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Fear and Financial Crisis

Ben S. Bernanke, Timothy F. Geithner, Henry M. Paulson Jr.

The crisis of 2008 was a classic financial panic, a staple of economic history at least since the Dutch tulip crisis of 1637, except this time it was rooted in a mania over dubious mortgages rather than fashionable flowers. As the housing boom went bust, investors and creditors frantically reduced their exposures to anything and anyone associated with mortgages and financial instruments backed by mortgages, triggering fire sales and margin calls. The financial panic crippled credit and shattered confidence in the broader economy, while the resulting job losses and foreclosures created more panic in financial markets, a vicious cycle that threatened to drag down the economy along with the financial system.

It’s hard to overstate just how chaotic and frightening the crisis became. A one-­month period starting in September 2008 included the abrupt nationalization of the mortgage giants Fannie Mae and Freddie Mac, the most aggressive financial intervention by the U.S. government since the Depression; the failure of the venerable investment bank Lehman Brothers, the largest bankruptcy in U.S. history; the collapse of the brokerage firm Merrill Lynch into the arms of Bank of America; an $85 billion rescue of the insurer AIG to prevent an even larger bankruptcy than Lehman’s; the demise of Washington Mutual and Wachovia, the two largest failures of federally insured banks in U.S. history; the first-­ever government guarantees for more than $3 trillion worth of money market funds; the equally unprecedented backstopping of a further $1 trillion worth of commercial paper; and congressional approval, after an initial market-­crushing rejection, of a $700 billion arsenal of government support for the entire financial system. This all happened during the home stretch of a presidential campaign. History was moving at warp speed, and consequential decisions had to be made every day in the fog of uncertainty.

Importantly, the events of 2007–2009 were a panic not only in the psychological sense, although emotions certainly ran high, but also in a narrower, technical sense. For economic historians, a panic refers specifically to a broad-based run on short-­term liabilities. Panics can occur because finance, a large and dynamic sector that is normally an important driver of economic growth, is also inherently fragile. The fragility stems from the fact that banks and other financial intermediaries perform two key economic functions that occasionally come into conflict. First, they give people an easily accessible place to stash their money, one that provides more safety and a higher interest rate than a mattress. Second, they use that money to make loans to households and businesses. In other words, they borrow short-­term in order to lend long-­term, a process known as “maturity transformation.”

Maturity transformation is a vital social function, but it comes with a built-in risk: Every institution that borrows short and lends long is vulnerable to a “run on the bank,” if for any reason depositors or other short-­term creditors lose confidence in that institution. Even a solvent bank, with assets more valuable than its liabilities, can collapse if those assets are too illiquid to cover its immediate demands for cash. A panic is a bank run writ large: It is a situation in which creditors lose confidence in the system as a whole and run on a wide range of short-­term liabilities. Historically, panics have typically led to large contractions in credit and sharp declines in asset prices, with predictably disastrous effects on the broader economy.

The United States, like most countries, has tried to reduce the danger of runs and panics with regulations that limit banks from taking excessive risks, along with government insurance for depositors that reduces their incentive to run if they fear their bank is in danger. But modern financial institutions depend on many forms of funding other than deposits that remain uninsured and potentially “runnable.” And in the modern age, a run on a bank no longer requires a physical run from an actual bank, just a click of a mouse.

The more general point is that financial institutions, unlike other businesses whose success depends primarily on the cost and quality of their goods and services, depend primarily on confidence. No financial institution can function without it, but it can go at any time, for rational or irrational reasons. When it goes, it usually goes quickly, and it’s hard to get back. Fear is hard-­wired into the human psyche, and the herd mentality is powerful, which makes stampedes hard to predict and hard to stop. Consequently, the potential for panic can never be fully eradicated, because there’s no way to eradicate overconfidence or confusion.

In other words, the world will face the threat of financial crises as long as risk-­taking and maturity transformation remain central to finance, and as long as humans remain human. Unfortunately, disaster will always be possible.

From First Responders. Edited by Ben S. Bernanke, Timothy F. Geithner, and Henry M. Paulson Jr., with J. Nellie Liang. Published by Yale University Press in 2020. Reproduced with permission.

Ben S. Bernanke is distinguished fellow in residence at the Brookings Institution and was chairman of the Federal Reserve from 2006 to 2014. Timothy F. Geithner is president of the global private equity firm Warburg Pincus and was secretary of the Treasury from 2009 to 2013. Henry M. Paulson, Jr., is chairman of the Paulson Institute at the University of Chicago and was secretary of the Treasury from 2006 to 2009.

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