Over the Cliff: from the Subprime to the Global Financial Crisis

Home , Bear Stearns, Lehman Brothers, List of bank runs, Shadow banking system

Journal of Economic Perspectives—Volume 25, Number 1—Winter 2011—Pages 49–70

Over the Cliff: From the Subprime to the Global Financial Crisis

Frederic S. Mishkin

hhee fi nancialnancial crisiscrisis ooff 22007007 ttoo 22009009 ccanan bbee ddividedivided iintonto ttwowo ddistinctistinct pphases.hases. TThehe fi rstrst andand moremore limitedlimited phasephase ffromrom AAugustugust 22007007 ttoo AAugustugust 22008008 sstemmedtemmed T ffromrom losseslosses iinn oonene rrelativelyelatively ssmallmall ssegmentegment ooff tthehe UU.S..S. fi nancialnancial system—system— nnamely,amely, subprimesubprime rresidentialesidential mmortgages.ortgages. DDespiteespite tthishis ddisruptionisruption ttoo fi nancialnancial markets,markets, rrealeal GDPGDP inin tthehe UUnitednited SStatestates ccontinuedontinued ttoo rriseise iintonto tthehe ssecondecond qquarteruarter ooff 22008,008, aandnd fforecastersorecasters wwereere ppredictingredicting oonlynly a mmildild rrecession.ecession. FForor eexample,xample, tthehe CCongres-ongres- ssionalional BBudgetudget OOffiffi cece (2008)(2008) rreleasedeleased oonene ooff iitsts pperiodiceriodic ““TheThe BBudgetudget aandnd EEconomicconomic OOutlook:utlook: AnAn Update”Update” reportsreports onon SeptemberSeptember 8,8, 2008.2008. ItIt said:said: “Accor“Accor ddinging toto CBO’sCBO’s uupdatedpdated forecastforecast fforor tthehe rrestest ooff 22008008 aandnd fforor 22009,009, tthehe eeconomyconomy iiss aaboutbout hhalfwayalfway tthroughhrough anan extendedextended pperioderiod ooff veryvery slowslow growth.growth. . . . WWhetherhether oorr nnotot tthathat pperioderiod ooff sslowlow growthgrowth wwillill uultimatelyltimately bbee ddesignatedesignated a rrecessionecession iiss sstilltill uuncertain.ncertain. HHowever,owever, tthehe iincreasencrease inin thethe unemploymentunemployment rrateate aandnd tthehe ppaceace ooff eeconomicconomic ggrowthrowth aarere ssimilarimilar ttoo cconditionsonditions dduringuring ppreviousrevious mmildild rrecessions.”ecessions.” IInn kkeepingeeping wwithith tthathat vview,iew, CCBOBO pprojectedrojected tthathat unemploymentunemployment wouldwould riserise modestlymodestly fromfrom 5.45.4 percentpercent inin 20082008 toto 6.26.2 percentpercent inin 22009009 andand thatthat fourth-quarterfourth-quarter toto fourth-quarterfourth-quarter rrealeal GDPGDP wouldwould growgrow onlyonly 0.90.9 percentpercent iinn 20082008 butbut wwouldould rreboundebound mmodestlyodestly ttoo 11.8.8 ppercentercent ggrowthrowth iinn 22009.009. IInn ssummerummer ooff 22008,008, wwhenhen I wwasas sservingerving oonn tthehe FFederalederal RReserveeserve BBoardoard ooff GGovernors,overnors, ttherehere wwasas eevenven ttalkalk thatthat tthehe FFeded mmightight nneedeed ttoo rraiseaise iinterestnterest rratesates ttoo kkeepeep iinflnfl ationation underunder ccontrol.ontrol. IInn mmid-Septemberid-September 2008,2008, hhowever,owever, tthehe fi nancialnancial crisiscrisis enteredentered a farfar moremore vvirulentirulent phase.phase. InIn rapidrapid succession,succession, thethe investmentinvestment bankbank LehmanLehman BrothersBrothers

■ FFredericrederic S.S. MishkinMishkin isis AAlfredlfred LernerLerner ProfessorProfessor ofof BankingBanking andand FinancialFinancial Institutions,Institutions, GGraduateraduate SchoolSchool ofof Business,Business, ColumbiaColumbia University,University, NewNew YorkYork City,City, NewNew York.York. HeHe isis alsoalso a RResearchesearch AAssociate,ssociate, NNationalational BBureauureau ooff EEconomicconomic RResearch,esearch, CCambridge,ambridge, MMassachusetts.assachusetts. FFromrom SSeptembereptember 20062006 toto AAugustugust 22008,008, hhee wwasas a MMember,ember, BBoardoard ooff GGovernorsovernors ooff tthehe FFederalederal RReserveeserve SSystem,ystem, WWashington,ashington, D.C.D.C. HisHis e-maile-mail addressaddress isis 〈 [email protected]@columbia.edu〉. doi=10.1257/jep.25.1.49 50 Journal of Economic Perspectives

eenteredntered bankruptcybankruptcy onon SeptemberSeptember 15,15, 2008;2008; thethe insuranceinsurance fi rmrm AIGAIG collapsedcollapsed onon SSeptembereptember 116,6, 2008;2008; therethere waswas a runrun onon thethe ReserveReserve PrimaryPrimary FundFund moneymoney marketmarket ffundund oonn tthehe ssameame dday;ay; aandnd tthehe hhighlyighly ppublicizedublicized sstruggletruggle ttoo ppassass tthehe TTroubledroubled AAssetsset RReliefelief PProgramrogram ((TARP)TARP) bbegan.egan. HHowow ddidid ssomethingomething tthathat aappearedppeared inin mid-2008mid-2008 toto bebe a ssignifiignifi cantcant butbut fairlyfairly mmildild fi nnancialancial ddisruptionisruption transformtransform intointo a full-flfull-fl edgededged globalglobal fi nancialnancial crisis?crisis? WhatWhat ccausedaused thisthis transformation?transformation? DidDid thethe governmentgovernment responsesresponses toto thethe globalglobal fi nancialnancial ccrisisrisis helphelp avoidavoid a worldwideworldwide depression?depression? WhatWhat challengeschallenges dodo thesethese governmentgovernment iinterventionsnterventions raiseraise forfor tthehe wworldorld fi nancialnancial systemsystem andand thethe economyeconomy goinggoing forward?forward? LLet’set’s sstarttart wwithith a bbriefrief ssteptep bbackack ttoo tthehe fi rstrst phasephase ofof thethe globalglobal fi nancialnancial crisis.crisis.

TThehe FFirstirst PPhase:hase: TThehe SSubprimeubprime MMortgageortgage CrisisCrisis

TThehe fi r rstst ddisruptionisruption ofof creditcredit marketsmarkets inin thethe recentrecent fi n nancialancial crisiscrisis isis oftenoften dateddated ttoo AugustAugust 7,7, 22007,007, wwhenhen tthehe FFrenchrench bbankank BBNPNP PParibasaribas ssuspendeduspended rredemptionedemption ooff sshareshares heldheld inin somesome ofof itsits mmoneyoney mmarketarket ffunds.unds. A bboomoom iinn UU.S..S. hhousingousing ppricesrices hhadad ppeakedeaked aaroundround 22005.005. AAss hhousingousing ppricesrices sstartedtarted ttoo ddecline,ecline, mmortgage-backedortgage-backed fi nan-nan- ccialial securities—insecurities—in mmanyany ccases,ases, ssecuritiesecurities bbasedased oonn ssubprimeubprime rresidentialesidential mmortgagesortgages bbutut thenthen divideddivided iintonto mmoreore sseniorenior cclaimslaims tthathat wwereere ssupposedlyupposedly ssafeafe aandnd jjuniorunior cclaimslaims thatthat werewere recognizedrecognized toto bebe risky—beganrisky—began toto experienceexperience hugehuge losses.losses. ByBy earlyearly 22008,008, losseslosses oonn tthesehese ssecuritiesecurities wwereere eestimatedstimated ttoo bbee oonn tthehe oorderrder ooff $$500500 bbillionillion ddollarsollars (for(for eexample,xample, GGreenlaw,reenlaw, HHatzius,atzius, KKashyap,ashyap, aandnd SShin,hin, 22008).008). WWhathat developeddeveloped iinn llateate 22007007 aandnd iintonto 22008008 wwasas a sserieseries ooff rrunsuns oonn fi nancialnancial iinstitutions.nstitutions. ButBut iinsteadnstead ooff tthehe cclassiclassic bbankank rrun,un, iitt wwas,as, aass ddescribedescribed bbyy GGortonorton aandnd MMetricketrick ((2009),2009), a rrunun oonn tthehe sshadowhadow bbankinganking ssystem.ystem. A bbankank hhasas ddepositseposits tthathat aarere sshort-termhort-term liabilitiesliabilities andand assetsassets tthathat aarere llong-termong-term lloans.oans. TThus,hus, iinn a cclassiclassic bbankank rrun,un, whenwhen bbankank ddepositorsepositors rrunun ttoo wwithdrawithdraw ddeposits,eposits, tthehe bbankank ccannotannot rreadilyeadily cconvertonvert itsits long-termlong-term assetsassets intointo cash.cash. InIn thethe shadowshadow bankingbanking system,system, institutionsinstitutions hhaveave short-termshort-term liabilitiesliabilities inin thethe formform ofof short-termshort-term borrowing,borrowing, likelike repurchaserepurchase aagreementsgreements (or(or repos),repos), wwhichhich uusese llonger-termonger-term aassetsssets llikeike mmortgage-backedortgage-backed ssecuri-ecuri- ttiesies asas collateral.collateral. A kkeyey eelementlement ooff tthishis bborrowingorrowing iiss tthehe uusese ooff a ““haircut,”haircut,” tthathat iis,s, a requirementrequirement tthathat bborrowersorrowers ppostost ccollateralollateral tthathat iiss vvaluedalued aatt mmoreore tthanhan tthehe lloan.oan. FForor eexample,xample, iiff a bborrowerorrower ttookook ooutut a $$100100 mmillionillion lloanoan iinn a rrepoepo aagreement,greement, iitt mmightight hhaveave ttoo ppostost $$105105 mmillionillion ooff mmortgage-backedortgage-backed ssecuritiesecurities aass ccollateral,ollateral, aandnd tthehe haircuthaircut wouldwould tthenhen bbee 5 ppercent.ercent. AAss tthehe vvaluealue ooff mmortgage-backedortgage-backed ssecuritiesecurities ffellell andand uncertaintyuncertainty aboutabout theirtheir futurefuture valuevalue increased,increased, haircutshaircuts roserose toto levelslevels asas hhighigh asas 5050 ppercent.ercent. TThehe rresultesult wwasas tthathat tthehe ssameame aamountmount ooff ccollateralollateral wwouldould nnowow ssupportupport lessless borrowing,borrowing, leadingleading toto deleveragingdeleveraging inin whichwhich fi nancialnancial institutionsinstitutions hhadad toto sellsell offoff assets.assets. TheThe resultingresulting “fi“fi rere sale”sale” dynamicdynamic (discussed(discussed byby ShleiferShleifer andand VVishnyishny inin tthishis iissue)ssue) lleded ttoo aann aadversedverse ffeedbackeedback lloopoop iinn wwhichhich tthehe ddeclineecline iinn aassetsset vvaluesalues loweredlowered tthehe ccollateral’sollateral’s vvaluealue wwhilehile ffurtherurther rraisingaising uuncertainty,ncertainty, ccausingausing hhaircutsaircuts toto riserise further,further, forcingforcing fi nancialnancial institutionsinstitutions toto deleveragedeleverage andand sellsell moremore aassets,ssets, andand soso on.on. Frederic S. Mishkin 51

Figure 1 Credit Spreads 2000–2009

Bear Stearns rescue Beginning of Lehman 7.00 financial crisiss Brothers TED spread bankruptcy 6.00 Baa spread 5.00

4.00

3.00

Interest rate (percent) 2.00

1.00

0.00 6.05 Jan. 00 Jan. 01 Jan. 02 Jan. 03 Jan. 04 Jan. 05 Jan. 06 Jan. 07 Jan. 08 Jan. 09

Source: FRED, Federal Reserve Bank of St. Louis, and British Bankers’ Association. Note: The TED spread is the difference between the 3-month LIBOR rate and the constant maturity 3-month Treasury bill rate. The Baa spread is the difference between the constant maturity Baa rate and the 10-year constant maturity Treasury bond rate.

OOnene ssignalignal ofof thethe resultingresulting creditcredit marketmarket disruptionsdisruptions appearsappears inin thethe interestinterest rrateate sspreadspreads bbetweenetween safesafe andand rriskyisky fi nancialnancial instruments.instruments. ForFor example,example, thethe “TED“TED sspread”pread” isis thethe spreadspread betweenbetween thethe interestinterest raterate onon interbankinterbank lendinglending (as(as measuredmeasured bbyy tthehe LLIBORIBOR iinterestnterest rrateate oonn tthree-monthhree-month eeurodollarurodollar ddeposits)eposits) aandnd tthehe iinterestnterest rrateate onon three-monththree-month U.S.U.S. TreasuryTreasury bills.bills. TheThe TEDTED spreadspread providesprovides anan assessmentassessment ooff ccounterpartyounterparty riskrisk fromfrom oneone bankbank lendinglending toto another,another, reflrefl ectingecting bothboth liquidityliquidity aandnd creditcredit riskrisk concerns.concerns. FigureFigure 1 showsshows howhow thethe TEDTED spreadspread rocketedrocketed upup fromfrom anan aaverageverage ofof aroundaround 4040 basisbasis pointspoints (0.40(0.40 percentagepercentage points)points) beforebefore AugustAugust 7,7, 2007,2007, ttoo 224040 bbasisasis ppointsoints bbyy AAugustugust 220,0, 22007,007, bbeforeefore aabatingbating ssomewhat.omewhat. TThehe collapsecollapse ofof BearBear StearnsStearns inin MarchMarch 20082008 waswas thethe mostmost visiblevisible ofof thesethese runsruns oonn thethe shadowshadow fi nancingnancing system.system. Short-termShort-term fi nancingnancing forfor BearBear StearnsStearns drieddried up.up. IItsts long-termlong-term assetsassets couldcould notnot quicklyquickly bebe turnedturned intointo readyready cashcash atat a fairfair price,price, andand wwithoutithout accessaccess toto short-termshort-term funding,funding, itit couldcould notnot continue.continue. TheThe FederalFederal ReserveReserve bbrokeredrokered a dealdeal forfor JPMorganJPMorgan ChaseChase toto purchasepurchase Bear,Bear, whichwhich waswas notnot unprece-unprece- ddented,ented, butbut asas partpart ofof thethe dealdeal thethe FedFed alsoalso tooktook ontoonto itsits booksbooks $30$30 billionbillion ofof BearBear SStearns’stearns’s ttoxicoxic aassets,ssets, whichwhich waswas unprecedented.unprecedented. However,However, thisthis dealdeal andand thethe openingopening ooff nnewew FFederalederal RReserveeserve llendingending ffacilitiesacilities ttoo iinvestmentnvestment bbanksanks hhelpedelped rrestoreestore ssomeome ccalmalm ttoo tthehe mmarket.arket. TThehe TTEDED sspreadpread ssurgedurged ttoo ooverver 220000 bbasisasis ppointsoints iinn MMarcharch 22008008 bbutut tthenhen ffellell bbackack bbelowelow 110000 bbasisasis ppoints.oints. BByy ssummerummer 22008,008, ccreditredit mmarketsarkets wwereere cclearlylearly iimpairedmpaired aandnd ccreditredit rriskisk wwasas rrising,ising, asas cancan bebe seenseen byby thethe riserise inin thethe spreadspread betweenbetween interestinterest ratesrates onon BaaBaa corpo-corpo- rrateate bondsbonds andand TreasuryTreasury bondsbonds inin FigureFigure 1.1. However,However, thethe fi nancialnancial crisiscrisis lookedlooked llikeike iitt ccouldould bebe contained.contained. TheThe Baa–TreasuryBaa–Treasury spreadspread hadhad climbedclimbed toto overover 200200 basisbasis ppoints,oints, butbut thesethese levelslevels werewere similarsimilar toto thosethose thatthat occurredoccurred inin thethe aftermathaftermath ofof thethe 52 Journal of Economic Perspectives

mmildild rrecessionecession inin 22001.001. TThehe TTEDED sspread,pread, aalthoughlthough eelevated,levated, wwasas aalsolso bbelowelow iitsts ppeakeak vvaluesalues immediatelyimmediately afterafter thethe revelationsrevelations ofof problemsproblems atat BNPBNP ParibasParibas andand thethe BearBear SStearnstearns collapse.collapse. ManyMany publicpublic andand privateprivate forecastersforecasters reasonedreasoned thatthat thethe worstworst waswas pprobablyrobably over.over. AAfterfter aall,ll, ttheyhey aargued,rgued, thethe subprimesubprime mortgagemortgage sectorsector waswas onlyonly a smallsmall ppartart ooff ooverallverall ccapitalapital mmarkets,arkets, aandnd tthehe llossesosses iinn tthehe rrelatedelated mmortgage-backedortgage-backed ssecuri-ecuri- tties,ies, aalthoughlthough ssubstantial,ubstantial, seemedseemed mmanageable.anageable. IIndeed,ndeed, tthehe CCongressionalongressional BudgetBudget OOffiffi cece (2008)(2008) waswas forecastingforecasting inin earlyearly SeptemberSeptember 20082008 thatthat thethe ConsumerConsumer PricePrice IIndexndex wouldwould riserise fromfrom 2.92.9 percentpercent inin 20072007 toto 4.74.7 percentpercent inin 2008.2008. AsAs discusseddiscussed inin WWesselessel (2009),(2009), therethere waswas talktalk inin thethe FederalFederal ReserveReserve asas toto whetherwhether thethe easingeasing phasephase ooff mmonetaryonetary ppolicyolicy mmightight hhaveave ttoo bbee rreversedeversed ttoo ccontainontain iinflnfl ation.ation. TThehe storystory ooff tthishis fi rstrst phasephase ooff tthehe 22007–2009007–2009 fi nancialnancial crisiscrisis hashas bbeeneen ddiscussediscussed eextensivelyxtensively inin manymany places,places, includingincluding inin symposiasymposia inin thethe WinterWinter 20092009 andand WinterWinter 22010010 issuesissues ofof tthishis jjournal.ournal. HHere,ere, tthehe ffocusocus iiss oonn uunderstandingnderstanding wwhathat hhappenedappened nnext.ext.

TThehe SSecondecond PPhase:hase: GGloballobal FinancialFinancial CCrisisrisis

IInn thethe spacespace ofof a fewfew shortshort weeksweeks inin SeptemberSeptember 2008,2008, everythingeverything changed.changed. OnOn MMonday,onday, SSeptembereptember 15,15, 2008,2008, afterafter sufferingsuffering losseslosses inin thethe subprimesubprime market,market, LehmanLehman BBrothers,rothers, thethe fourth-largestfourth-largest investmentinvestment bankbank byby assetasset sizesize withwith overover $600$600 billionbillion inin aassetsssets aandnd 225,0005,000 employees,employees, fi ledled forfor bankruptcy—thebankruptcy—the largestlargest bankruptcybankruptcy fi lingling iinn U.S.U.S. history.history. ManyMany discussionsdiscussions ofof thethe evolutionevolution ofof thethe fi nancialnancial crisiscrisis viewview thethe LLehmanehman bankruptcybankruptcy asas thethe keykey eventevent thatthat morphedmorphed thethe subprimesubprime crisiscrisis intointo a viru-viru- llentent globalglobal fi nancialnancial crisis.crisis. AlthoughAlthough thethe LehmanLehman bankruptcybankruptcy ledled a largelarge increaseincrease iinn uncertaintyuncertainty andand a wavewave ofof distresseddistressed sellingselling ofof securitiessecurities thatthat causedcaused a collapsecollapse iinn aassetsset pricesprices andand a dryingdrying upup ofof liquidity,liquidity, I willwill argueargue thatthat thethe collapsecollapse ofof LehmanLehman wwasas ffollowedollowed bbyy tthreehree eeventsvents tthathat wwereere aatt lleasteast aass iimportantmportant iinn ccausingausing tthehe ssubprimeubprime ccrisisrisis ttoo ggoo gglobal:lobal: tthehe AAIGIG ccollapseollapse oonn SSeptembereptember 116,6, 22008;008; tthehe rrunun oonn tthehe RReserveeserve PPrimaryrimary FFundund onon thethe samesame day;day; andand thethe strugglestruggle toto getget thethe TroubledTroubled AssetAsset ReliefRelief PPlanlan ((TARP)TARP) aapprovedpproved byby CCongressongress ooverver tthehe ffollowingollowing couplecouple ofof weeks.weeks. IInn consideringconsidering thesethese events,events, it’sit’s alsoalso importantimportant toto rememberremember thatthat thethe fi nan-nan- ccialial ssystemystem hhadad bbeeneen ggreatlyreatly weakenedweakened beforebefore SeptemberSeptember 20082008 inin waysways thatthat werewere nnotot yyetet ffullyully recognized.recognized. JustJust asas a relativelyrelatively smallsmall soundsound oror vibrationvibration cancan triggertrigger anan aavalanchevalanche ifif thethe snowsnow conditionsconditions havehave mademade thethe dangerdanger ofof suchsuch anan avalancheavalanche high,high, iitt mmayay bbee tthathat ggiveniven tthehe aamountmount ooff ssystemicystemic rriskisk eembeddedmbedded iinn tthehe fi nancialnancial system,system, ssomeome ootherther stressstress oorr ffailureailure ofof a fi nancialnancial institutioninstitution wouldwould alsoalso havehave revealedrevealed thethe ffragilityragility ofof thethe fi nancialnancial system—andsystem—and thenthen ledled toto a chainchain reactionreaction thatthat couldcould alsoalso hhaveave ttippedipped tthehe fi nancialnancial systemsystem overover thethe cliff.cliff.

TThehe LLehmanehman BBankruptcyankruptcy MManyany commentatorscommentators havehave arguedargued thatthat thethe TreasuryTreasury andand thethe Fed’sFed’s decisiondecision ttoo aallowllow LLehmannehmann ttoo ggoo bbankruptankrupt wwasas a ccolossalolossal mmistakeistake tthathat tturnedurned a mmildild fi nnancialancial disruptiondisruption iintonto a ggloballobal fi nnancialancial crisis.crisis. WithWith hhindsight,indsight, iitt iiss hhardard ttoo aarguergue thatthat allowingallowing LLehmanehman ttoo ggoo bbankruptankrupt wwasas tthehe rrightight ddecision.ecision. BButut iit’st’s uusefulseful Over the Cliff: From the Subprime to the Global Financial Crisis 53

ttoo rememberremember tthathat aatt tthehe ttime,ime, ttherehere wwasas a pplausiblelausible ccasease fforor llettingetting LLehmanehman ggoo iintonto bankruptcy.bankruptcy. FFirst,irst, iinn ppracticalractical tterms,erms, tthehe UU.S..S. ggovernmentovernment oorr iitsts rregulatoryegulatory aauthoritiesuthorities hhadad nnoo aauthorityuthority toto putput LehmanLehman iintonto a governmentgovernment cconservatorshiponservatorship ssoo iitt ccouldould kkeepeep ffunc-unc- ttioning,ioning, aass tthehe TTreasuryreasury wwasas aableble ttoo ddoo wwithith FFannieannie MMaeae andand FreddieFreddie MMac.ac. TThus,hus, tthehe oonlynly ppossibleossible ssolutionolution wwasas ttoo bbrokerroker a ppurchaseurchase ooff LLehman.ehman. BBarclaysarclays wwasas iinn ddiscussionsiscussions aaboutbout bbuyinguying LLehman,ehman, bbutut BBritishritish bbankank rregulatorsegulators wwereere sskeptical,keptical, aandnd tthehe FFeded rrefusedefused ttoo ttakeake mmoreore bbadad aassetsssets oontonto iitsts bbalancealance ssheet,heet, aass iitt hhadad ddoneone wwithith BBearear Stearns.Stearns. BBarclaysarclays eendednded uupp bbuyinguying ppartsarts ooff LLehmanehman a wweekeek aafterfter iitt ddeclaredeclared bbankruptcy.ankruptcy. SSecond,econd, thethe bailoutbailout ofof BearBear StearnsStearns hadhad extendedextended thethe governmentgovernment safetysafety nnetet ooutsideutside thethe bankingbanking systemsystem toto investmentinvestment banks,banks, andand thethe U.S.U.S. TreasuryTreasury andand thethe FFederalederal RReserveeserve wwereere cconcernedoncerned aaboutbout iincreasingncreasing tthehe mmoraloral hhazardazard iincentivesncentives fforor a wwiderider ssetet ooff fi nancialnancial institutionsinstitutions toto taketake onon excessiveexcessive risk.risk. Indeed,Indeed, asas wewe nownow know,know, LLehmanehman waswas goinggoing toto extraordinaryextraordinary efforts,efforts, includingincluding shadyshady accountingaccounting practices,practices, ttoo hidehide itsits leverage,leverage, eveneven afterafter thethe fi nancialnancial crisiscrisis startedstarted inin AugustAugust 2007.2007.1 LLettingetting LLehmanehman failfail wouldwould serveserve asas a warningwarning toto otherother fi nancialnancial fi rmsrms thatthat theythey neededneeded toto rreinein iinn ttheirheir rriskisk ttaking.aking. TThird,hird, itit waswas anan openopen secretsecret inin thethe fi nancialnancial marketsmarkets andand amongamong governmentgovernment ooffiffi ccialsials tthathat iiff aanyny ooff thethe majormajor investmentinvestment banksbanks wouldwould runrun intointo trouble,trouble, LehmanLehman wwouldould bbee aatt tthehe ttopop ooff tthehe llist.ist. LLehmanehman wwasas aamongmong tthehe mmostost lleveragedeveraged ooff tthehe mmajorajor iinvestmentnvestment banks;banks; itit waswas unwillingunwilling toto raiseraise capital;capital; itit hadhad a poorpoor reputationreputation forfor riskrisk mmanagement;anagement; aandnd iitt hhadad a hhighigh eexposurexposure ttoo llossesosses oonn ssubprimeubprime mmortgagesortgages bbecauseecause iitt hhadad llargearge hholdingsoldings ooff ssecuritiesecurities ttiedied ttoo vvaluationsaluations ooff tthesehese mmortgagesortgages oonn iitsts bbooksooks ((McDonald,McDonald, 2009;2009; SSorkin,orkin, 22009).009). SSorkinorkin ((2009)2009) ddocumentsocuments tthathat iimmediatelymmediately aafterfter thethe BearBear StearnsStearns bailout,bailout, thethe U.S.U.S. TreasuryTreasury SecretarySecretary immediatelyimmediately turnedturned hishis aattentionttention toto LehmanLehman becausebecause hehe thoughtthought itit wwouldould bebe thethe nextnext ttroublerouble spot.spot. WWithith LLehman’sehman’s vvulnerabilityulnerability alreadyalready well-known,well-known, LehmanLehman seemedseemed likelike a naturalnatural testtest casecase ttoo pproviderovide aann oobjectbject llessonesson tthathat mmarketarket pparticipantsarticipants sshouldhould ttakeake mmeasureseasures ttoo pprotectrotect tthemselves.hemselves. IIndeed,ndeed, manymany ooff tthehe dderivativeerivative contractscontracts withwith Lehman’sLehman’s ccounterpartiesounterparties wwereere uunwoundnwound ssuccessfullyuccessfully afterafter Lehman’sLehman’s bbankruptcy.ankruptcy. FFinally,inally, tthehe fi nancialnancial systemsystem inin mid-Septembermid-September 20082008 waswas farfar moremore vulnerablevulnerable tthanhan aalmostlmost aallll ppolicymakersolicymakers aandnd mmarketarket pparticipantsarticipants rrealizedealized aatt tthathat ttime.ime. TTherehere iiss a ddistinctistinct possibilitypossibility thatthat thethe fi nancialnancial systemsystem wouldwould havehave implodedimploded eveneven ifif LehmanLehman hhadad bbeeneen bbailedailed oout.ut.

TThehe AAIGIG CCollapseollapse TThehe FFinancialinancial PProductsroducts UUnitnit ooff AAmericanmerican IInternationalnternational GroupGroup (AIG)(AIG) hadhad wwrittenritten overover $400$400 billionbillion dollarsdollars ofof insuranceinsurance contractscontracts calledcalled creditcredit defaultdefault swaps,swaps, wwhichhich hadhad ttoo mmakeake ppaymentsayments wwhenhen ssubprimeubprime mmortgageortgage ssecuritiesecurities ssuffereduffered llosses.osses.

1 As described in the Examiner’s Report for the United States Bankruptcy Court, Southern District of New York (Valukas, 2010), Lehman Brothers used a repo transaction, referred to as Repo 105, to reduce net leverage by $50 billion when reporting earnings at Q1 2008 and Q2 2008. In this transaction, repos were treated as sales, rather than borrowings, thereby taking them off the books. In addition, Lehman did not report that only $2 billion of $40 billion of liquid assets were readily accessible. 54 Journal of Economic Perspectives

WWithith thethe LehmanLehman BrothersBrothers collapse,collapse, itit seemedseemed moremore likelylikely thatthat AIGAIG mightmight havehave ttoo mmakeake eenormousnormous ppaymentsayments uundernder thesethese ccontracts,ontracts, soso short-termshort-term fundingfunding toto AIGAIG ddriedried up.up. OnOn SSeptembereptember 116,6, 22008,008, tthehe FFederalederal RReserveeserve ssteppedtepped iinn wwithith aann $$8585 bbillionillion lloanoan toto keepkeep AIGAIG aflafl oatoat (with(with totaltotal loansloans fromfrom thethe FedFed andand thethe U.S.U.S. governmentgovernment eeventuallyventually rrisingising ttoo ooverver $$170170 bbillion).illion). TThehe enormousenormous risk-takingrisk-taking atat AIGAIG andand itsits potentialpotential toto blowblow upup thethe fi nancialnancial ssystemystem hhadad bbeeneen llargelyargely unrecognizedunrecognized byby governmentgovernment offioffi cials,cials, regulators,regulators, andand mmarkets.arkets. OnceOnce BBearear StearnsStearns hadhad toto bebe bailedbailed out,out, itit becamebecame apparentapparent thatthat a widerwider ggrouproup ooff fi nancialnancial institutionsinstitutions couldcould posepose majormajor systemicsystemic risksrisks toto thethe fi nancialnancial system.system. BButut iinn ddiscussionsiscussions atat tthathat ttimeime aamongmong rregulatorsegulators andand academicsacademics aboutabout thethe needneed toto rregulateegulate a widerwider groupgroup ofof fi nancialnancial institutionsinstitutions (in(in whichwhich I participated),participated), AIGAIG waswas not mentionedmentioned inin thethe categorycategory ofof fi rmsrms thatthat wouldwould requirerequire specialspecial supervisorysupervisory atten-atten- ttion.ion. This,This, alongalong withwith FedFed ChairmanChairman Bernanke’sBernanke’s laterlater statementstatement inin CongressionalCongressional ttestimonyestimony aboutabout howhow angryangry hehe waswas thatthat AIGAIG tooktook onon suchsuch risk,risk, describingdescribing AIGAIG asas eeffectivelyffectively runningrunning a hugehuge hedgehedge fundfund insideinside anan insuranceinsurance companycompany (Torres(Torres andand SSon,on, 22009),009), iindicatesndicates tthathat tthehe AAIGIG bblow-uplow-up wwasas a ssurprise.urprise.

RReserveeserve PPrimaryrimary FFundund TThehe ssameame ddayay ooff tthehe AAIGIG ccollapse—Septemberollapse—September 116,6, 22008—also008—also ssawaw a rrunun oonn tthehe ReserveReserve PrimaryPrimary Fund,Fund, a largelarge moneymoney marketmarket mmarketarket ffundund rrunun bbyy BBruceruce BBent,ent, oonene ofof thethe originatorsoriginators ofof moneymoney marketmarket mmutualutual ffundsunds iinn 11970.970. BBeforeefore tthehe ccrisis,risis, BBentent hadhad publiclypublicly criticizedcriticized thethe industryindustry forfor takingtaking onon tootoo muchmuch riskrisk inin itsits assetasset hholdings.oldings. HHee sstatedtated iinn a lletteretter ttoo tthehe SSecuritiesecurities aandnd EExchangexchange CCommissionommission iinn SSeptembereptember 20072007 (Bent,(Bent, 2007):2007): “When“When I fi rstrst createdcreated thethe moneymoney marketmarket fundfund inin 11970,970, itit waswas designeddesigned withwith thethe tenetstenets ofof safetysafety andand liquidity.”liquidity.” HeHe addedadded thatthat thesethese pprinciplesrinciples hadhad “fallen“fallen byby thethe waysidewayside aass pportfolioortfolio mmanagersanagers cchasedhased tthehe hhighestighest yyieldield andand ccompromisedompromised tthehe iintegrityntegrity ooff tthehe mmoneyoney ffund.”und.” AAlas,las, BBentent ddidid nnotot ffollowollow hhisis ownown advice,advice, andand thethe ReserveReserve PPrimaryrimary FFundund hheldeld $$785785 mmillionillion ooff LLehmanehman ppaper.aper. WithWith thethe LLehmanehman bbankruptcy,ankruptcy, tthehe ffundund ccouldould nnoo llongeronger aaffordfford ttoo rredeemedeem iitsts sharesshares atat thethe parpar valuevalue ofof $1—a$1—a situationsituation knownknown asas “breaking“breaking thethe buck”—andbuck”—and sshareholdershareholders pulledpulled outout theirtheir money,money, withwith thethe fundfund losinglosing 9090 percentpercent ofof itsits assets.assets. A runrun onon otherother mmoneyoney mmarketarket ffundsunds ffollowed,ollowed, wwithith aassetsssets iinn iinstitutionalnstitutional mmoneyoney mmarketarket mutualmutual ffundsunds ffallingalling ffromrom $$1.361.36 ttrillionrillion ttoo $$0.970.97 ttrillionrillion ffromrom SSeptembereptember ttoo OctoberOctober 2008.2008. InIn turn,turn, thisthis runrun putput pressurepressure onon thethe banks,banks, sincesince a signifisignifi cantcant aamountmount ooff bbankank ffundingunding wwasas ccomingoming ffromrom bbankank ccommercialommercial ppaperaper aandnd ccertifiertifi catescates ooff depositsdeposits hheldeld bbyy mmoneyoney mmarketarket mmutualutual ffunds.unds.

TTARPARP IInn tthehe wakewake ofof thesethese events,events, U.S.U.S. TreasuryTreasury Secretary,Secretary, HankHank Paulson,Paulson, thenthen pproposedroposed onon SeptemberSeptember 19,19, 2008,2008, thethe TroubledTroubled AssetAsset ReliefRelief ProgramProgram (TARP)(TARP) iinn aann iinfamousnfamous three-pagethree-page document.document. InIn itsits originaloriginal form,form, itit wouldwould havehave givengiven thethe U.S.U.S. TTreasuryreasury thethe authorization,authorization, withwith nono accountabilityaccountability toto thethe Congress,Congress, toto spendspend $700$700 bbillionillion purchasingpurchasing subprimesubprime mortgagemortgage assetsassets fromfrom ttroubledroubled fi nancialnancial institutions—institutions— mmoneyoney wwhichhich wwasas ssubsequentlyubsequently usedused toto injectinject capitalcapital intointo bankingbanking institutions.institutions. ItIt Frederic S. Mishkin 55

ssoonoon becamebecame cclearlear tthathat CCongressongress wwouldould votevote downdown tthehe ooriginalriginal bill,bill, whichwhich itit ddidid oonn SSeptembereptember 229.9. EEventuallyventually tthehe bbillill wwasas ppassedassed oonn OOctoberctober 33,, 22008,008, bbutut ppassageassage rrequiredequired numerousnumerous “Christmas-tree”“Christmas-tree” provisionsprovisions suchsuch asas a taxtax breakbreak forfor makersmakers ofof ttoyoy wwoodenooden aarrows.rrows.

TThehe BBroaderroader CContextontext IIff tthehe FFederalederal ReserveReserve hadhad cutcut a dealdeal withwith BarclaysBarclays toto rescuerescue LehmanLehman beforebefore bbankruptcy,ankruptcy, wouldwould thethe crisiscrisis havehave beenbeen defused?defused? TheThe underlyingunderlying stressesstresses inin thethe fi nancialnancial systemsystem werewere allall tootoo real.real. A counterfactualcounterfactual historyhistory wouldwould havehave toto taketake intointo aaccountccount thatthat a weakenedweakened Lehman,Lehman, purchasedpurchased beforebefore bankruptcy,bankruptcy, mightmight havehave laterlater bbroughtrought downdown Barclays.Barclays. RescuingRescuing LehmanLehman wwouldould hhaveave iincreasedncreased moralmoral hazardhazard aamongmong ootherther fi nancialnancial institutions,institutions, perhapsperhaps settingsetting upup a llargerarger crashcrash llater.ater. TThehe ccostsosts ooff thethe AIGAIG creditcredit defaultdefault swapsswaps werewere eventuallyeventually goinggoing toto comecome due,due, quitequite possiblypossibly uunexpectedly.nexpectedly. RRunsuns onon variousvarious shadowshadow bankingbanking institutions,institutions, likelike thethe runrun onon thethe RReserveeserve PrimaryPrimary FFundund aandnd tthenhen oonn mmoneyoney mmarketarket ffundsunds inin general,general, werewere becomingbecoming mmoreore common.common. Here,Here, ratherrather thanthan trytry toto laylay outout a persuasivepersuasive counterfactualcounterfactual history,history, I wwillill eemphasizemphasize ttwowo mmajorajor cchangeshanges tthathat ooccurredccurred bbyy llateate SSeptembereptember 22008.008. FFirst,irst, eevenven tthoughhough mmarketsarkets hhadad bbeeneen ddigestingigesting bbadad nnewsews aaboutbout mmortgage-backedortgage-backed ssecuritiesecurities sincesince mid-2007,mid-2007, thethe eventsevents ofof SeptemberSeptember 20082008 showedshowed thatthat riskrisk takingtaking wwasas ffarar mmoreore eextensivextensive tthanhan mmarketsarkets hhadad rrealizedealized aandnd tthehe ffragilityragility ofof thethe fi nancialnancial ssystemystem wwasas ffarar ggreaterreater tthanhan mmostost mmarketarket pparticipantsarticipants ccouldould hhaveave iimagined.magined. TThehe AAIGIG bblowuplowup andand thethe runrun onon thethe ReserveReserve PrimaryPrimary FundFund revealedrevealed thatthat thethe fi nancialnancial systemsystem wwasas engagedengaged inin whatwhat couldcould bebe describeddescribed asas oneone hugehuge “carry“carry trade.”trade.” Technically,Technically, carrycarry ttradesrades areare onesones iinn wwhichhich a ttraderrader bborrowsorrows aatt a llowow iinterestnterest rrateate ttoo ffundund tthehe ppurchaseurchase ooff assetsassets thatthat yieldyield a highhigh interestinterest rate.rate. CarryCarry tradestrades generategenerate immediateimmediate profiprofi ts,ts, bbutut maymay bebe veryvery riskyrisky becausebecause thethe higherhigher interestinterest raterate onon thethe purchasedpurchased assetsassets maymay jjustust reflrefl ectect greatergreater tailtail riskrisk forfor thatthat asset.asset. AIG’sAIG’s issuingissuing ofof creditcredit defaultdefault swapsswaps isis a cclassiclassic exampleexample ofof a typetype ofof carrycarry trade,trade, becausebecause thethe fi rrmm wwasas earningearning largelarge profiprofi tsts oonn thethe premiumspremiums paidpaid onon thesethese contractscontracts untiluntil thethe tailtail riskrisk becamebecame a realization.realization. IInn a pprescientrescient andand now-famousnow-famous paper,paper, RajanRajan (2005)(2005) warnedwarned thatthat thisthis carry-tradecarry-trade pproblemroblem waswas a dangerdanger toto thethe fi nancialnancial systemsystem becausebecause incentivesincentives inin compensationcompensation sschemeschemes fforor fi nancialnancial fi rmsrms werewere leadingleading fi nancialnancial marketmarket participantsparticipants toto engageengage inin fi nancialnancial transactionstransactions thatthat producedproduced immediateimmediate incomeincome butbut exposedexposed thethe fi nancialnancial ssystemystem ttoo mmassiveassive rrisks.isks. SSecond,econd, aalthoughlthough mmarketsarkets hhadad bbeeneen wwatchingatching ggovernmentovernment aagenciesgencies sscramblecramble ttoo dealdeal withwith thethe fi nancialnancial crisiscrisis sincesince latelate 2007,2007, thethe eventsevents ofof SeptemberSeptember 20082008 raisedraised sseriouserious ddoubtsoubts tthathat tthehe UU.S..S. ggovernmentovernment hhadad tthehe ccapabilityapability ttoo mmanageanage tthehe ccrisis.risis. AAfterfter aall,ll, thethe FedFed aandnd tthehe UU.S..S. TTreasuryreasury pprovedroved uunablenable ttoo ccraftraft a ssolutionolution ssoo tthathat LLehmanehman wwouldould nnotot ffail.ail. TThehe AAIGIG bbailoutailout wwasas hhugeuge aandnd uunexpected.nexpected. TTARPARP wwasas ooriginallyriginally pproposedroposed aass a fl imsy,imsy, three-pagethree-page proposal,proposal, wwhichhich rraisedaised cconcernsoncerns tthathat tthehe TTreasuryreasury wwasas uunprepared,nprepared, aandnd tthehe iinitialnitial TTARPARP pproposalroposal ffailedailed oonn a bbipartisanipartisan vvote.ote. EEvenven tthoughhough tthehe TARPTARP llegislationegislation wwasas eeventuallyventually ppassed,assed, tthehe rreputationaleputational ddamageamage wwasas ddone.one. AAfterfter SSeptembereptember 2008,2008, tthehe ppatternattern ooff rrunsuns oonn tthehe sshadowhadow bbankinganking ssystemystem iinten-nten- ssifiifi eedd andand worsened.worsened. BanksBanks beganbegan toto hordehorde cashcash andand werewere unwillingunwilling toto lendlend toto eacheach 56 Journal of Economic Perspectives

oother,ther, despitedespite hugehuge injectionsinjections ofof liquidityliquidity intointo thethe fi nancialnancial systemsystem byby thethe EuropeanEuropean CCentralentral Bank,Bank, thethe BankBank ofof England,England, andand thethe FederalFederal Reserve.Reserve. TheThe subprimesubprime crisiscrisis hhadad bbecomeecome a ffull-flull-fl edged,edged, globalglobal fi nancialnancial crisis.crisis. TThehe patternspatterns ofof creditcredit spreadsspreads telltell thethe story.story. AsAs shownshown inin FigureFigure 1,1, thethe TEDTED sspreadpread roserose fromfrom aaroundround 110000 bbasisasis ppointsoints dduringuring tthehe wweekeek bbeforeefore tthehe LLehmanehman bbank-ank- rruptcyuptcy toto overover 300300 basisbasis pointspoints onon SeptemberSeptember 17,17, thethe dayday afterafter thethe liquidityliquidity squeezesqueeze oonn AAIGIG aandnd tthehe RReserveeserve PPrimaryrimary FFundund mmaterialized.aterialized. TThehe TTEDED sspreadpread tthenhen ddroppedropped bbyy 100100 basisbasis points,points, butbut asas conficonfi dencedence inin thethe abilityability andand competencecompetence ofof thethe govern-govern- mmentent ttoo rreacteact qquicklyuickly toto containcontain thethe crisiscrisis weakenedweakened overover thethe nextnext couplecouple ofof weeks,weeks, iitt cclimbedlimbed ttoo ooverver 445050 bbasisasis ppointsoints bbyy OOctoberctober 110.0. TThehe sspreadpread bbetweenetween iinterestnterest rratesates oonn BBaaaa ccorporateorporate andand TreasuryTreasury bbonds,onds, sshownhown iinn FFigureigure 11,, aalsolso rroseose bbyy ooverver 220000 bbasisasis ppointsoints andand nownow roserose wellwell aboveabove thethe levelslevels seenseen inin 20012001 duringduring thethe priorprior recessionrecession pperiod.eriod. TheThe stockstock marketmarket crashcrash alsoalso accelerated,accelerated, withwith thethe weekweek ofof OctoberOctober 6,6, 2008,2008, sshowinghowing tthehe wworstorst wweeklyeekly ddeclineecline iinn UU.S..S. hhistory.istory. CConditionsonditions inin tthehe fi nancialnancial marketsmarkets continuedcontinued toto deteriorate.deteriorate. TheThe publicpublic angeranger tthathat resultedresulted fromfrom thethe TARPTARP “bailouts”—which“bailouts”—which involvedinvolved injectionsinjections ofof capitalcapital intointo fi nancialnancial institutions,institutions, withwith littlelittle restrictionsrestrictions onon theirtheir use—becameuse—became soso intenseintense thatthat iitt bbecameecame iincreasinglyncreasingly clearclear thatthat thethe newnew ObamaObama administration,administration, takingtaking offioffi cece inin JJanuaryanuary 2009,2009, wouldwould notnot bebe ableable toto getget additionaladditional fundsfunds beyondbeyond thosethose alreadyalready allo-allo- ccatedated toto TTARP,ARP, iiff nneeded.eeded. FFigureigure 1 sshowshows tthathat aalthoughlthough tthehe TTEDED sspreadpread ffellell ffromrom iitsts ppeakeak inin OctoberOctober 20082008 withwith tthehe hhelpelp ooff ggovernmentovernment ssupportupport ttoo tthehe fi nancialnancial sector,sector, tthehe spreadspread betweenbetween BaaBaa andand TreasuryTreasury bondsbonds continuedcontinued toto rise,rise, peakingpeaking atat overover 550000 bbasisasis ppointsoints iinn DDecemberecember 22009.009. BByy tthehe eendnd ooff 22008,008, tthehe sstocktock mmarketarket hhadad ffallenallen bbyy ooverver hhalfalf ffromrom iitsts ppeakeak iinn ffallall 22007.007.

TThehe LLinksinks ffromrom FinancialFinancial CrisisCrisis toto RecessionRecession

DDataata thatthat llaterater bbecameecame aavailablevailable showedshowed thatthat GDPGDP ggrowthrowth inin thethe U.S.U.S. eeconomyconomy hhadad turnedturned downdown inin thethe thirdthird quarterquarter ofof 2008,2008, fallingfalling atat a –1.3–1.3 percentpercent annualannual rrate,ate, butbut itit waswas inin thethe fourthfourth quarterquarter ofof 20082008 thatthat thethe recessionrecession thatthat startedstarted inin DDecemberecember 22007007 becamebecame tthehe wworstorst eeconomicconomic ccontractionontraction iinn tthehe UUnitednited SStatestates ssinceince WWorldorld WarWar II.II. RealReal U.S.U.S. GDPGDP contractedcontracted sharplysharply inin thethe fourthfourth quarterquarter ofof 20082008 andand tthehe fi rstrst quarterquarter ofof 2009,2009, decliningdeclining atat annualannual ratesrates ofof –5.4–5.4 andand –6.4–6.4 percent,percent, respec-respec- ttively.ively. TheThe unemploymentunemployment raterate skyrocketed,skyrocketed, exceedingexceeding 1010 percentpercent byby OctoberOctober 2009.2009. A worldwideworldwide recessionrecession ensuedensued asas well.well. WorldWorld economiceconomic growthgrowth fellfell atat anan annualannual rrateate ofof ––6.46.4 ppercentercent inin thethe fourthfourth quarterquarter ofof 20082008 andand –7.3–7.3 percentpercent inin thethe fi rstrst qquarteruarter ofof 2009.2009. A moremore extensiveextensive descriptiondescription ofof howhow fi nancialnancial crisescrises leadlead toto sharpsharp eeconomicconomic downturnsdownturns cancan bbee ffoundound iinn MMishkinishkin ((2011),2011), bbutut tthehe bbasicasic sstorytory hhasas tthreehree iinterrelatednterrelated pparts.arts. FFirst,irst, a fi nancialnancial crisiscrisis widenswidens creditcredit spreads,spreads, likelike thethe differencedifference betweenbetween interestinterest rratesates onon BaaBaa corporatecorporate andand TreasuryTreasury bondsbonds shownshown earlierearlier inin FigureFigure 1.1. TheThe resultresult isis tthathat conventionalconventional monetarymonetary policypolicy isis defanged:defanged: eveneven ifif interestinterest ratesrates onon TreasuryTreasury bbondsonds fallfall becausebecause ofof a weakeningweakening economyeconomy andand easingeasing ofof monetarymonetary policy,policy, thethe Over the Cliff: From the Subprime to the Global Financial Crisis 57

Figure 2 Financial Variables, 2007–2009

A: Baa Corporate Bond Rate

Beginning of Bear Stearns Lehman 12 financial crisis rescue Brothers bankruptcy

6 Interest rate (percent) 4

0 Jan. 07March 07May 07July 07 Sept. 07Nov. 07Jan. 08 March 08May 08 July 08 Sept. 08Nov. 08Jan. 09 March 09May 09July 09 Sept. 09Nov. 09

iinterestnterest rratesates rrelevantelevant ttoo hhouseholdousehold aandnd bbusinessusiness ppurchaseurchase ddecisionsecisions ggoo uup,p, ccausingausing a dropdrop inin aggregateaggregate demand.demand. FigureFigure 2A2A showsshows thatthat BaaBaa corporatecorporate bondbond ratesrates barelybarely bbudgedudged atat tthehe beginningbeginning ofof thethe fi nancialnancial crisiscrisis inin 20072007 oror duringduring thethe BearBear StearnsStearns eepisodepisode iinn MMarcharch 22008,008, bbutut cclimbedlimbed ssubstantiallyubstantially iinn SSeptembereptember 22008.008. SSecond,econd, thethe declinedecline inin assetasset pricesprices duringduring a fi nancialnancial crisiscrisis causescauses a declinedecline inin tthehe vvaluealue ooff ccollateral,ollateral, whichwhich makesmakes itit harderharder forfor nonfinonfi nancialnancial fi rmsrms toto borrow.borrow. InIn aaddition,ddition, tthehe ddeteriorationeterioration ooff bbalancealance ssheetsheets aatt fi nancialnancial fi rms,rms, whichwhich havehave thethe exper-exper- ttiseise toto mmitigateitigate aadversedverse sselectionelection andand mmoraloral hhazardazard pproblems,roblems, causescauses theirtheir lendinglending ttoo ffallall ((aa processprocess knownknown asas “deleveraging”),“deleveraging”), whichwhich causescauses spendingspending toto decline.decline. FFigureigure 2B2B showsshows howhow totaltotal bankbank lendinglending continuedcontinued toto riserise earlyearly inin thethe fi nancialnancial ccrisisrisis iinn 2007,2007, andand eveneven remainedremained stablestable throughthrough MarchMarch 20082008 andand thethe BearBear StearnsStearns rrescue.escue. RightRight afterafter SSeptembereptember 22008,008, bbankank llendingending rrisesises llargelyargely bbecauseecause llendersenders wwereere ddrawingrawing hheavilyeavily oonn aalready-establishedlready-established llinesines ooff ccredit,redit, bbutut bbyy mmid-2009id-2009 bbankank llendingending iiss onon a downwarddownward trend.trend. OfOf course,course, thisthis declinedecline shouldshould notnot onlyonly bebe attributedattributed toto thethe ddeclineecline inin thethe supplysupply ofof loans,loans, butbut alsoalso toto thethe declinedecline inin thethe demanddemand forfor loansloans asas a rresultesult ooff wweakeningeakening eeconomicconomic cconditions.onditions. TThird,hird, thethe ggeneraleneral riserise inin uncertaintyuncertainty thatthat occursoccurs duringduring a fi nancialnancial crisiscrisis alsoalso lleadseads toto anan increaseincrease inin asymmetricasymmetric information,information, furtherfurther hinderinghindering thethe abilityability ofof fi nnancialancial marketsmarkets toto allocateallocate fundsfunds toto householdshouseholds andand businessesbusinesses withwith productiveproductive 58 Journal of Economic Perspectives

Figure 2 (continued)

B: Bank Lending

Beginning of Bear Stearns Lehman 7600 financial crisis rescue Brothers bankruptcy 7400

7200

7000

6800

6600

6400

6200

6000

5800

Billions of dollars (seasonally adjusted data) 5600

5400 Jan. 07March 07May 07 July 07Sept. 07Nov. 07Jan. 08March 08May 08 July 08Sept. 08Nov. 08Jan. 09March 09May 09 July 09Sept. 09Nov. 09

iinvestmentnvestment oopportunities.pportunities. FFigureigure 22CC sshowshows hhowow tthehe mmarketarket fforor aasset-backedsset-backed ccommer-ommer- ccialial paper,paper, whichwhich hadhad seemedseemed toto bebe recoveringrecovering inin mid-2008,mid-2008, dwindleddwindled fromfrom dailydaily aaverageverage iissuancessuance ooff $$6464 bbillionillion aatt tthehe bbeginningeginning ooff SSeptembereptember 22008008 ttoo $$16.616.6 bbillionillion bbyy tthehe eendnd ooff 22009.009.

PPolicyolicy RResponsesesponses ttoo tthehe FFinancialinancial CCrisisrisis

TThehe mostmost ppowerfulowerful UU.S..S. policypolicy responsesresponses toto thethe fi nancialnancial crisiscrisis camecame throughthrough ppoliciesolicies thatthat appliedapplied toto thethe fi nancialnancial andand bankingbanking system:system: conventionalconventional andand uncon-uncon- vventionalentional monetarymonetary ppolicies,olicies, bankbank “stress“stress tests,”tests,” andand bailoutsbailouts ofof somesome banksbanks andand fi nnancialancial institutions.institutions. ManyMany ofof thesethese policiespolicies werewere implementedimplemented byby thethe FederalFederal RReserve,eserve, bbutut oothersthers iinvolvednvolved ccooperationooperation wwithith fi scalscal authorities.authorities.

UUnconventionalnconventional MMonetaryonetary PPolicyolicy IInn 22002,002, BenBen Bernanke,Bernanke, thenthen a membermember ofof thethe BoardBoard ofof GovernorsGovernors ofof thethe FFederalederal Reserve,Reserve, ggaveave a sspeechpeech oonn tthehe ooccasionccasion ooff MMiltonilton FFriedman’sriedman’s 990th0th bbirthdayirthday aandnd cconcludedoncluded byby sayingsaying (Bernanke,(Bernanke, 2002):2002): “Regarding“Regarding thethe GreatGreat Depression.Depression. YYou’reou’re rightright [referring[referring toto MiltonMilton FriedmanFriedman andand AnnaAnna Schwarz],Schwarz], wewe diddid it.it. We’reWe’re vveryery sorry.sorry. ButBut thanksthanks toto you,you, wewe won’twon’t dodo itit again.”again.” HeHe clearlyclearly meantmeant it.it. DuringDuring thethe fi nancialnancial crisis,crisis, thethe FederalFederal Reserve’sReserve’s modusmodus operandioperandi waswas massivemassive experimentationexperimentation Frederic S. Mishkin 59

Figure 2 (continued)

C: Asset-Backed Commercial Paper Issuance

Beginning of Bear Stearns Lehman 80 financial crisis rescue Brothers bankruptcy 70

20 Net issuance (billions of dollars)

0 Jan. 07March 07May 07July 07 Sept. 07Nov. 07Jan. 08 March 08May 08 July 08 Sept. 08Nov. 08Jan. 09 March 09May 09July 09 Sept. 09Nov. 09

Source: FRED database, Federal Reserve Bank of St. Louis, and Federal Reserve Board of Governors. Note: The Baa corporate bond rate is the constant maturity interest rate. Asset-backed commercial paper issuance is the daily average of issuance of asset-backed commercial paper. Bank lending is total loans and leases of commercial banks. iinn aann uunprecedentednprecedented ssituation:ituation: tthathat iis,s, iitt wwasas eemployingmploying a llargearge nnumberumber ooff mmeasureseasures ttoo ccontainontain tthehe ccrisis,risis, nnotot kknowingnowing eexactlyxactly wwhichhich oonesnes wouldwould work.work. TToo bebe sure,sure, tthehe FFeded sstartedtarted ooffff uusingsing cconventionalonventional mmonetaryonetary ppolicy—thatolicy—that iis,s, ttargetingargeting a llowerower ffederalederal fundsfunds iinterestnterest rrate.ate. SStartingtarting iinn tthehe SeptemberSeptember 20072007 meeting,meeting, tthehe FFederalederal RReserveeserve lloweredowered iitsts ffederalederal ffundsunds rrateate ttargetarget bbyy ½ ppercentageercentage ppointoint ffromrom 5.255.25 toto 4.754.75 percent,percent, andand subsequentlysubsequently pushedpushed thethe raterate steadilysteadily downward.downward. ByBy AAprilpril 22008,008, tthehe rrateate wwasas ddownown ttoo 2 ppercent,ercent, aandnd bbyy DDecemberecember 22008,008, tthehe ttargetarget rrangeange fforor tthehe ffederalederal ffundsunds rrateate wwasas 0 ttoo 00.25.25 ppercent.ercent. EEvenven bbeforeefore tthehe zzero-boundero-bound fforor iinterestnterest rratesates wwasas rreached,eached, tthehe FFeded hhadad tturnedurned ttoo nnonconventionalonconventional mmonetaryonetary ppolicyolicy mmeasures.easures. TTwowo uunconventionalnconventional ppolicyolicy mmeasures—liquidityeasures—liquidity pprovisionrovision aandnd aassetsset ppurchases—resulturchases—result iinn anan expansionexpansion ooff tthehe ccentralentral bbankank bbalancealance ssheetheet aandnd aarere tthereforeherefore uusuallysually ddescribedescribed uundernder tthehe hheadingeading ““quantitativequantitative eeasing.”asing.” OOnene ootherther uunconventionalnconventional mmeasureeasure iiss mmanagementanagement ooff eexpectations.xpectations. I wwillill ssayay a ffewew wwordsords aaboutbout eeach.ach. TThehe fi rrstst uunconventionalnconventional formform ooff mmonetaryonetary ppolicy,olicy, liquidity provision, iinvolvesnvolves eexpandingxpanding FedFed lendinglending toto bothboth banksbanks andand otherother fi nancialnancial institutions.institutions. LiquidityLiquidity pprovisionrovision isis ddirectedirected atat maintainingmaintaining thethe smoothsmooth functioningfunctioning ofof fi nancialnancial markets,markets, bbutut iitt ddoesoes aaffectffect hhouseholdousehold aandnd bbusinessusiness sspending.pending. 60 Journal of Economic Perspectives

TThehe ttraditionalraditional methodmethod fforor tthehe FFeded ttoo pproviderovide lliquidityiquidity hhasas bbeeneen tthroughhrough lloansoans mmadeade aatt tthehe ddiscountiscount rrate—theate—the iinterestnterest raterate onon loansloans itit mmakesakes ttoo bbanks.anks. InIn mid-mid- AAugustugust 2007,2007, thethe FedFed loweredlowered thethe discountdiscount raterate toto 5050 basisbasis pointspoints (0.5(0.5 percentagepercentage ppoints)oints) aabovebove tthehe ffederalederal ffundsunds rrateate ttargetarget ffromrom tthehe nnormalormal 110000 bbasisasis ppoints.oints. IItt tthenhen lloweredowered iitt ffurtherurther iinn MMarcharch 22008008 ttoo oonlynly 2255 bbasisasis ppointsoints aabovebove tthehe ffederalederal ffundsunds rrateate ttarget.arget. InIn aaddition,ddition, thethe FedFed expandedexpanded thethe typestypes ofof securitiessecurities thatthat wouldwould bebe eligibleeligible fforor useuse asas collateral.collateral. ButBut discountdiscount lendinglending hashas twotwo problems:problems: 1)1) it’sit’s traditionallytraditionally bbeeneen viewedviewed asas a badbad signalsignal forfor banksbanks toto borrowborrow throughthrough thethe discountdiscount mechanism,mechanism, bbecauseecause itit suggestssuggests theythey havehave nowherenowhere elseelse toto turn;turn; andand 2)2) discountdiscount lendinglending hashas ttraditionallyraditionally oonlynly ggoneone ttoo bbanks,anks, nnotot ttoo ootherther fi nancialnancial institutions.institutions. TToo solvesolve thethe problemproblem ofof negativenegative signals,signals, thethe FedFed setset upup a temporarytemporary TermTerm AAuctionuction FacilityFacility (TAF)(TAF) whichwhich enabledenabled banksbanks toto borrowborrow anonymouslyanonymously atat a raterate ddeterminedetermined throughthrough a competitivecompetitive auction.auction. TheThe TAFTAF auctionsauctions startedstarted atat amountsamounts ooff $20$20 billion,billion, butbut asas thethe crisiscrisis worsened,worsened, thethe totaltotal loansloans outstandingoutstanding thoughthough thisthis mmechanismechanism roserose toto exceedexceed $400$400 billion.billion. (The(The EuropeanEuropean CentralCentral BankBank conductedconducted ssimilarimilar operations,operations, withwith oneone auctionauction inin JuneJune 20082008 leadingleading toto lendinglending ofof overover 440000 billionbillion euros.)euros.) TThehe FedFed aalsolso iinventednvented nnewew llendingending pprogramsrograms ttoo bbroadenroaden iitsts pprovisionrovision ooff lliquidityiquidity bbeyondeyond bbankinganking iinstitutions.nstitutions. TheseThese includedincluded lendinglending toto investmentinvestment bbanksanks andand llendingending toto promotepromote ppurchasesurchases ofof commercialcommercial paper,paper, mmortgage-backedortgage-backed ssecurities,ecurities, andand otherother asset-backedasset-backed securities.securities. InIn addition,addition, thethe FedFed engagedengaged inin llendingending toto propprop upup BearBear StearnsStearns2 aandnd AAIGIG aandnd toto FannieFannie MaeMae andand FreddieFreddie Mac.Mac. TThehe enlargementenlargement ofof thethe Fed’sFed’s lendinglending programsprograms duringduring thethe 2007–20092007–2009 periodperiod waswas rremarkable,emarkable, expandingexpanding thethe Fed’sFed’s balancebalance sheetsheet byby overover $1$1 trilliontrillion byby thethe endend ofof 22008,008, withwith thethe balance-sheetbalance-sheet expansionexpansion continuingcontinuing intointo 2009.2009. TheThe numbernumber ofof newnew pprogramsrograms overover thethe coursecourse ofof thethe crisiscrisis spawnedspawned a wholewhole newnew setset ofof acronyms:acronyms: TSLF,TSLF, PPDCF,DCF, AAMLF,MLF, MMMIFF,MIFF, CCPFF,PFF, aandnd TTALF.ALF. YYetet anotheranother methodmethod toto increaseincrease liquidityliquidity waswas throughthrough swapswap lineslines withwith foreignforeign ccentralentral banks.banks. TheseThese foreignforeign centralcentral banksbanks alsoalso engagedengaged inin massivemassive amountsamounts ofof lliquidityiquidity provision,provision, butbut couldcould createcreate liquidityliquidity onlyonly inin theirtheir ownown domesticdomestic currency,currency, wwhilehile manymany ofof theirtheir fi nnancialancial institutionsinstitutions requiredrequired dollardollar fundingfunding toto conductconduct theirtheir ooperations.perations. TheThe FederalFederal ReserveReserve providedprovided foreignforeign centralcentral banksbanks withwith U.S.U.S. dollardollar ddepositseposits inin exchangeexchange forfor depositsdeposits inin theirtheir homehome currency,currency, oftenoften inin essentiallyessentially uunlimitednlimited amounts.amounts. OOverall,verall, thethe availableavailable researchresearch suggestssuggests thatthat liquidityliquidity provisionprovision diddid helphelp stabi-stabi- llizeize fi nancialnancial marketsmarkets duringduring thisthis crisis.crisis. ForFor example,example, McAndrews,McAndrews, Sarkar,Sarkar, andand WangWang ((2008)2008) fi ndnd thatthat announcementsannouncements aboutabout thethe TermTerm AuctionAuction FacilityFacility (TAF)(TAF) diddid signifisignifi - ccantlyantly llowerower ccreditredit sspreads.preads. WWuu ((2008),2008), CChristensen,hristensen, LLopez,opez, aandnd RRudebuschudebusch ((2009),2009), aandnd SSarkararkar andand SShraderhrader (2010)(2010) alsoalso concludeconclude thatthat thethe TAFTAF andand otherother creditcredit facilitiesfacilities

2 The lending to JPMorgan to prop up Bear Stearns was in effect a purchase of assets. In order for the Federal Reserve to abide by its legal authority, it could not purchase private assets outright. Instead, it made a nonrecourse loan: that is, the Fed had no recourse to require JPMorgan to pay back the loan, but instead would take ownership of the collateral, the $30 billion of toxic assets. Hence the Fed would bear any losses or gains on these assets, so in economic terms it had purchased these assets. Over the Cliff: From the Subprime to the Global Financial Crisis 61

hhelpedelped lowerlower interestinterest rates.rates.3 BabaBaba andand PackerPacker (2009),(2009), McAndrewsMcAndrews (2009),(2009), andand GGoldberg,oldberg, Kennedy,Kennedy, andand MiuMiu (2010)(2010) fi ndnd thatthat thethe U.S.U.S. dollardollar swapswap facilitiesfacilities helpedhelped iimprovemprove tthehe pperformanceerformance ofof thethe dollardollar swapswap markets.markets. UsingUsing a similarsimilar event-studyevent-study mmethodology,ethodology, Ait-Sahalia,Ait-Sahalia, Adnritzky,Adnritzky, Jobst,Jobst, Nowak,Nowak, andand TamirisaTamirisa (2010)(2010) fi ndnd thatthat lliquidityiquidity provision,provision, notnot onlyonly inin thethe UnitedUnited States,States, butbut alsoalso inin thethe UnitedUnited KingdomKingdom aandnd JJapan,apan, ddidid hhelpelp lowerlower interbankinterbank riskrisk premiums.premiums. TThehe secondsecond ccategoryategory ooff nnonconventionalonconventional aapproachespproaches ttoo mmonetaryonetary ppolicy,olicy, asset purchases, iiss bbasedased oonn tthehe bbeliefelief tthathat a ddirectirect ppurchaseurchase ccanan sstimulatetimulate sspendingpending bbyy raisingraising ppricesrices oonn pparticulararticular cclasseslasses ooff bbonds,onds, ttherebyhereby lloweringowering tthehe iinterestnterest rratesates tthathat hhouseholdsouseholds aandnd bbusinessesusinesses hhaveave ttoo ppay.ay. TThishis ppolicyolicy bbeganegan wwithith tthehe ppurchaseurchase ofof $300$300 billionbillion ofof long-termlong-term TreasuryTreasury bonds,bonds, whichwhich startedstarted inin MarchMarch 22009009 aandnd eendednded iinn OOctoberctober 22009.009. EEmpiricalmpirical eevidencevidence oonn a ppreviousrevious FFeded aattemptttempt ttoo lowerlower long-termlong-term iinterestnterest rratesates rrelativeelative ttoo sshort-termhort-term rratesates iinn tthehe 11960s—which960s—which wwasas dubbeddubbed ““OperationOperation TTwist”wist” bbecauseecause iitsts iintentntent wwasas ttoo ““twist”twist” aandnd fl aattentten tthehe yyieldield curve—deemedcurve—deemed thatthat itit didn’tdidn’t workwork (Modigliani(Modigliani andand Sutch,Sutch, 1967).1967). However,However, aass SolowSolow andand TobinTobin (1987)(1987) pointedpointed oout,ut, FFederalederal RReserveeserve ppurchasesurchases ooff llong-termong-term TTreasuryreasury bbondsonds aatt tthathat ttimeime wwereere ssmallmall aandnd eendednded uupp bbeingeing ooffsetffset bbyy iissuancessuance ooff llong-termong-term bbonds.onds. A llargerarger aassetsset ppurchaseurchase pprogram,rogram, aannouncednnounced iinn NNovemberovember 22008008 aandnd ttermi-ermi- nnatedated iinn MMarcharch 22010,010, wwasas tthehe ooutrightutright ppurchaseurchase ooff $$1.251.25 ttrillionrillion ooff mmortgage-backedortgage-backed ssecurities.ecurities. TThehe FFeded ppurchasedurchased mmortgage-backedortgage-backed ssecuritiesecurities iinn aann aattemptttempt ttoo llowerower rresidentialesidential mmortgageortgage rrates,ates, ttherebyhereby sstimulatingtimulating tthehe ddemandemand fforor hhousing,ousing, wwhichhich wwouldould nnotot oonlynly sstabilizetabilize hhousingousing ppricesrices aandnd tthehe fi nnancialancial markets,markets, butbut wouldwould alsoalso sstimulatetimulate spendingspending onon residentialresidential construction.construction. ResearchResearch onon thethe effecteffect ofof thethe Fed’sFed’s llarge-scalearge-scale assetasset purchasespurchases duringduring thethe globalglobal fi nnancialancial crisiscrisis byby Gagnon,Gagnon, Raskin,Raskin, RRemache,emache, andand SackSack (2010),(2010), fi nndsds tthathat tthesehese pprogramsrograms lloweredowered llong-termong-term bbondond rratesates rrelativeelative ttoo sshorthort rratesates oonn tthehe oorderrder ooff 5500 bbasisasis ppoints,oints, aandnd lloweredowered iinterestnterest rratesates oonn mmortgage-backedortgage-backed ssecuritiesecurities eevenven ffurtherurther bbyy iimprovingmproving lliquidityiquidity iinn tthishis mmarket,arket, ttherebyhereby hhavingaving a ssubstantialubstantial eeffectffect oonn rresidentialesidential mmortgageortgage rrates.ates. BBothoth liquidityliquidity pprovisionrovision aandnd aassetsset ppurchasesurchases fi t underunder tthehe ggeneraleneral hheadingeading ooff quantitative easing——thatthat is,is, waysways inin whichwhich thethe FederalFederal ReserveReserve greatlygreatly expandedexpanded tthehe mmonetaryonetary basebase aalonglong wwithith iitsts bbalancealance ssheet.heet. TTherehere hhasas bbeeneen ssomeome qquestionuestion aass toto whetherwhether tthishis eexpansionxpansion ooff tthehe mmonetaryonetary bbasease bbyy iitselftself ccouldould sstimulatetimulate tthehe eeconomy.conomy. IIt’st’s nnotot cclearlear wwhyhy tthishis wwouldould wwork:ork: aass CCurdiaurdia aandnd WWoodfordoodford ((2010)2010) aargue,rgue, whywhy shouldshould anan expansionexpansion ofof thethe monetarymonetary basebase leadlead toto higherhigher aggregateaggregate ddemandemand whenwhen itit waswas unableunable toto furtherfurther lowerlower interestinterest ratesrates oror stimulatestimulate bankbank llending?ending? InIn addition,addition, eevidencevidence ffromrom JJapaneseapanese eexperiencexperience iinn rrecentecent ddecadesecades ddoesn’toesn’t llendend mmuchuch ssupportupport ttoo tthehe iideadea tthathat a ppureure eexpansionxpansion ooff a ccentralentral bbank’sank’s balancebalance sheetsheet isis particularlyparticularly eeffectiveffective iinn sstimulatingtimulating aaggregateggregate ddemandemand ((Kuttner,Kuttner, 22004).004). BBernankeernanke ((2009)2009) hhasas aalsolso eexpressedxpressed hhisis sskepticismkepticism tthathat qquan-uan- ttitativeitative eeasingasing bbyy iitselftself wwouldould bbee eeffective.ffective. HHee iindicatedndicated tthathat tthehe eexpansionxpansion ooff

3 Presenting an alternative view, Taylor and Williams (2009) fi nd no evidence that actual lending from the Term Auction Facility (TAF) helped to ease credit markets. 62 Journal of Economic Perspectives

tthehe balancebalance sheetsheet shouldshould insteadinstead bbee viewedviewed asas a resultresult ofof whatwhat hehe referredreferred toto asas credit easing, thatthat iis,s, aann aattemptttempt ttoo llowerower sspreadspreads bbetweenetween ddifferentifferent aassetsset cclasseslasses tthroughhrough assetasset purchasespurchases aandnd lliquidityiquidity pprovision.rovision. A fi nalnal nonconventionalnonconventional approachapproach toto monetarymonetary policypolicy isis management of expectations. InIn MarchMarch 2009,2009, thethe FedFed OpenOpen MarketMarket CommitteeCommittee addedadded toto itsits policypolicy statementstatement tthathat iitt wwouldould maintainmaintain “exceptionally“exceptionally low”low” interestinterest ratesrates “for“for anan extendedextended period.”period.” TTherehere isis theoreticaltheoretical supportsupport forfor thethe propositionproposition thatthat a commitmentcommitment toto keepkeep short-short- ttermerm iinterestnterest rratesates llowow fforor a ssubstantialubstantial pperioderiod ooff ttimeime hhelpselps llowerower llong-termong-term iinterestnterest rratesates andand alsoalso raisesraises inflinfl aationtion eexpectations,xpectations, ttherebyhereby rreducingeducing tthehe realreal interestinterest raterate ((EggertssonEggertsson andand Woodford,Woodford, 2003,2003, 2004;2004; Woodford,Woodford, 2003).2003). ButBut atat leastleast soso far,far, nono eempiricalmpirical evidenceevidence isis availableavailable onon howhow effectiveeffective thethe managementmanagement ofof expectationsexpectations wwasas dduringuring tthishis eepisode.pisode.

TThehe BBankank SStresstress TTestsests FFinancialinancial marketsmarkets beganbegan toto recoverrecover inin thethe fi rstrst halfhalf ofof 2009.2009. TheThe provisionprovision ofof hhugeuge aamountsmounts ooff lliquidityiquidity aappearedppeared ttoo ddoo tthehe ttrickrick iinn tthehe iinterbanknterbank llendingending mmarket,arket, wwithith thethe TEDTED spreadspread fallingfalling fromfrom itsits peakpeak ofof overover 400400 basisbasis pointspoints inin OctoberOctober toto bbelowelow 100100 basisbasis pointspoints inin JanuaryJanuary 2009.2009. ThisThis spreadspread fellfell toto belowbelow pre-crisispre-crisis levelslevels ((lessless thanthan 2020 basisbasis points)points) byby MayMay 2009.2009. CreditCredit spreadsspreads alsoalso beganbegan toto fallfall withwith thethe BBaa–Treasuryaa–Treasury spreadspread decliningdeclining fromfrom itsits peakpeak inin October,October, butbut atat a slowerslower pacepace thanthan tthehe iimprovementmprovement iinn thethe interbankinterbank market,market, asas illustratedillustrated inin FigureFigure 1.1. ByBy latelate 2009,2009, hhowever,owever, ccreditredit spreadsspreads werewere returningreturning toto normal,normal, reachingreaching levelslevels thatthat werewere justjust a llittleittle aabovebove thosethose beforebefore thethe crisis,crisis, andand actuallyactually lowerlower thanthan thethe spreadsspreads thatthat existedexisted iinn 22002002 shortlyshortly afterafter thethe previousprevious recessionrecession ended.ended. TheThe stockstock marketmarket alsoalso beganbegan toto rrecoverecover fromfrom itsits troughtrough inin MarchMarch 2009,2009, leadingleading toto a sustainedsustained bullbull marketmarket inin whichwhich iitt rroseose ooverver 5500 ppercentercent ooverver tthehe nnextext yyear.ear. A keykey elementelement inin thethe fi nancialnancial marketmarket recoveryrecovery waswas thethe U.S.U.S. Treasury’sTreasury’s require-require- mment,ent, aannouncednnounced inin FebruaryFebruary 2009,2009, thatthat thethe 1919 largestlargest bankingbanking institutionsinstitutions undergoundergo tthehe SupervisorySupervisory CCapitalapital AssessmentAssessment ProgramProgram (SCAP)(SCAP) oror “stress“stress tests,”tests,” asas theythey werewere ccommonlyommonly ccalled.alled. TheThe stressstress teststests werewere a supervisorysupervisory assessment,assessment, ledled byby thethe FederalFederal RReserveeserve inin cooperationcooperation withwith thethe OffiOffi cece ofof thethe ComptrollerComptroller ofof thethe CurrencyCurrency andand tthehe FFDIC,DIC, ofof thethe balancebalance sheetsheet positionposition ofof thesethese banksbanks toto ensureensure thatthat theythey hadhad ssuffiuffi cientcient capitalcapital toto withstandwithstand badbad macroeconomicmacroeconomic outcomes.outcomes. TheThe stressstress teststests werewere ddesignedesigned asas a forward-lookingforward-looking exerciseexercise toto projectproject possiblepossible erosionerosion ofof bankbank capitalcapital uundernder twotwo sscenarios:cenarios: thethe bbaselineaseline consensusconsensus forecastforecast byby privateprivate sectorsector economistseconomists aass ofof FebruaryFebruary 22009,009, wwhichhich entailedentailed a continuingcontinuing declinedecline inin economiceconomic activity,activity, andand a wworseorse scenarioscenario ofof a muchmuch moremore severesevere recessionrecession (for(for detailsdetails ofof thethe scenarios,scenarios, seesee BBoardoard ooff GGovernorsovernors ooff tthehe FFederalederal RReserveeserve SSystem,ystem, 22009).009). TThehe TreasuryTreasury announcedannounced thethe resultsresults inin earlyearly MayMay 20092009 andand theythey werewere wellwell rreceivedeceived byby marketmarket participants,participants, allowingallowing thesethese banksbanks toto raiseraise substantialsubstantial amountsamounts ooff ccapitalapital fromfrom pprivaterivate capitalcapital markets,markets, asas waswas requiredrequired byby thethe stressstress tests.tests. TheThe sstresstress teststests werewere a keykey factorfactor thatthat helpedhelped increaseincrease thethe amountamount ofof informationinformation inin thethe mmarketplace,arketplace, therebythereby reducingreducing asymmetricasymmetric iinformationnformation aandnd aadversedverse sselectionelection aandnd mmoraloral hhazardazard pproblems.roblems. HHoshioshi aandnd KKashyapashyap ((forthcoming)forthcoming) ffoundound tthathat ssimilarimilar sstresstress Frederic S. Mishkin 63

ttestsests inin JapanJapan inin 20032003 werewere a keykey elementelement ofof thethe recoveryrecovery ofof thethe JapaneseJapanese bankingbanking ssystemystem aafterfter tthehe ““lostlost ddecade”ecade” ffromrom 11992992 ttoo 22002.002.

BBailingailing OOutut FFinancialinancial InstitutionsInstitutions SSomeome ooff tthehe FFed’sed’s lliquidityiquidity provisionprovision waswas toto bailbail outout fi nancialnancial institutions,institutions, asas ooccurredccurred wwithith BBearear SStearns,tearns, AAIG,IG, aandnd tthehe ggovernment-sponsoredovernment-sponsored eenterprisesnterprises FFannieannie MMaeae aandnd FFreddiereddie MMac.ac. IInn eeachach ooff tthesehese ccases,ases, tthehe FFederalederal RReserveeserve pprovidedrovided tthishis lliquidityiquidity iinn ccooperationooperation wwithith tthehe UU.S..S. TTreasury,reasury, whichwhich alsoalso mademade llargearge lloans.oans. AAlthoughlthough thethe TroubledTroubled AssetAsset ReliefRelief ProgramProgram (TARP)(TARP) waswas initiallyinitially intendedintended toto ppurchaseurchase subprimesubprime mortgagemortgage assetsassets toto helphelp propprop upup fi nancialnancial institutions’institutions’ balancebalance ssheets,heets, itit soonsoon becamebecame clearclear thatthat agreeingagreeing onon a priceprice forfor thosethose assetsassets waswas unwork-unwork- aable.ble. TheThe TreasuryTreasury switchedswitched toto usingusing thethe TARPTARP fundsfunds toto injectinject capitalcapital intointo fi nancialnancial iinstitutions,nstitutions, therebythereby shoringshoring upup theirtheir balancebalance sheetssheets moremore directly.directly. InIn addition,addition, oonn SeptemberSeptember 29,29, thethe U.S.U.S. TreasuryTreasury announcedannounced a TemporaryTemporary GuaranteeGuarantee ProgramProgram fforor MoneyMoney MarketMarket Funds,Funds, whichwhich insuredinsured thatthat investorsinvestors wouldwould receivereceive atat leastleast thethe $$11 parpar valuevalue perper share.share. OnOn OctoberOctober 14,14, 2008,2008, thethe FDICFDIC announcedannounced thethe TemporaryTemporary LLiquidityiquidity GGuaranteeuarantee ProgramProgram ((TLGP)TLGP) tthathat gguaranteeduaranteed nnewly-issuedewly-issued seniorsenior unse-unse- ccuredured bankbank debt,debt, suchsuch asas loansloans ofof depositsdeposits atat thethe federalfederal reservereserve andand commercialcommercial ppaper,aper, aass wellwell asas non–interest-bearingnon–interest-bearing transactiontransaction accounts.accounts. ItsIts statedstated purposepurpose waswas ttoo ““strengthenstrengthen conficonfi dencedence andand encourageencourage liquidityliquidity inin thethe bankingbanking system”system” (FDIC,(FDIC, 22008).008). AlthoughAlthough thesethese pprogramsrograms wwereere iinitiallynitially iintendedntended ttoo llastast llessess tthanhan a yyear,ear, ttheyhey hhaveave bbeeneen eextendedxtended sseveraleveral ttimes.imes. TThehe sspreadingpreading bankbank failuresfailures inin EuropeEurope inin fallfall 20082008 ledled ttoo ssimilarimilar bbailoutsailouts ooff fi nancialnancial institutions:institutions: forfor example,example, thethe U.K.U.K. TreasuryTreasury setset upup a bailoutbailout planplan thatthat guar-guar- aanteednteed 250250 billionbillion poundspounds ofof bankbank liabilities,liabilities, addedadded 100100 billionbillion poundspounds toto a facilityfacility tthathat sswapswaps tthesehese aassetsssets fforor governmentgovernment bonds,bonds, andand allowedallowed thethe U.K.U.K. governmentgovernment ttoo buybuy upup toto 5050 billionbillion poundspounds ofof equityequity stakesstakes inin BritishBritish banks.banks. AllessandriAllessandri andand HHaldanealdane ((2009)2009) ddiscussiscuss $$1010 ttrillionrillion wworthorth ooff tthesehese bbailoutailout ppackagesackages aacrosscross 2200 ccoun-oun- ttries,ries, wwhichhich includeinclude bothboth guaranteeingguaranteeing thethe debtdebt ofof thethe banksbanks andand injectinginjecting capitalcapital iintonto them.them. TTherehere wwasas a hhighigh ddegreeegree ooff iinternationalnternational ccoordinationoordination iinn tthesehese ppolicies.olicies. AAit-Sahaliam,it-Sahaliam, AAdnritzky,dnritzky, JJobst,obst, NNowak,owak, aandnd TTamirisaamirisa ((2010)2010) fi ndnd thatthat comprehen-comprehen- ssiveive bailoutsbailouts whichwhich helpedhelped rrecapitalizeecapitalize tthehe fi nnancialancial sectorsector diddid helphelp llowerower interbankinterbank rriskisk premiums,premiums, bbutut bailoutsbailouts ooff individualindividual bbanksanks oonn anan adad hochoc basisbasis werewere receivedreceived poorlypoorly bbyy thethe marketsmarkets aandnd lleded ttoo a rriseise iinn iinterbanknterbank rriskisk ppremiums.remiums. A pplausiblelausible eexplanationxplanation iiss tthathat whenwhen governmentsgovernments ppursueursue aadd hhococ bbailouts,ailouts, iitt ssuggestsuggests ttoo mmarketsarkets tthathat tthehe pproblemroblem iinn thethe creditcredit marketsmarkets maymay bebe worseworse thanthan theythey expected.expected. InIn contrast,contrast, pursuingpursuing a compre-compre- hhensiveensive approachapproach ttoo rrecapitalizeecapitalize tthehe fi nnancialancial systemsystem hhelpselps ttoo rrestoreestore cconfionfi dencedence andand uunfreezenfreeze thethe creditcredit mmarkets.arkets. FFurthermore,urthermore, ttheyhey fi nndd tthathat ttherehere wwereere sstrongtrong sspilloverspillovers ffromrom actionsactions takentaken inin oneone countrycountry toto others,others, suggestingsuggesting tthehe bbenefienefi tsts ofof a coordinatedcoordinated ppolicyolicy responseresponse bbetweenetween ccountriesountries ttoo ccopeope wwithith a ggloballobal fi nancialnancial ccrisis.risis.

EExpansionaryxpansionary FFiscaliscal PolicyPolicy FFiscaliscal sstimulustimulus ttoo ddirectlyirectly increaseincrease aggregateaggregate demanddemand waswas anotheranother keykey piecepiece ooff tthehe ggovernmentovernment responseresponse toto thethe globalglobal fi nancialnancial crisis,crisis, bothboth inin thethe UnitedUnited StatesStates 64 Journal of Economic Perspectives

aandnd inin manymany otherother countries.countries. TheThe incomingincoming ObamaObama administrationadministration pushedpushed forfor thethe $$787787 bbillionillion fi scalscal stimulusstimulus package,package, thethe AmericanAmerican RecoveryRecovery andand ReinvestmentReinvestment ActAct ooff 22009.009. TheThe planplan featuredfeatured $288$288 billionbillion ofof taxtax cutscuts andand $499$499 billionbillion inin governmentgovernment sspendingpending increases.increases. TheThe evidenceevidence onon thethe effecteffect ofof thethe fi scalscal stimulusstimulus packagepackage isis mmixed,ixed, butbut twotwo argumentsarguments suggestsuggest thatthat thatthat itit waswas farfar lessless importantimportant toto addressingaddressing tthehe fi nancialnancial crisiscrisis thanthan werewere actionsactions byby centralcentral banksbanks toto provideprovide liquidityliquidity andand ggovernmentovernment rrecapitalizationecapitalization aandnd gguaranteesuarantees ooff tthehe fi nancialnancial system.system. FFirst,irst, asas a basicbasic mattermatter ofof timing,timing, mostmost ofof thethe additionaladditional governmentgovernment stimulusstimulus ppackageackage ddidid nnotot ccomeome oonn llineine uuntilntil llateate 22009009 aandnd iintonto 22010.010. WWhilehile oonene ccanan cconstructonstruct a theoreticaltheoretical argumentargument thatthat thethe expectationexpectation ofof thethe stimulusstimulus packagepackage helpedhelped toto rreassureeassure fi nancialnancial markets,markets, anyany directdirect effecteffect ofof thethe stimulusstimulus onon thethe fi nancialnancial crisiscrisis tthroughhrough tthehe eearlyarly mmonthsonths ooff 22009009 wwasas nnecessarilyecessarily qquiteuite llimited.imited. SSecond,econd, therethere isis a veryvery activeactive debatedebate aboutabout howhow muchmuch a fi scalscal stimulusstimulus willwill aaffectffect ooutput.utput. FForor eexample,xample, HHallall (2009)(2009) ssummarizesummarizes tthehe ttheoreticalheoretical aandnd empiricalempirical eevidencevidence oonn fi sscalcal sstimulustimulus aass yyieldingielding aann ooutpututput mmultiplierultiplier bbetweenetween 00.7.7 aandnd 11.. AAnalysisnalysis ooff tthehe stimulusstimulus uusingsing ddynamicynamic sstochastictochastic ggeneraleneral eequilibriumquilibrium mmodelsodels iinn CCogan,ogan, CCwik,wik, TTaylor,aylor, aandnd WWielandieland ((2009)2009) aandnd UUhlighlig ((2010)2010) fi ndnd multipliersmultipliers iinn tthehe 00.6.6 rrange,ange, wwhilehile eeconometricconometric eevidencevidence eemployedmployed bbyy BBarroarro aandnd RRedlickedlick ((2009)2009) fi ndsnds aann ooutpututput mmultiplierultiplier ooff aaroundround 00.7..7. OOnn tthehe ootherther hhand,and, eeconomistsconomists iinn tthehe OObamabama aadministrationdministration aandnd tthehe CCongressionalongressional BBudgetudget OOffiffi ce,ce, usingusing llarge-scalearge-scale KKeynesianeynesian eeconometricconometric mmodels,odels, eestimatedstimated tthathat tthehe ooutpututput mmultiplierultiplier fforor fi scalscal sstimulustimulus wwasas wwellell aabovebove one.one. Moreover,Moreover, a numbernumber ofof modelsmodels pointpoint outout thatthat whenwhen thethe interestinterest rrateate ffallsalls ttoo tthehe zzeroero llowerower bboundound aafterfter a llargearge nnegativeegative aaggregateggregate ddemandemand sshock,hock, tthehe ooutpututput mmultiplierultiplier ffromrom a fi scalscal sstimulustimulus mmayay bbee mmuchuch hhigherigher bbecauseecause eexpan-xpan- ssionaryionary fi scalscal policypolicy raisesraises inflinfl ationation expectations,expectations, ttherebyhereby lloweringowering rrealeal iinterestnterest rrates:ates: fforor eexample,xample, EEggertssonggertsson ((2009),2009), WWoodfordoodford ((2010),2010), aandnd CChristiano,hristiano, EEichen-ichen- bbaum,aum, aandnd RRebeloebelo ((2009)2009) fi ndnd ssuchuch a rresultesult iinn ccalibratedalibrated NNewew KKeynesianeynesian mmodels.odels. TThehe ccontroversyontroversy ooverver ddiscretionaryiscretionary fi sscalcal sstimulustimulus iiss eexploredxplored bbyy AAuerbach,uerbach, GGale,ale, aandnd HHarrisarris iinn tthehe FFallall 22010010 iissuessue ooff tthishis jjournal.ournal.

HHaveave PPoliciesolicies ttoo AAmelioratemeliorate tthehe FFinancialinancial CCrisisrisis SSucceeded?ucceeded? TThehe questionquestion ooff wwhetherhether oorr iinn wwhichhich wwaysays tthehe ppoliciesolicies ttoo ddefuseefuse tthehe fi nancialnancial ccrisisrisis havehave succeededsucceeded willwill bebe debateddebated forfor years.years. OneOne groupgroup ofof skepticsskeptics pointspoints outout tthathat householdshouseholds andand fi rmsrms havehave seenseen tightertighter creditcredit standardsstandards andand a higherhigher costcost ofof ccreditredit duringduring tthehe rrecession,ecession, ffromrom wwhichhich ttheyhey cconcludeonclude tthathat mmonetaryonetary ppolicyolicy hhasas nnotot beenbeen effectiveeffective dduringuring tthehe rrecentecent fi nancialnancial crisiscrisis (for(for eexample,xample, KKrugman,rugman, 22008).008). AAnothernother viewview holdsholds thatthat manymany governmentgovernment actionsactions werewere ineffective,ineffective, whilewhile othersothers mmayay havehave rraisedaised tthehe pperceivederceived llevelevel ooff rriskisk iinn fi nnancialancial marketsmarkets ((forfor eexample,xample, sseeee TTaylor,aylor, 2009).2009). MMyy oownwn view,view, asas I havehave arguedargued moremore extensivelyextensively elsewhereelsewhere (Mishkin,(Mishkin, 2009),2009), isis tthathat conclusionsconclusions aboutabout thethe effectivenesseffectiveness ofof policypolicy shouldshould beginbegin byby consideringconsidering thethe ccounterfactual—thatounterfactual—that is,is, wwhathat wwouldould tthehe llikelyikely ccourseourse ooff eeventsvents bbee wwithoutithout tthehe ppolicyolicy iinterventions?nterventions? ForFor eexample,xample, iiff tthehe FFederalederal RReserveeserve hhadad not loweredlowered thethe federalfederal fundsfunds rrateate byby ooverver 550000 bbasisasis ppointsoints sstartingtarting iinn SSeptembereptember 22007,007, iitt sseemseems cclearlear tthathat iinterestnterest Over the Cliff: From the Subprime to the Global Financial Crisis 65

rratesates onon default-freedefault-free TreasuryTreasury securitiessecurities wouldwould havehave beenbeen higher,higher, butbut I believe,believe, ffurther,urther, tthathat creditcredit spreadsspreads wouldwould havehave widenedwidened byby eveneven moremore thanthan theythey diddid duringduring tthishis ccrisisrisis bbecauseecause tthehe wweakereaker economyeconomy wwouldould hhaveave mmadeade cconditionsonditions iinn fi nancialnancial mmarketsarkets eevenven mmoreore sstressed.tressed. TThehe ooutcomeutcome wwouldould tthenhen llikelyikely hhaveave bbeeneen tthathat hhouse-ouse- hholdsolds andand fi rmsrms wouldwould havehave facedfaced muchmuch higherhigher interestinterest rates,rates, withwith thethe resultresult thatthat hhouseholdousehold andand fi rmrm spendingspending wouldwould havehave declineddeclined eveneven moremore precipitouslyprecipitously thanthan wwee saw.saw. TheThe bankingbanking stressstress teststests andand systematicsystematic effortsefforts toto recapitalizerecapitalize thethe bankingbanking ssystemystem aalsolso sseemeem ttoo hhaveave bbeeneen uuseful.seful. SSomeome ppartsarts ooff tthehe ggovernmentovernment iinterventionntervention wwereere llessess uusefulseful thanthan oothers.thers. ButBut takentaken asas a wwhole,hole, I bbelieveelieve thethe governmentgovernment actionsactions hhelpedelped ttoo ppreventrevent a ffarar ddeepereeper rrecessionecession andand eveneven possiblypossibly a depression.depression.

AAftermath:ftermath: CleaningCleaning UpUp afterafter thethe CrisisCrisis

TThehe ggloballobal fi nancialnancial crisiscrisis ofof 2007–20092007–2009 appearsappears toto bebe waning.waning. ThereThere areare threethree kkeyey aareasreas wwherehere ggovernmentovernment ppoliciesolicies aarere nneededeeded ttoo ccleanlean uupp aafterfter tthehe ccrisisrisis iinn oorderrder ttoo rrestoreestore tthehe wworld’sorld’s fi nancialnancial sectorsector andand thethe broaderbroader economyeconomy toto health.health.

SShrinkinghrinking CCentralentral BBankank BBalancealance SSheetsheets AActionsctions byby centralcentral banksbanks toto containcontain thethe globalglobal fi nnancialancial crisiscrisis resultedresulted inin hugehuge eexpansionsxpansions ofof theirtheir balancebalance sheets.sheets. TheThe expansionexpansion ofof balancebalance sheetssheets arisingarising fromfrom lliquidityiquidity pprovisionrovision iiss ttypicallyypically eeasyasy ttoo rreverseeverse bbecauseecause mmostost ooff tthehe lliquidityiquidity ffacili-acili- ttiesies hhaveave pprovidedrovided lloansoans aatt iinterestnterest rratesates tthathat aarere hhigherigher tthanhan mmarketarket rratesates dduringuring nnormalormal times.times. AAss fi nnancialancial mmarketsarkets rreturneturn ttoo nnormal,ormal, mmarketarket pparticipantsarticipants aarere nnoo llongeronger wwillingilling ttoo bborroworrow aatt aabove-marketbove-market rrates,ates, aandnd tthishis ssourceource ooff bbalancealance ssheetheet eexpansionxpansion naturallynaturally reversesreverses itselfitself asas thethe fi nnancialancial systemsystem recovers—whichrecovers—which isis exactlyexactly wwhathat hashas hhappened.appened. TThehe assetasset mmarketarket ppurchasesurchases ooff llong-termong-term mmortgage-backedortgage-backed securitiessecurities areare notnot sself-liquidatingelf-liquidating inin thisthis way.way. OverOver $1$1 trilliontrillion ofof thethe mortgage-backedmortgage-backed securitiessecurities havehave mmaturitiesaturities ofof tenten yearsyears oror more.more. Thus,Thus, a strategystrategy ofof justjust lettingletting themthem runrun offoff willwill lleaveeave thethe FederalFederal ReserveReserve inin thisthis marketmarket forfor a longlong time,time, whichwhich raisesraises severalseveral issues.issues. FFirst,irst, bbyy hholdingolding tthesehese ssecurities,ecurities, tthehe FFederalederal RReserveeserve wwillill bbee eexposedxposed ttoo bbothoth ccreditredit aandnd interestinterest raterate risk.risk.4 Second,Second, thethe presencepresence ofof privateprivate securitiessecurities onon thethe FederalFederal RReserveeserve balancebalance sheetsheet meansmeans thatthat thethe FedFed hashas becomebecome directlydirectly involvedinvolved inin perhapsperhaps tthehe mmostost ppoliticizedoliticized fi nancialnancial marketmarket inin thethe UnitedUnited States.States. TheThe publicpublic andand CongressCongress mmayay bbeginegin ttoo hholdold tthehe FFeded aaccountableccountable fforor wwhathat hhappensappens sspecifipecifi callycally toto mortgagemortgage rrates,ates, rratherather thanthan toto interestinterest ratesrates inin general.general. PoliticiansPoliticians maymay tendtend toto seesee thethe FedFed asas iinstitutionallynstitutionally rresponsibleesponsible forfor developmentsdevelopments iinn tthehe hhousingousing mmarkets.arkets. CCanan thethe FedFed extricateextricate itselfitself fromfrom thisthis situationsituation byby sellingselling thethe mortgage-mortgage- bbackedacked securities?securities? TheThe experienceexperience ofof thethe conclusionconclusion ofof thethe purchasepurchase programprogram

4 Because the balance sheet of the Federal Reserve is in effect part of the overall government balance sheet, it is not clear why potential losses on the Fed’s balance sheet should matter. However, such losses would likely result in severe criticisms of the Federal Reserve and so weaken its independence. 66 Journal of Economic Perspectives

fforor mmortgage-backedortgage-backed securitiessecurities atat thethe endend ofof MarchMarch 20102010 isis encouraging.encouraging. ForFor ssomeome mmonthsonths bbeforeefore thisthis date,date, thethe FedFed hadhad beenbeen inin essenceessence thethe solesole buyerbuyer inin thisthis mmarket.arket. However,However, givengiven thatthat fi nancialnancial marketsmarkets hadhad stabilizedstabilized andand thatthat thethe endend ofof tthehe ppurchaseurchase programprogram waswas wellwell publicized,publicized, thethe Fed’sFed’s exitexit fromfrom thethe marketmarket diddid notnot ccauseause aanyny ddisruption.isruption. TThehe sspreadspreads ooff mmortgage-backedortgage-backed ssecuritiesecurities overover TTreasuryreasury bbillsills ddidid notnot riserise afterafter AprilApril 1,1, 22010.010. TThishis eexperiencexperience suggestssuggests thatthat ifif thethe FedFed announcesannounces a pprogramrogram ooff assetasset salessales wellwell inin advanceadvance andand fi nancialnancial marketsmarkets areare functioningfunctioning nnormally,ormally, iitt sshouldhould bebe ableable toto liquidateliquidate itsits positions.positions. OfOf course,course, ifif thisthis turnsturns outout notnot ttoo bebe thethe case,case, thenthen thethe FedFed couldcould discontinuediscontinue itsits salessales andand announceannounce thatthat itsits salessales aarere ccontingentontingent oonn tthehe mmarketarket ccontinuingontinuing ttoo ffunctionunction nnormally.ormally. A fi nalnal concernconcern ssometimesometimes rraisedaised iiss tthathat tthehe eexpansionxpansion iinn tthehe mmonetaryonetary bbasease wwillill nnecessarilyecessarily bbee iinflnfl aationary,tionary, bbutut tthishis iiss uunlikelynlikely ttoo bbee tthehe ccasease iinn tthehe ccurrenturrent eenvironment.nvironment. TThehe rreasoneason iiss tthathat bbanksanks aarere pperfectlyerfectly hhappyappy ttoo hholdold hhugeuge aamountsmounts ooff eexcessxcess rreserves—thuseserves—thus eessentiallyssentially nneutralizingeutralizing tthehe eeffectffect tthishis mmoneyoney wwouldould havehave onon demanddemand oror thethe priceprice level—aslevel—as longlong asas theythey areare paidpaid interestinterest onon tthehe reserves,reserves, asas isis nownow thethe case.case. However,However, purchasepurchase ofof long-termlong-term governmentgovernment bbondsonds hashas raisedraised concernsconcerns thatthat thethe FedFed isis willingwilling toto accommodateaccommodate proflprofl iigategate fi scalscal ppolicyolicy byby monetizingmonetizing governmentgovernment debt,debt, andand thisthis doesdoes havehave thethe potentialpotential toto castcast iinflnfl aationtion eexpectationsxpectations aadriftdrift wwithoutithout aann aanchor,nchor, wwhichhich ccouldould hhaveave iinflnfl aationarytionary cconsequencesonsequences iinn tthehe ffuture.uture.

TToo-Big-To-Failoo-Big-To-Fail TThehe ggloballobal fi nancialnancial crisiscrisis hashas revealedrevealed thethe needneed toto revamprevamp fi nancialnancial regula-regula- ttion.ion. FrenchFrench etet al.al. (2010)(2010) offeroffer discussionsdiscussions ofof fi nnancialancial regulationregulation inin thethe future,future, asas ddoo ssomeome ooff thethe otherother paperspapers inin thisthis symposium.symposium. HereHere I willwill focusfocus onon justjust oneone issue,issue, tthehe ttoo-big-to-failoo-big-to-fail problem.problem. ““TooToo bbigig ttoo ffail”ail” iiss a mmisnomer.isnomer. A fi nnancialancial fi rrmm ccanan bbee ssystemicallyystemically iimpor-mpor- ttant—thatant—that iis,s, iitsts ffailureailure ccanan tthreatenhreaten tthehe hhealthealth ooff tthehe fi nnancialancial system—becausesystem—because 11)) itit isis veryvery largelarge oorr 22)) iitsts aactivitiesctivities aarere ssoo iinterconnectednterconnected wwithith tthehe rrestest ooff tthehe fi nan-nan- ccialial ssystem.ystem. SSoo a mmoreore aaccurateccurate ttermerm wwouldould bbee ““tootoo iinterconnectednterconnected ttoo ffail”ail” oorr ““tootoo ssystemicallyystemically iimportantmportant ttoo ffail.”ail.” TThehe ffailureailure ooff tthehe hhedgeedge ffundund LLongong TTermerm CCapitalapital MManagementanagement iinn 11998998 iiss a cclassiclassic eexamplexample ooff a fi rmrm thatthat waswas notnot enormousenormous inin size,size, bbutut waswas systemicallysystemically iimportant.mportant. IInn aanyny ccase,ase, tthehe ddiffiiffi ccultyulty isis thatthat whenwhen creditorscreditors kknownow a fi rmrm fallsfalls iintonto tthishis ccategory,ategory, ttheyhey ccanan eexpectxpect ggovernmentovernment ttoo pproviderovide ssomeome aassistancessistance iiff thethe fi rmrm getsgets intointo trouble,trouble, whichwhich mmeanseans tthathat ttheyhey hhaveave llessess iincentivencentive ttoo monitormonitor thethe fi rrmm aandnd ppullull ooutut ttheirheir mmoneyoney iiff iitt iiss ttakingaking oonn ttoooo mmuchuch rrisk.isk. OOff ccourse,ourse, tthishis mmakesakes eexcessivexcessive rrisk-takingisk-taking mmoreore llikelyikely aandnd rraisesaises tthehe ccostost ttoo ttaxpayersaxpayers ooff thethe eventualeventual ggovernmentovernment bbailout.ailout. TToo-big-to-failoo-big-to-fail isis nownow a largerlarger problemproblem thanthan before,before, inin partpart becausebecause banksbanks havehave mmergederged iinn a wwayay thatthat createscreates eveneven largerlarger bankingbanking institutionsinstitutions andand because,because, withwith tthehe FFeded bailoutbailout ofof BearBear StearnsStearns inin MarchMarch 20082008 andand thenthen thethe fi nancialnancial assistanceassistance toto AAIGIG bbyy tthehe FFeded andand thethe U.S.U.S. TreasuryTreasury inin SeptemberSeptember ofof 2008,2008, itit hashas becomebecome clearclear tthathat a muchmuch widerwider rangerange ofof fi nancialnancial fi rmsrms areare likelylikely toto bebe consideredconsidered “too“too bigbig toto ffail”ail” inin thethe future.future. Indeed,Indeed, thethe mostmost prominentprominent casecase ofof a fi rmrm thatthat waswas notnot bailedbailed Frederic S. Mishkin 67

oout—Lehmanut—Lehman BrothersBrothers inin SeptemberSeptember 2008—was2008—was followedfollowed byby suchsuch a severesevere crisiscrisis tthathat iitt iiss uunlikelynlikely tthathat ggovernmentsovernments wwouldould letlet thisthis happenhappen again.again. InIn thethe wakewake ofof thethe LLehmanehman failure,failure, governmentsgovernments throughoutthroughout thethe worldworld bailedbailed outout oror guaranteedguaranteed allall ttheirheir mmajorajor fi nancialnancial institutions.institutions. OOnene wwayay ttoo aaddressddress tthehe ttoo-big-to-failoo-big-to-fail problemproblem isis ttoo llimitimit tthehe ssizeize ooff fi nancialnancial iinstitutions,nstitutions, whichwhich mightmight involveinvolve eithereither thethe breakupbreakup ofof largelarge fi nancialnancial institutionsinstitutions aand/ornd/or limitslimits oonn wwhathat aactivitiesctivities bankingbanking institutionsinstitutions cancan engageengage in.in. However,However, aarbitraryrbitrary llimitsimits oonn theirtheir sizesize oror activitiesactivities mightmight wellwell decreasedecrease thethe effieffi ciencyciency oror raiseraise ootherther rrisksisks iinn tthehe fi nancialnancial system.system. AnAn alternativealternative approachapproach isis toto subjectsubject systemicallysystemically iimportantmportant institutionsinstitutions toto greatergreater regulatoryregulatory oversight,oversight, saysay byby a systemicsystemic regulatorregulator ((asas ddiscussediscussed inin Mishkin,Mishkin, 2010a;2010a; FrenchFrench etet al.,al., 2010),2010), oror byby imposingimposing largerlarger capitalcapital rrequirementsequirements fforor ssystemicallyystemically iimportantmportant fi nancialnancial fi rms.rms. TThehe DDodd–Frankodd–Frank fi nancialnancial reformreform billbill passedpassed inin summersummer 20102010 givesgives thethe federalfederal ggovernmentovernment oneone mmoreore ttoolool fforor ddealingealing wwithith ssystemicallyystemically iimportantmportant fi nancialnancial compa-compa- nnies.ies. BeforeBefore Dodd–Frank,Dodd–Frank, thethe U.S.U.S. governmentgovernment onlyonly couldcould taketake overover individualindividual bbankinganking iinstitutions,nstitutions, bbutut nnotot fi nancialnancial holdingholding companiescompanies thatthat ownown banksbanks andand otherother fi nnancialancial institutions.institutions. (In(In otherother words,words, itit couldcould taketake overover Citibank,Citibank, butbut notnot CitigroupCitigroup oorr a ffree-standingree-standing investmentinvestment bankbank likelike LehmanLehman Brothers.)Brothers.) ItIt usedused toto bebe thatthat thethe ggovernmentovernment hadhad onlyonly twotwo alternativesalternatives withwith suchsuch fi rms:rms: sendsend themthem intointo bankruptcybankruptcy oorr bailbail themthem out.out. Now,Now, thethe federalfederal governmentgovernment hashas “resolution“resolution authority”authority” overover ssuchuch fi rms,rms, whichwhich meansmeans thatthat theythey cancan treattreat themthem asas theythey wouldwould anan insolventinsolvent bank.bank. CCriticsritics havehave expressedexpressed concernsconcerns thatthat thisthis federalfederal resolutionresolution authorityauthority willwill furtherfurther eentrenchntrench too-big-to-failtoo-big-to-fail andand soso makemake tthehe mmoraloral hhazardazard pproblemroblem wworseorse ((forfor eexample,xample, WWallison,allison, 2010).2010). AsAs withwith allall regulatoryregulatory authority,authority, thethe devildevil willwill bebe inin thethe details.details. ButBut tthehe nnewew rresolutionesolution aauthorityuthority iiss llikelyikely ttoo hhelpelp llimitimit mmoraloral hhazardazard bbecauseecause iitt ggivesives tthehe ggovernmentovernment a bbigig ssticktick ttoo fforceorce ssystemicallyystemically iimportantmportant fi nancialnancial institutionsinstitutions toto desistdesist ffromrom riskrisk takingtaking oror toto raiseraise moremore capital—orcapital—or elseelse faceface a governmentgovernment takeovertakeover thatthat iimposesmposes ccostsosts oonn mmanagersanagers aandnd sshareholders.hareholders.

RRetrenchingetrenching FFiscaliscal PPolicyolicy TThehe combinationcombination ofof massivemassive bailouts,bailouts, fi scalscal stimulusstimulus packages,packages, andand thethe sharpsharp eeconomicconomic ccontractionsontractions thatthat reducedreduced taxtax revenuerevenue hashas shiftedshifted thethe fi scalscal situationsituation forfor mmanyany ccountries.ountries. AAss RReinharteinhart andand RRogoffogoff (2009)(2009) pointpoint out,out, thethe aftermathaftermath ofof fi nan-nan- ccialial ccrisesrises isis aalmostlmost aalwayslways a largelarge increaseincrease inin governmentgovernment indebtedness,indebtedness, andand wewe hhaveave sseeneen eexactlyxactly tthishis ppatternattern inin thethe aftermathaftermath ofof thethe currentcurrent crisis.crisis. BudgetBudget defidefi citscits ooverver 1100 ppercentercent ooff GGDPDP iinn aadvanceddvanced ccountriesountries llikeike tthehe UUnitednited SStatestates hhaveave bbeeneen ccommonommon iinn 22009009 aandnd 22010.010. TThishis riserise inin governmentgovernment borrowingborrowing cancan eveneven raiseraise thethe rriskisk ofof sovereignsovereign debtdebt defaults,defaults, whichwhich cancan bebe a particularparticular problemproblem ifif sovereignsovereign debtdebt iiss bbeingeing hheldeld bbyy mmanyany bbanksanks aass a ““safe”safe” aasset.sset. TThishis rriskisk hhasas bbecomeecome a sseriouserious cconcernoncern iinn EEuropeurope aafterfter tthehe GGreekreek ssovereignovereign ddebtebt ccrisis.risis. AAss bbudgetudget ddefiefi citscits surgedsurged afterafter thethe crisis,crisis, thethe ratioratio ofof governmentgovernment debtdebt toto GDPGDP iiss pprojectedrojected toto jumpjump ttoo vveryery hhighigh llevelsevels iinn mmanyany ccountries.ountries. IInn tthehe nnextext ddecadeecade oorr sso,o, ggettingetting fi sscalcal hhousesouses iinn oorderrder wwillill bbecomeecome oonene ofof thethe highesthighest prioritiespriorities forfor govern-govern- mmentent ppolicyolicy tthroughouthroughout tthehe wworld.orld. IInn mmanyany ccountries,ountries, ggovernmentsovernments aalreadylready ffacedaced a 68 Journal of Economic Perspectives

llong-termong-term pproblemroblem ooff uunsustainablensustainable sspendingpending ggrowthrowth oonn hhealthealth ccareare aandnd ppensions;ensions; tthehe ccurrenturrent fi scalscal imbalancesimbalances havehave broughtbrought thosethose problemsproblems forwardforward inin timetime fromfrom tthehe llong-termong-term iintonto tthehe mmiddle-term,iddle-term, aandnd iinn ssomeome ccountriesountries iintonto tthehe short-termshort-term andand tthehe iimmediatemmediate ffuture.uture.

CConclusiononclusion

WWhathat startedstarted inin 20072007 asas a crisiscrisis inin oneone smallsmall partpart ofof thethe fi nancialnancial systemsystem ledled toto a worldwideworldwide economiceconomic conflconfl agrationagration byby latelate 20082008 andand earlyearly 2009.2009. ThereThere areare twotwo keykey llessonsessons ffromrom wwhathat hhasas hhappened.appened. FFirst,irst, tthehe ggloballobal fi nancialnancial systemsystem isis farfar moremore inter-inter- cconnectedonnected thanthan wwasas ppreviouslyreviously rrecognizedecognized aandnd eexcessivexcessive rrisk-takingisk-taking tthathat tthreatenedhreatened tthehe ccollapseollapse ooff tthehe wworldorld fi nancialnancial systemsystem waswas farfar moremore pervasivepervasive thanthan almostalmost anyoneanyone rrealized.ealized. UnderstandingUnderstanding howhow systemicsystemic riskrisk cancan arisearise andand designingdesigning policiespolicies toto reinrein iinn thisthis riskrisk takingtaking areare taskstasks ofof thethe highesthighest priority.priority. Second,Second, extraordinaryextraordinary actionsactions bbyy ccentralentral bbanksanks aandnd ggovernmentsovernments hhaveave ccontainedontained tthishis ggloballobal fi nancialnancial crisis,crisis, butbut ssuccessfullyuccessfully uunwindingnwinding tthesehese ppoliciesolicies wwillill pproverove ttoo bebe a highlyhighly challengingchallenging task.task.

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