The working paper "Evidence on Outcomes" is one of a series of working papers looking back at the decisions made during the financial crisis. The papers were presented at Brookings as part of our event "Responding to the Global Financial Crisis: What we did and why we did it." Read select papers and view video from the event here. The paper by Liang, McConnell, and Swagel summarized here is forthcoming.
This week at Brookings, the Hutchins Center on Fiscal and Monetary Policy and the Yale Program on Financial Stability gathered dozens of experts who, ten years ago, were on the front lines of the government’s response to the global financial crisis. Their mission was to record the decisions that were made on the myriad of responses to the crisis and the reasons behind those decisions. Although the final product won’t be published for some time, we’ve posted working drafts of several of the papers available on the Brookings website here.
In our paper, Meg McConnell (at the New York Federal Reserve Bank); Phillip Swagel (now at the University of Maryland, a veteran of the Paulson Treasury), and I (now at Brookings, formerly on the staff of the Federal Reserve Board), sum up the outcomes on financial markets and on the real economy of all the actions taken. The totality of the evidence suggests that the interventions, though far from perfect, prevented a second Great Depression. Research on the individual actions taken show they were effective in that they moved key outcome measures, such as risk spreads, and ultimately credit, output, and employment, in the desired direction. However, while the economy performed substantially better than might be expected based on previous financial crises, the actions were not able to prevent a severe recession and a weak recovery.
Financial crises are damaging to growth and employment. We draw eight lessons for future crisis fighters to help to reduce their economic costs:
LESSON 1: A strong regulatory and supervisory structure is necessary to reduce the costs of a crisis on the real economy.
The US regulatory and supervisory structure was weak and not well-matched to the risks in the financial system, which had grown rapidly outside of commercial banks prior to the crisis. It also did not have a viable bankruptcy or resolution process that would allow large and complex financial firms to fail in an orderly way that would minimize damage to the economy. The regulatory and supervisory structure needs to be kept up-to-date with changes in the financial system, and to make it more resilient to a wider range of shocks.
LESSON 2: A strong regulatory and supervisory structure is not a substitute for strong crisis management capabilities.
While a more stringent regime is now in place in the US and in many other jurisdictions, no regime, no matter how well designed, will be able to prevent a financial crisis from occurring ever again. By reflecting on the lessons from the responses to past crises, governments will be better prepared to respond more effectively when faced with the next crisis.
LESSON 3: Prepare (at least) for what is likely.
Understand that the causes and manifestations of future crises will likely differ from those of this crisis, but prepare for a few conditions that are likely to be present in any financial crisis. These include sudden and sustained reductions in liquidity in financial markets, widespread loss of confidence in the adequacy of financial institution capital even if they comply with regulatory standards, and the potential for abrupt failures of financial institutions that could seriously disrupt credit and growth. Authorities should practice responses to manifestations of these common types of conditions.
LESSON 4: Prepare to be surprised.
Recognize the limits of real-time information and inherent ambiguity and unpredictability associated with navigating effectively in crisis situations. Organizations should develop the capacity for rapid innovation, experimentation, and learning.
LESSON 5: Communicate before, during, and after periods of financial crisis.
Communicate with the public on an ongoing basis about the role that the financial system plays in the economy and the principles that will guide policy actions in a crisis. Communication alone cannot deliver concrete outcomes in terms of economic performance or financial system functioning, but it can help to increase the public’s understanding of the rationale for the types of policy actions taken in a crisis.
LESSON 6: There will always be forces that push against early intervention.
Accept that there will always be a variety of forces—including uncertainty, valid concerns about triggering unintended consequences, and gaps in legal authority—that will come together to favor inaction over action until conditions become sufficiently dire. In other words, many of the actions we judge ex post as having come too late will have been seen by many decision-makers in real-time as having come precisely when, and not before, conditions warranted.
LESSON 7: “Late” intervention limits the potential for good outcomes.
Recognize that once conditions become sufficiently extreme or dire, even good decisions and well-executed actions may not yield “good” outcomes, particularly on the macro front, because the extreme conditions themselves have often already laid the groundwork for a deeper economic downturn. One of the hallmarks of decision-making in a financial crisis may be that even the best decisions are likely to yield outcomes that would be viewed as weak or lackluster during normal times.
LESSON 8: “Late” intervention may raise rather than lower the potential for unintended consequences.
Recognize that once conditions have eroded sufficiently, the range of policy options shrinks. Late intervention may necessitate more extreme actions and more substantial deviation from the public’s expectations. These actions may also engender in the public a greater sense of unfairness.