David Warsh: Fed's failure to communicate in the Great Crash of '08

The bursting of the South Sea Bubble and Mississippi Bubble in 1720 is regarded by some economists as the first modern financial crisis.

The bursting of the South Sea Bubble and Mississippi Bubble in 1720 is regarded by some economists as the first modern financial crisis.


Why were the Bush and incoming Obama administrations so ill-prepared to explain themselves in 2008? It’s one thing to say that no one saw the panic coming. It’s another, after the whirlwind had come and gone, for political leaders and regulators to have so poorly explained what they had done to save the day.

What happened was simple: after the authorities permitted Lehman Brothers to fail in September, a breakneck banking panic ensued, the first on such a scale, since the experience of the Panic of 1907 led to the creation of the Federal Reserve System.

The 2008 event spilled far beyond the boundaries of the traditional banking system, as defined by law and regulation, to threaten all kinds of related institutions, such as the insurance giant AIG International, General Electric and General Motors, engaged in what came to be called “shadow banking.”

The panic lasted five weeks, until coordinated lending by central bankers, led by the U.S. Federal Reserve Board, staunched the fear in mid-October.

A deep recession followed, but it was much less severe than what would have happened if the central banks of the industrial nations hadn’t acted with alacrity, and with the backing of leaders of both parties.

Two plausible reasons have been advanced to account for the authorities’ failure to make clear what they had done and take credit for it.

One is that central banks and national treasuries habitually downplay their role as lenders of last resort for fear that their readiness to step in – in effect, firefighters with deep pockets – may encourage excessive risk-taking among market participants.  Indeed, a preoccupation with “free-market” solutions may have led to ostrich-like behavior in 2008.

The other possibility is that financial markets were so protected by the belt-and-suspenders banking reforms undertaken after the Great Depression – and economists in those years so swept up in a priori theorizing – that political leaders simply never learned the main task for which central banks had been chartered in the first place.  They exist, that is, to prevent bank panics from turning into devastating meltdowns by emergency lending to any and all threatened firms, against good collateral, at a penalty rate.

The familiar dual mandate – maintaining stable prices and sustainable employment – are in fact second and third on the list of the Fed’s responsibilities, after crisis management.

The unwillingness of either political party to give the other credit for what it had achieved, before and after a hotly-contested presidential election, may have played a role as well.  Whatever the reasons for the failure to communicate effectively after 2008, US politics have been substantially corroded by it ever since.

An important step to improve the situation was taken last week when the Yale Program on Financial Stability announced the creation of its Crisis Response Project, an online platform designed to serve as a resource for policy makers dealing with crisis situations – and, presumably, a focal point for those caught up in them.

Organized by Yale School of Management Prof. Andrew Metrick, in 2013, the Program on Financial Stability has been supported since its inception by the Alfred P. Sloan Foundation – mostly to assemble an intensive summer school program for up-and-coming central bankers and regulators.  A one-year Master’s Degree program in Systemic Risk Management will enroll its first students in the autumn. The program’s advisory board, chaired by former Treasury Secretary Timothy Geithner, is luminous.

A $10 million grant from Bill Gates, Bloomberg Philanthropies, Jeff Bezos and the Peter G. Peterson Foundation will enable the Crisis Response Center to concentrate on analyzing the “war-time situations” that periodically develop, as opposed to the task of writing and enforcing regulations for financial institutions. “The first time you contemplate a potential solution to a crisis shouldn’t be when you’re in the middle of one,” said Metrick.

To this point the best explications of the patterns of crises and their remedies have been historical, Lombard Street: A Description of the Money Market, by Walter Bagehot, in 1873;   Manias, Panics and Crashes: A History of Financial Crises, by Charles P. Kindleberger, in 1978; and,  of the recent event, Slapped by the Invisible Hand: The Panic of 2007, by Gary Gorton, in 2010.  The contemplated “online platform” represents a significance advance.

But financial institutions evolve so quickly – “at the speed of thought,” as Andrew Lo, of the Massachusetts Institute of Technology’s Sloan School of Management puts it in Adaptive Markets – that what is wanted is a theoretical perspective. This role was performed in interpreting the recent crisis, for the most part unsatisfactorily, by Hyman Minsky, of Washington University in St. Louis and the Levy Economics Institute of Bard College, who sketchily interpreted a crisis he often predicted but did not live to see. Minsky, a student of Joseph Schumpeter, died in 1996.

Enter Martin Shubik, a 91-year-old theorist of especially broad background, and merhaps the world’s first mathematical institutional economist. A student of Oskar Morgenstern at Princeton University in the years just after World War II, Shubik made major contributions to the entry into economics of game theory. He worked for many years at RAND Corp, at General Electric Co. and IBM Corp, and, since 1963, as a member of the Yale faculty.

Minsky, whom he knew well, “was intuitively right about almost everything,” says Shubik.  But he lacked the temperament and tools necessary to devise a successful theory. As for historians and institutional scholars of the present day – Morgan Ricks, say, author of The Money Problem: Rethinking Financial Regulation, or Gorton – they are brilliant on the details, “but in the end, they only have words” to describe what may happen next, Shubik says.

In fact Shubik has sought for nearly 50 years to integrate monetary theory and general equilibrium theory, most recently in The Guidance of an Enterprise Economy, with Eric Smith, of the Earth-Life Science Institute in Tokyo and George Mason University. E. Roy Weintraub, of Duke University, a distinguished historian of thought, describes the book as “the first modern attempt to provide an intellectual framework in which money appears naturally in various market institutions.”

It is, of course, the last attempt to provide a successful theory that is best remembered, not the first. And there is a chance that Shubik’s work simply disappears with his death, he acknowledges. There is also a chance, he says, “that in twenty or thirty years, this will be seen to have been the starting point.”

It will be a great long way, obviously, and the work of many hands, to a really satisfactory theory of speculative manias, panics and crashes – and their prevention, or at least mitigation. As with nuclear war and climate change, however, it will be theory of financial crises that shows how to diminish the odds.

David Warsh, a veteran financial and political columnist (and  a former colleague of New England DIary's editor) is proprietor of economicprincipals.com,  where this essay first appeared.