THE PARADOX OF FINANCIAL CRISIS / THE WALL STREET JOURNAL OP EDITORIAL

OPINION

The Paradox of Financial Crises

Aggressive government intervention wall lead to a stronger financial system less dependent on the taxpayer.

By TIMOTHY F. GEITHNER


May 12, 2014 6:52 p.m. ET


During the terrifying autumn of 2008, when I was serving as president of the Federal Reserve Bank of New York, my team was on a conference call with Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke debating whether the administration should ask Congress for stronger weapons to confront the crisis. Meg McConnell, a colleague, pressed the mute button on the speakerphone and pleaded with me to tell them that if they didn't go to Congress now, "there will be shantytowns and soup lines across the country."


Why did she fear that? We were in the midst of a classic financial panic—similar to the bank runs in the Great Depression. But most people did not yet feel the impact of the run. The losses suffered on Wall Street seemed welcome and deserved, and of no consequence to the vast majority of Americans.


There was little memory of how panics kill economies, but the panic was already killing ours. American households lost 16% of their wealth in 2008 alone, several times as large as the losses at the start of the Great Depression, during which unemployment rose to 25% and total output fell more than 25%.


Financial crises are devastating, but unlike threats to national security, Americans don't give their presidents much in the way of emergency authority to fight them. That reluctance stems from the fear of "moral hazard"—the valid concern that market actors who can expect a bailout in case things go wrong will be encouraged to take too many risks. That same fear typically makes governments, even when they do have the authority, too slow to act.


And so the government had very limited weapons with which to combat the financial crisis of 2008. On "Lehman weekend" (Sept. 13-14), it had no ability, in the absence of a willing buyer, to prevent the investment bank from collapse. And that's why Presidents Bush and Obama had to ask Congress for successive waves of emergency authority.


Ultimately, Congress provided both presidents with the authority to prevent the collapse of the financial system and get the economy growing again. Yet the actions we took were highly controversial, deeply unpopular on the left and the right, and met by vocal skepticism from academics and the public.


That was partly because what one has to do in a panic is the opposite of what seems fair and just. In a financial crisis, the natural instinct is to let creditors suffer losses, let firms fail, and protect taxpayers from any risk of loss. But in a financial panic, a strategy based on those instincts will lead to depression-level unemployment.


Instead, the government and the central bank have to step in and take risks on a scale that the private sector can't and won't. They have to reduce the incentive for investors, lenders and depositors to run and liquidate assets in panic selling. They have to raise the confidence of businesses and individuals that there will not be a systemwide collapse—breaking a vicious cycle in which the fear of a financial-system collapse and a deep recession feed on each other and become self-fulfilling.


Breaking this cycle requires a massive injection of cash into the economy, as directly as possible into the hands of those who will spend it, to offset the loss of private earnings and the collapse in private demand. It also requires doing whatever it takes to keep the financial system from collapse. The banking system is like the power grid; the economy simply can't function if the lights go out and people can't get access to credit.


In a true financial panic, the moral imperative is to ignore moral hazard and first put out the fire. This is counterintuitive. It feels deeply unfair. And it creates some unfortunate collateral beneficiaries in terms of the firms protected from their mistakes. But this is the only way to ultimately protect the innocent victims of the crisis from the calamitous damage of economic depressions.


Because two presidents were willing to put politics aside and deploy a massive and creative rescue, we prevented economic catastrophe and got the economy growing again in about six months. We kept the ATMs working, saved the auto industry, fixed the broken credit channels so that the economy could grow, recapitalized the banking system, and restored much of the damage to America's savings.


The conventional wisdom in early 2009 was that the financial rescue would cost $1-$2 trillion. In fact, the financial system paid for the protection we provided and taxpayers have already earned tens of billions of dollars in profits on these programs.


Herein lies the central paradox: The more aggressive the government is in designing a rescue plan, the easier it is to force more restructuring in the financial sector, and the better the chances of leaving the surviving system stronger and less dependent on the taxpayer.

It is true that we were not able to do all that was important or desirable. The rescue was unorthodox and messy, and the country is still living with the deep scars of the crisis. Long-term unemployment remains alarmingly high. There are very high levels of poverty and appalling inequality, not just in income and wealth, but in the opportunities Americans have for a quality education or economic mobility.

But we did do the essential thing, which was to prevent another Great Depression, with its decade of shantytowns and bread lines. We put out the financial fire, not because we wanted to protect the bankers, but because we wanted to prevent mass unemployment.

We still face many challenges as a country. But we are a stronger country today and in a much stronger position to confront those challenges because America passed its stress test.


Mr. Geithner was secretary of the Treasury from 2009-13 and is the author of "Stress Test: Reflections on Financial Crises" published this week by Crown.