Next financial crisis

Will we survive the next financial crisis?

Three officials who rescued the economy in 2008 warn it might be harder to stop the next panic.

By BEN S. BERNANKE , TIMOTHY F. GEITHNER and HENRY M. PAULSON JR.

As we pass the 10-year anniversaries of the defining events of the 2008 global financial crisis, it’s a good opportunity to reflect on what happened, what we learned and whether it could happen again. Certainly, none of the three of us or our colleagues had ever lived through a crisis like that one, a crisis that was in some ways worse even than the early stages of the Great Depression. The good news is that, this time, concerted government action managed to stop the panic, stabilize the financial system, revive the credit markets and help start a recovery that continues to this day. Indeed, on key dimensions, the U.S. recovery from the Great Recession compares favorably to recoveries from previous severe financial crises, both in the United States and abroad, and the recoveries of other advanced economies from this crisis.

Yet even so, the crisis was extraordinarily damaging, for both the United States and the world. Millions of Americans lost their jobs, their businesses, their savings and their homes. The popular anger generated by the crisis and by longer-term trends of increasing inequality, insecurity, and social immobility has roiled our politics and our society.

The U.S. government was not well prepared for the financial conflagration of 2008, which helps explain why this fire burned so hot, why the efforts to contain it often seemed so messy, and even why that response became so wildly unpopular. Better preparation could have created better outcomes. If the regulatory system had been less Balkanized and more capable of addressing the risks, if crisis managers had been empowered all along to use overwhelming force to avoid financial collapse, and if there had been mechanisms in place from the start to ensure that the financial system would pay for its own rescue, the fire would have been less intense, and the firefighting would have seemed less inconsistent and unfair.

A DECADE LATER, the vital question to ask is whether the United States is better prepared today. We believe the answer is: yes and no. There are better safeguards in place to avoid a panic in the first place—the financial equivalent of more aggressive fire prevention measures and stronger fire-resistant building codes. But the emergency authorities for government officials to respond when an intense crisis does happen are in many ways even weaker than they were in 2007.

It’s worth recapping why the system was so unsafe before the crisis. The basic problems a decade ago were too much risky leverage, too much runnable short-term financing and the migration of too much risk to shadow banks where regulation was negligible and the Federal Deposit Insurance Corp.’s and Federal Reserve’s emergency safety net was inaccessible. Meanwhile, America’s regulatory bureaucracy was fragmented and outdated, with no one responsible for monitoring and addressing systemic risks.

The Dodd-Frank regulatory reforms and the U.S.-led global effort to increase bank capital have produced more robust defenses against potential crises. Bank liquidity requirements were enhanced worldwide, reducing the reliance of financial institutions on unstable overnight funding. A range of other reforms have made derivatives markets and markets for short-term funding safer and more transparent. Importantly, financial regulators have been mandated to look for potential threats to the financial system as a whole, not just factors that affect individual firms or markets.

Together, these and other reforms should reduce the frequency and severity of financial crises, as long as they are preserved and not weakened over time. But stronger rules and stricter oversight will never prevent all crises. And unfortunately, the changes of the past decade could actually block some of the most effective actions used to defeat the panic a decade ago.

We ultimately went to Congress at the height of the crisis to get the authority we needed to recapitalize endangered firms. We believe that if we had started the crisis with that authority, we could have acted more forcefully, swiftly and comprehensively to help restore confidence in the system. Instead, we had to rely for most of the crisis on the more limited Fed liquidity tools and ad hoc rescues that kept us from getting out in front of the crisis.

DESPITE THE MANY positive elements of the Dodd-Frank reforms that Congress enacted in 2010, the final law curtailed rather than expanded these most effective firefighting tools. The FDIC’s broad guarantee authority, so effective during the crisis, was eliminated, as was the ability of the Fed to lend to individual nonbank financial firms. Congress limited the Fed’s discretion to judge when its loans are secured to its satisfaction, making it harder for the central bank to accept risky collateral in a future emergency. It also imposed disclosure requirements that could well make the Fed’s discount window, in principle the primary tool for making liquidity available to banks, useless in a future crisis.

Congress took away the Treasury’s power to issue guarantees, even though that power protected the savings of ordinary Americans and vital short-term funding for much of corporate America when money market funds were melting down. Congress also curtailed the executive branch’s ability to take credit risk alongside the Fed, as it had done to backstop consumer credit markets. And, of course, with the expiration of the Troubled Asset Relief Program (TARP) which recapitalized the banking system, there is no standing ability to inject capital into nonbank firms to avert systemic crisis, though the FDIC has long had such powers for commercial banks without significant problems or controversies.

When another serious crisis does arrive, Congress would have the power to undo these limitations. But that’s easier said than done. At a minimum, financial firefighters would have to spend time, energy and political capital to get the trucks and hoses they need while the fire is already burning, which can intensify crises and increase their ultimate costs to taxpayers and the economy. And it’s hard to look at the bitterly polarized politics of modern America and feel confident that unpopular but necessary actions would emerge when it mattered most.

The financial system and the economy seem stronger today. But the world is full of risks. Although the extreme crisis is rare, someday it will come. And even though Washington is mired in a noisy state of gridlock, now is as good a time as any to fill in the gaps in the 2010 reforms and prepare for the worst. As a great philosopher warned: If you want peace, prepare for war.