC Governor reference to “moral hazard,” Bagehot’s Kevin Warsh (2009) noted the chaos in April rule, and Kindleberger’s 1996 book Manias, 2009: “Characterizing the current period as Panics and Crashes, which is mentioned in a ‘recession’ is still wanting, insufficient in passing. And that is a telling point for econ- some important respects. In my view, this omists. Economists had little to offer in period should equally be considered a panic the way of policy advice during the crisis. ,” likening it to the Panics of 1837, 1857, Kindleberger’s vague description of a cycle 1873, 1893, and 1907. But, a public narra- of manias, followed by panics, and ending in tive of the underlying causes of the crisis crashes seems to be a kind of reference point was not articulated until Bernanke (2009a, since macroeconomic models cannot display August), who explained the events as “ . crises. But Kindleberger does not explain a generalized run by providers of short-term financial crises and his description does not funding to a set of financial institutions, pos- lead to any policy advice. Economics (actu- sibly resulting in the failure of one or more of ally insurance) contributed the concept of those institutions.” “moral hazard.” Geithner’s point about moral Geithner emphasizes, and it is one of the hazard is that during a crisis, any policy to main points of the book, that what is needed ameliorate the situation is open to the charge to combat a financial crisis is the “. use of “moral hazard,” but a crisis is not the time of overwhelming force to quell panics . .” to address that issue. Moral hazard is per- (p. 397). “Overwhelming force” refers to haps controversial, but the first point—that having a credibly large amount of commit- we need models of crises—should not be. ted resources available to use with discretion During the crisis, there seems to have during a financial crisis. Geithner learned been a steady stream of criticism from this in the previous crises he experienced “moral hazard fundamentalists.” “. I found as a policymaker; the Mexican crisis and the more hawkish obsessions with moral the Asian crisis. However, obtaining and hazard and inflation during a credit crunch using overwhelming force is complicated bizarre and frustrating” (p. 131). And after by politics. “It turned out that things had Lehman: “I had heard enough moral haz- to get a lot worse before Congress would ard fundamentalism” (p. 217). Geithner even consider expanding our authority to becomes quite irritated at constantly being make things better, a common problem in told that crisis response policies would crisis response” (p. 164). “It took the fall of cause “moral hazard.” In fact, the term Lehman and the impending collapse of AIG “moral hazard fundamentalists” appears to to persuade President Bush and [Treasury have become part of the policymakers’ lex- Secretary] Hank [Paulson] to seek legislative icon during the crisis. Before he joined the authority to try to repair the entire system” Obama administration Larry Summers wrote (p. 208). The timing of overwhelming force an op ed in the Financial Times, September 23, 2007, entitled “Beware Moral Hazard 1 All unattributed quotations and pages numbers refer Fundamentalists,” arguing that in a financial to Geithner’s book. crisis “avoiding moral hazard” cannot be the Gorton: Stress for Success 977 basis for crisis response policies.2 Geithner costs to rise or maybe generating a bank run.5 also has this view. Stigma issues arise throughout the book. Lehman Brothers filed for bankruptcy on And although never mentioned by Bagehot, September 15, 2008, and within a month maintaining the secrecy of borrower identi- Congress passed the Troubled Asset Relief ties seems paramount during crises. Program (TARP). TARP was $700 billion During the crisis of 2007–08, the new allocated by Congress to address the crisis; Federal Reserve lending programs that it passed on October 3, 2008. Bernanke and were introduced were carefully designed to Geithner argue that they could not legally avoid stigma.6 The identities of borrowers have saved Lehman Brothers. Clearly, the were kept secret. But, the stress tests intro- results of the Lehman bankruptcy were dev- duced during the crisis had exactly the oppo- astating. Lingering still is the question of site goal: find and publicly reveal the weak whether large banks should be allowed to fail banks! The stress tests of the largest banks during a crisis. Was Lehman’s bankruptcy a are widely viewed as a great success. The mistake? A large part of the book is devoted banks calculated losses that they would incur to the events surrounding Lehman Brothers. during a forward-looking stress scenario Bagehot’s (1873) rule that in a crisis the proposed by the government. The banks’ central bank should lend freely, at a high rate, results (in terms of bank capital) were then and on good collateral is frustratingly vague.3 compared to the regulators’ calculations and In a crisis, events are not clear. In particular, then the results were announced in terms of it is not even clear if there is a crisis. During how much capital each bank would have to a crisis it is not exactly clear what consti- raise. Yet, there were no runs on the banks tutes “good collateral.”4 Bagehot’s advice is identified publicly as weak. The stress tests a passive and incomplete response to a cri- came late in the crisis and the results may sis. Most likely because it does not have the have eliminated any residual uncertainty. all the right tools, the central bank is, in a The information environment during a crisis way, passive because it relies on banks com- deserves careful study. ing forward to borrow. Use of the discount Broadly, policy responses in a crisis are window faces the problem of “stigma,” which fundamentally about managing expectations. refers to a bank’s reluctance to go to the dis- The lenders, who ran on the banks demand- count window because of fears that depos- ing cash, need to be convinced that it is safe itors, creditors, and investors will view this to lend again. That is, at one point in time, as a sign of weakness, causing its borrowing there is a panic, and later, beliefs are revised and the runs dissipate.
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