When coming out of a surgery, a patient’s major body systems are often out of whack. Blood pressure, respiration, oxygen saturation, pulse rate, blood sugar, kidney function, bowel function, and many other indicators can differ from their normal levels. This is because the body has just undergone a trauma and is trying to right itself. The usual response to these indicators is to monitor them as they return to normal by themselves. This is why there are all those machines beeping and whizzing both during and after surgery. The body has amazing ability to self-correct and recuperate. Except when it doesn’t.
On Monday, September 18, 2008, the world economy flat lined. That is the day that the Reserve Primary Fund, a money market fund with $62 billion in assets “broke the buck,” meaning it suspended redemptions. Money market funds are viewed by many investors as essentially riskless, a half-step away from US Treasury Bills. When this proved not to be the case, panic ensued. On that day an electronic run on money market funds began, as scared investors, who had never experienced such a phenomenon, drained over a $100 billion from their funds. On Thursday that same week, institutional investors sought to redeem $500 billion—a heckuva lot of money—from the money markets, but were dissuaded from doing so by the personal intervention of Treasury Secretary Hank Paulsen (I wonder what he told them), though they still redeemed an additional $105 billion. On Friday, September 19, Paulsen announced a temporary program to insure money market funds and the Federal Reserve opened up a loan program to allow borrowing to meet the demand for redemptions. That same week regulators also restricted short sales of money market funds. [My account of this history is based on this report from the Joint Economic Committee of Congress.]
The actions of Paulsen, Bernanke, Geithner, and President Bush that week, and during the subsequent ones, quite possibly saved the world’s financial system from a complete crash and a resulting depression that makes our current woes look like a picnic. In many ways, their efforts remind me of one of those ER episodes where all the doctors are gone and a few medical students and nurses are trying to save a dying patient. They flail around, knocking things over, yelling, making mistakes, trying things that don’t work and might even do damage, but they get the heart beating again. It is not a comforting metaphor, but it captures the essence of the crisis we were in.
When the history books get written, maybe Bush’s team will get the credit they deserve. Maybe there will be a financial 13 Days movie coming out of Hollywood that captures their heroic efforts, though I sort of doubt it, given the current animosity towards Wall Street and towards the federal government (I’m not saying that animosity isn’t well-deserved!). Isn’t the best approach for the government to get out of the way and let markets do their thing? In general, yes. But it isn’t quite that simple. Markets, like the human body, are not always self-correcting.
Let me put on my economics professor hat for a moment. Consider the market for oranges. If an orange farmer loses his shorts because he spends too much time tailgating at Gator football games rather than spraying his trees against insects, can the market handle it? Of course. These ideosyncratic risks that are faced by buyers and sellers in markets can be fully absorbed, even though they are no fun for the people who face losses. But a systemic risk cannot be absorbed. These might be acts of God, such as a frost that wipes out the whole US crop, or human-induced, say by farmers adopting a new fertilizer that raises yields in the short run, but kills the trees down the road. These systemic risks can wipe out the whole US orange market. But even these systemic risks can be absorbed in the larger market, where there are lots of substitutes for oranges, including oranges imported from other countries. The larger and more diversified a market, the less systematic risk exists.
Participants in financial markets face massive idiosyncratic risks. There are winners and losers. Financial institutions who make bad decisions should be allowed to fail, in general. That is how market discipline works, and that discipline is a healthy thing for the economy. The social benefits of having a vibrant, dynamic financial market are enormous. But the systemic risk that can exist in these markets can also have enormous costs.
This is for two reasons. First, the rest of the economy depends in critical ways on the financial markets. Even careful, risk-averse companies that have solid fundamentals rely on banks and other financial intermediaries. Firms don’t have piles of gold lying around to meet their obligations. They, like ordinary people, keep their liquid assets in the financial industry. When credit freezes up and assets stop flowing, the rest of the economy can freeze up. Even a firm without any debts still has to puts its money somewhere, and big chunk of those assets are likely to end up in conservative places, like money market funds. This is why money markets freezing up is analogous to the economy flat lining.
The second reason systemic risk can be so dangerous in financial markets is that the whole market is based on trust. By trust I don’t mean trust between individual traders, who don’t trust each other at all in many cases. I mean trust in the integrity of the system. All of these assets are held as zeros and ones in computers all over the country. People trust that they will be able to convert those zeros and ones into dollar bills because of the nexus of commonly accepted accounting procedures, reputational capital, regulations, backups of informational systems, insurance, and other safeguards. A CEO can walk around his plant and accessing the value of his company by looking at the machinery and workers and technologies he has in place and the products he is producing. But financial capital consists of digits on some hard drive who knows where. When the whole financial system starts to panic and that trust erodes, there is the potential for catastrophe.
So, when the financial system flat lines, who is there to infuse liquidity and, more important, trust and calm back into the market? The short answer to that question is the US federal government (as well as other governments and central banks, though when times are scary, everyone around the world seems to want US treasuries). Ultimately, it is trust in Uncle Sam that keeps this financial house of cards afloat. While various arguments have been made that the regulations and policies of the government were the cause of the financial crisis in the first place, those arguments are basically irrelevant to the issue of the government maintaining that essential trust that people need to have in financial institutions.
Bush’s economic team was flying by the seat of its pants during the Fall of 2008. Now that the crisis has subsided (for the time being), we need a lot of careful study to evaluate the decisions they made and how to prevent future crises from occurring. What we don’t need is more naiveté about how markets will correct and everything will return to normal. As an old-fashioned, Chicago-trained economist, I like nothing better than to let markets correct themselves. But that does not mean we simply let the whole economy flush itself down the toilet while we sing the praises of those markets to a soon-to-be impoverished nation.
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