The Paradox of Financial Crises

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


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 panicsimilar 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 collapsebreaking 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.

The War on Education


MAY 12, 2014

LONDONThe kidnapping of more than 200 schoolgirls in northern Nigeria by the Islamist terrorist group Boko Haram is beyond outrageous. Sadly, it is just the latest battle in a savage war being waged against the fundamental right of all children to an education. That war is global, as similarly horrifying incidents in Pakistan, Afghanistan, and Somalia attest.
Around the world, there have been 10,000 violent attacks on schools and universities in the past four years, according to a report by the Global Coalition to Protect Education from Attack. The evidence is as ample as it is harrowing, from the 29 schoolboys killed by suspected Boko Haram militants in the Nigerian state of Yobe earlier this year and Somali schoolchildren forced to become soldiers to Muslim boys attacked by ethnic Burmese/Buddhist nationalists in Myanmar and schoolgirls in Afghanistan and Pakistan who have been firebombed, shot, or poisoned by the Taliban for daring to seek an education.
These are not isolated examples of children caught in the crossfire; this is what happens when classrooms become the actual targets of terrorists who see education as a threat. (Indeed, Boko Haram is literally translated to mean that “false” or “Westerneducation is “forbidden.”) In at least 30 countries, there is a concerted pattern of attacks by armed groups, with Afghanistan, Colombia, Pakistan, Somalia, Sudan, and Syria the worst affected.
Such attacks reveal with stark clarity that providing education is not only about blackboards, books, and curricula. Schools around the world, from North America to northern Nigeria, now need security plans to ensure the safety of their pupils and provide confidence to parents and their communities.
At the World Economic Forum in Abuja, Nigeria’s capital, this week, together with partners from business and civil society, I launched a program to ensure the personal safety of children in areas where the threats to them are real and immediate. The Safe Schools Initiative will combine school and community-based plans with special measures to protect children attending some 5,000 primary and secondary schools in the most vulnerable areas.
For individual schools, the measures will include reinforcing security infrastructure, planning and response, training for staff, and counseling for students and community members. At the community level, education committees comprising parents, teachers, and volunteers will be formed, along with specially developed teacher-student-parent defense units for rapid response to threats.
Other countries’ experience grappling with similar threats has shown that it is crucial to engage religious leaders formally in promoting and safeguarding education. In Afghanistan, in collaboration with community shuras and protection committees, respected imams sometimes use their Friday sermons to raise awareness about the importance of education in Islam.
In Peshawar, Pakistan, in a program supported by UNICEF, prominent Muslims leaders have spoken out about the importance of education and of sending students back to school. In Somalia, religious leaders have gone on public radio in government-controlled areas and visited schools to advocate against the recruitment of child soldiers.
In countries such as Nepal and the Philippines, community-led negotiations have helped to improve security and take politics out of the classroom. In some communities, diverse political and ethnic groups have come together and agreed to develop Safe School Zones.” They have written and signed codes of conduct stipulating what is and is not allowed on school grounds, in order to prevent violence, school closures, and the politicization of education. In general, the signatory parties have kept their commitments, helping communities to keep schools open, improve the safety of children, and strengthen school administration.
Millions of children remain locked out of school around the world. This not just a moral crisis; it is also a wasted economic opportunity. In Africa, for example, education is particularly crucial as the continent’s economies increasingly shift from resource extraction to knowledge-driven industry. Providing a safe environment for learning is the most fundamental and urgent first step in solving the global education crisis.

Gordon Brown, former Prime Minister and Chancellor of the Exchequer of the United Kingdom, is United Nations Special Envoy for Global Education.

China's Alternate Reality of Slipping Growth


May 13, 2014 8:02 a.m. ET

As China's downshift continues, investors should worry that the economy is in even worse shape than meets the eye.  Government figures for April paint a dreary picture, led by a slowdown in the all-important real estate sector.

Housing sales this year through April have fallen 10% from a year earlier. Construction starts were down by almost a quarter. Fixed asset investment growth in April skidded to its slowest pace since 2002.  Retail sales, an imperfect proxy for consumer spending, grew by an anemic 11.9%, the slowest pace in three years. That adds up to a second quarter that is decelerating from an already sluggish first quarter, in which gross domestic product growth was 7.4%.  A bigger concern is that those GDP figures underestimate inflation, resulting in an exaggeration of real growth.

Citigroup economist Minggao Shen says there is "consistent evidence" that growth fell to as low as 6% in the first quarter.  He points to the government's GDP deflator, the number used to adjust nominal growth to the change in prices. The deflator has recently deviated from other measures of inflation, he says. This is at odds with a broader shift in China's growth makeup from manufacturing to services.

The latter tends to experience faster price increases.  Whatever the true rate of growth, the Communist Party sees job creation as the ultimate measure of its ability to stay in power. The official unemployment rate has barely fluctuated in years and is widely ignored, as it only captures a slice of the workforce. Other measures show some parts of the labor market holding up.

Online job advertisements in April were 81% higher than a year earlier, according to Zhaopin.com, a major online recruitment firm.  But employment may not hold up as the property market hits the rocks, given the mass of jobs it supports from construction workers to real-estate agents. Last week, Beijing pledged yet again to speed up construction of affordable housing, a signal the government sees a need to prop up this crucial sector. On Tuesday, the country's central bank urged more lending support for first-time home buyers.  Chinese policy makers have telegraphed for some time that slower growth is an inevitable part of its effort to reform the economy. Investors shouldn't be surprised by that. The question now is, exactly how slow is too slow?

Piketty and the Zeitgeist


MAY 13, 2014

PRINCETON – I get the same question these days wherever I go and from whomever I meet: What do you think of Thomas Piketty? It’s really two questions in one: What do you think of Piketty the book, and what do you think of Piketty the phenomenon?

The first question is much easier to answer. By sheer luck, I was among the earliest readers of the English-language version of Capital in the Twenty-First Century. Piketty’s publisher, Harvard University Press, had sent me the pre-publication galleys, hoping that I would contribute a blurb for the back cover. I did so happily, as I found the scope, depth, and ambition of the book impressive.
I was of course familiar with Piketty’s empirical work on income distribution, carried out jointly with Emmanuel Saez, Anthony Atkinson, and others. This research had already produced startling new findings on the rise of the incomes of the super-rich. It had shown that inequality in many advanced economies has reached levels not seen since the early part of the twentieth century. It was a tour de force on its own.
But the book goes far beyond the empirical work, and narrates an intriguing cautionary tale about the dynamics of wealth under capitalism. Piketty warns us not to be fooled by the apparent stability and prosperity that was the common experience of the advanced economies during a few decades in the second half of the twentieth century. In his story, it is the un-equalizing, destabilizing forces that may be dominant within capitalism.
Perhaps more than the argument itself, what makes Capital in the Twenty-First Century a great read is the sense of witnessing a superb mind grapple with the big questions of our time. Piketty’s emphasis on the political nature of the distribution of income; his subtle back-and-forth between the general laws of capitalism and the role played by contingency; and his willingness to offer bold (if, to many, impractical) remedies to save capitalism from itself are as refreshing as they are rare for an economist.
So I would have liked to claim that I was prescient in foreseeing the huge academic and popular success that the book would have upon publication. In truth, the book’s reception has been a big surprise.
For one thing, the book is hardly an easy read. It is almost 700 pages long (including the notes), and, though Piketty does not spend much time on formal theory, he is not beyond sprinkling an occasional equation or Greek letters throughout the text. Reviewers have made much of Piketty’s references to Honoré de Balzac and Jane Austen; yet the fact is that the reader will encounter mainly an economist’s dry prose and statistics, while the literary allusions are few and far between.
The economics profession’s response has not been uniformly positive. The book’s argument revolves around a number of accounting identities that relate saving, growth, and the return to capital to the distribution of wealth in a society. Piketty is very good at bringing these abstract relations to life by hanging real numbers on them and tracing their evolution over history. Nevertheless, these are relationships that are well known to economists.
Piketty’s pessimistic prognosis rests on a slight extension of this accounting framework. Under plausible assumptions – namely that the wealthy save enough – the ratio of inherited wealth to income (or wages) continues to increase as long as r, the average rate of return to capital, exceeds g, the growth rate of the economy as a whole. Piketty argues that this has been the historical norm, except during the tumultuous first half of the twentieth century. If that is what the future looks like, we are facing a dystopia in which inequality will rise to levels never before experienced.
Yet extrapolation is dangerous in economics, and the evidence that Piketty adduces to support his argument is hardly conclusive. As many have argued, the return to capital, r, may well start to decline if the economy becomes too rich in capital relative to labor and other resources and the rate of innovation slows down. Alternatively, as others have pointed out, the global economy may pick up speed, buoyed by developments in the emerging and developing world. Piketty’s vision needs to be taken seriously, but it is hardly an iron law.
Perhaps the source of the book’s success should be sought in the zeitgeist. It is difficult to believe that it would have had the same impact ten or even five years ago, in the immediate aftermath of the global financial crisis, even though identical arguments and evidence could have been marshaled then. Unease about growing inequality has been building up for quite some time in the United States. Middle-class incomes have continued to stagnate or decline, despite the economy’s recovery. It appears that it is now acceptable to talk about inequality in America as the central issue facing the country. This might explain why Piketty’s book has received greater attention in the US than in his native France.
Capital in the Twenty-First Century has reignited economists’ interest in the dynamics of wealth and its distribution – a topic that preoccupied classical economists such as Adam Smith, David Ricardo, and Karl Marx. It has brought to public debate crucial empirical detail and a simple but useful analytical framework. Whatever the reasons for its success, it has already made an undeniable contribution both to the economics profession and to public discourse.

Dani Rodrik is Professor of Social Science at the Institute for Advanced Study, Princeton, New Jersey. He is the author of One Economics, Many Recipes: Globalization, Institutions, and Economic Growth and, most recently, The Globalization Paradox: Democracy and the Future of the World Economy.