President, Warburg Pincus; former Secretary of the Treasury of the United States; former President of the Federal Reserve Bank of New York.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Secretary Geithner: In the United States, we completely redefined the lender of last resort tool kit, and the Federal Reserve Board Chairman redefined the frontiers of how to think about monetary policy at the zero bound. So yes. Absolutely.
On the monetary policy side, it is clear and straightforward. Central banks have used a commitment to purchase assets – with varying horizons, varying quantities, and varying type of assets – to try to improve economic outcomes. They also have used forward guidance. The Fed changed the way central banks think about these tools. If they had thought about them before in theory, they hadn’t really been deployed in practice, at least not on a meaningful scale.
On the lender of last resort side, we did several different types of things. Some were extensions of classic doctrines, some were new. The extensions fell into two categories. These included a set of swap lines to the emerging economies in the fall of 2008. These were limited in quantity, but were very effective as a signaling device. In this same category were the open-ended swap lines to the major central banks. Even though swap lines had been a feature of the arsenal in the past, using them in this context was completely novel.
The second extension of the classic tool kit was the way in which we used the discount window for banks. We designed a set of mechanisms to try to reduce the stigma facing banks that come to central banks to get liquidity in the crisis. These mechanisms included the term auction facility, in which we used an auction as a way to not just efficiently allocate liquidity but to encourage people to borrow.
The more novel things we did that hadn’t been deployed anywhere in the past were the things we did to provide a backstop, as well as a direct provision of liquidity, to the nonbank financial system. As you know, in the United States the nonbank financial system is an important source of credit to the economy. It includes a very diverse set of institutions and funding vehicles. Those had basically come to a stop in the panic. Institutions were unable to fund themselves, precipitating a classic run and liquidation spiral. Then there were a variety of funding vehicles like commercial paper and asset-backed lending vehicles that came to a stop as well. So, in the fall of 2008 and early 2009, we designed and launched a whole set of new facilities, adapting the classic lender of last resort doctrine to the challenge. Our goal was to break the run on those parts of the system under stress, and to reopen those channels of credit as well.
Where should we be looking now for financial stability risks given this experience?
Secretary Geithner: We should distinguish between two types of financial risks or shocks. There is an infinite variety of pain or trauma that can hit a financial system, individual institutions, or asset prices. During the 30 years before the crisis, we experienced all sorts of shocks. Some of them were just idiosyncratic failures of single firms that got risk management wrong or were consumed by fraud. Then you had a series of more generalized shocks, like the savings and loan crisis and the stock price plunge in 1987. These kinds of shocks can cause some trauma, but the scale of the threat they present to the system or to the economy is completely different from a classic systemic crisis like the one we faced in 2008.
The really important distinction to make in terms of both diagnosing the risks of a crisis and of thinking about how to respond is to try to determine when your system is vulnerable to a truly systemic disruption and when it is not. If there is a lot of dry tinder, you are more vulnerable and even a modest shock can risk tipping you over into a more systemic panic. You want to make your system resilient to such shocks. So, the most important thing is to ask yourself: where today do we face the kinds of vulnerabilities, the kinds of conditions – the dry tinder – that might make us more vulnerable to a more cataclysmic kind of shock that would be very damaging to the economy?
For systems to face that kind of threat you really need to have had a long boom in credit financed either through the banking system or through the financial system in ways that create a classic vulnerability to a run. That is, you need to have a set of long-dated assets that are illiquid, are vulnerable to a loss, and are funded short. We don’t face that sort of vulnerability in the financial system today. In many ways, the crisis is still too recent. The memory is too fresh for us to have had that long build up in borrowing through the banking system that makes you susceptible to systemic panic. Since the crisis, credit growth has been very modest while financial reforms have produced a system that is much better capitalized.
The one exception I would make to that general view is that Europe is vulnerable for different reasons to a kind of classic run or panic. They don’t have the institutions that would allow them to defend themselves credibly against such an event. For them to build that kind of arsenal (like what we eventually built in 2008-2009 to break a panic) they would have to do a whole range of things – creating institutions that aren’t in place today.
Beyond that, there is a familiar set of risks out there. But they are not risks on a scale like those that made the world vulnerable to a panic in 2008-2009.
What do we need to do to preserve the benefits of global finance?
Secretary Geithner: There are three classes of things that you need. You need a framework of prudential safeguards that protect you against the risk in banking systems. This means limits on leverage, limits on funding maturity mismatch, and limits on currency mismatch. These form the classic set of ex ante safeguards that are well understood but occasionally get kind of thin relative to risk. Preserving those safeguards, maintaining them, and making sure they are not eroded over time, is the most important thing.
Second, for small open economies and for emerging economies, you need to have a set of institutions – such as appropriate exchange arrangements, fiscal cushions, prudential limits on the banking system, and independent central banks – that help reduce your vulnerability to the types of large swings in capital that can come from living in a world of global capital flows.
And there’s a third thing that is very important as well. There is no set of ex ante defenses or prudential safeguards that can make a group of closely integrated economies invulnerable to every type of financial crisis. There is an inherent need in finance for what you might call a fire station. That is how I would describe the types of tools we deployed in 2008-2009 to break our panic. And those things have to be strong at the international level. Ideally, someone should have the full authority to intervene when a panic starts. But such an authority must be defined by a set of arrangements for cooperation at the global level. And it requires, in particular, a strong IMF balance sheet, so there is a capacity to provide supplemental resources to countries that lose the capacity to borrow in a panic.
We need those three things to preserve the benefits of global finance. A set of classic prudential ex ante defenses. For the emerging economies in particular, you need an institutional framework and a macroeconomic policy and exchange rate framework that make it safer to operate with an open capital account. And finally, a strong fire station at the national level, and a strong fire station or set of arrangements globally that allow you to act quickly and forcefully when a national financial crisis threatens to spread across countries.