Why We Need a Guarantor of Last Resort

More than a decade has passed since the worst of the 2007-2009 financial crisis.  In that time, we have learned that some of the gravest consequences of the crisis were not the economic fallout, but the political backlash it triggered.  After the panic that followed the failure of Lehman Brothers, the Federal Reserve and other regulators understandably concluded that they needed to do everything in their power to prevent the failure of another systemically important financial institution. The very next day, the Federal Reserve stretched the bounds of its legal authority to provide a record amount of liquidity support to the insurance company AIG.  Not long after, the Treasury Department asked Congress for $700 billion to provide yet further support for a financial system on the verge of breakdown.  The market’s reaction when Congress balked convinced lawmakers to pass the Emergency Economic Stabilization Act, providing Treasury the $700 billion it wanted.  Congress tried to impose some checks, but after the market’s reaction when the bill was voted down in the House, lawmakers felt pressed to act quickly.  They did not have time to investigate the underlying causes of the crisis, how best to address them, or who should be held accountable.  Instead, lawmakers essentially wrote Treasury the blank check that it had asked for, with some added bells and whistles to ensure the necessary support and some accountability.  The situation was a mess.

So where do things stand today?  Is the country prepared should another financial crisis strike?  Do financial regulators have the tools they need to contain a crisis before it inflicts massive harm on the real economy?  Do they have adequate incentive to identify and respond to a burgeoning crisis in a timely way?   Perhaps most importantly, would the political mess that the crisis created, and from which the country is still reeling, be any less likely?  Sadly, any effort to answer these questions can lead only to the answer that the country remains woefully unprepared should a crisis strike again.  As I explain in a new article, available here and forthcoming in the Texas Law Review, better options exist.  Institutionalizing an appropriately designed guarantor of last resort could go a long way in mitigating each of these challenges.  With deregulation already underway, now is the time for thoughtful lawmakers to devise a crisis containment scheme that actually has a viable chance of addressing the many challenges crises pose.

To understand the importance of emergency guarantee authority, it is helpful to review what happened during the 2008 financial crisis. In economic terms, policymakers did a respectable job.  In contrast to the Great Depression, where policymakers were determined to force bankers to stew in their own juices, Federal Reserve Chairman Ben Bernanke and other key policymakers were attuned to the inevitable relationship between the health of the financial system and the health of the real economy.  They were determined not to let unemployment soar to 25 percent as it did during the Great Depression.  So they opted for creativity, sometimes to a fault.  Except with respect to Lehman Brothers, regulators bent over backwards to use whatever tools they had as creatively as necessary to protect major financial institutions and other key features of the financial system.  The result was a crisis that inflicted massive harm and hurt the most vulnerable the most, but was nowhere near as bad as it could have been.

The more serious fallout has been political.  In a less flattering comparison with the Great Depression, no elected official took full responsibility for the efforts to stabilize the system.  No president explained to the public all that financial regulators were doing and why.  In contrast, President Franklin Delano Roosevelt used his very first fireside chat to discuss the impending bank holiday.  He created the fireside chats as a way of speaking directly to the public in terms they could understand.  He used that first radio broadcast to explain what happens in a bank run, why the banks would be closed down, and the order in which they would be opened.  He took responsibility and asked the public for its support.  With no president taking the lead, and Congress feeling like it had little choice but to rubber stamp regulators’ plans, it is no wonder the public remains so angry and confused.  The backlash first embodied in the Occupy Wall Street movement proved to have deep and far reaching consequences. Trust, which is also vital to prosperity, has yet to be restored.

Not only has the political backlash had a more lasting impact on the country, it also shaped the post-crisis reform agenda.  Politicians after the crisis had far more time to listen, and respond to, the public’s ire.  They placed new limits on the very tools that regulators had used to contain the economic fallout in 2007 and 2008.  They also adopted a number of substantive reforms aimed at making  a crisis less likely.  But those reforms were far from sufficient to ensure another crisis will not strike, and they are already being watered down.  Overall, the reform efforts were so focused on stability that they failed to address the exigencies that will arise should a crisis strike.

Pretending that another crisis won’t happen if we don’t prepare for it is not the answer.  It will, and the results could be disastrous.  The better approach is to implement crisis containment tools that can address both the economic and political exigencies that arise when a crisis strikes.  Emergency guarantee authority can do just that.  It can provide financial regulators the tools they need to contain a spreading panic while also ensuring that elected officials, in the White House and Congress, play roles consistent with their expertise and constraints.

The basic idea is simple:  The Treasury Department should be given broad but time-limited authority to extend guarantees when needed to contain the spread of an imminent financial crisis.  The breadth is needed to address the inevitable dynamism of finance.  The market-based system of intermediation from which the last crisis emanated was but the latest of many shadow banking systems to arise in the United States. Time and again, those systems have been the origin of financial crises.  Ex ante regulation of banks and other sources of systemic risk is critical, but will never alone suffice to prevent all crises.  Flexible emergency authority is a necessary supplement.

The breadth of this authority would be balanced by an array of checks to address the accountability and other deficits in the handling of the last crisis.  For one thing, the emergency guarantee authority (EGA) could only be invoked in the face of a clear threat and in consultation with the president.  This would ensure that the president takes ownership of the difficult decisions crises inevitably entail.  It would also avoid situations like the Lehman failure, where policymakers tried to duck responsibility for having made a choice by claiming the legal constraints that they had creatively gotten around in other circumstances tied their hands.  These triggering requirements would also help mitigate the moral hazard that arises if short-term creditors expect that they will be protected no matter what.

The EGA would also trigger an array of reporting requirements.  Some would be designed to address accountability—the public has a right to know what claims are protected and on what terms.  More importantly, within in a year of invoking the EGA, Treasury would have to provide a report to Congress of the reasons for invoking the EGA, the underlying problems in the financial system that had triggered the panic, and what should be done to address them.  This would enable the political debate and democratic accountability so lacking last time around.

The time-limited nature of the guarantee is the linchpin for making the system work.  The aim is to separate the exigent need to contain a spreading crisis from the longer term project of devising a comprehensive plan for resolving the underlying weaknesses and addressing the fairness and other issues that arise when the government intervenes.

The proposed time frame is two years.  This is intended to be long enough so that the guarantees are credible and sufficient to prevent a breakdown in the financial system that would devastate the real economy.  It is also designed to give regulators and other policymakers the time they need to understand what is causing the crisis and how best to address those underlying problems.  Precisely because the financial system tends to evolve in ways that move activity beyond regulation, regulators will almost inevitably have only a fraction of the information they need to understand the cause of a crisis and the myriad mechanisms through which underlying weaknesses may trigger widespread dysfunction.  Yet this is precisely the information necessary to devise a response adequate to the task yet not so excessive as to provide unnecessary windfalls.  The aim is not perfection but sufficient information for any substantive aid to at least be directed where it is most needed.  That these insights would have to be packaged into a comprehensive plan and delivered to Congress would provide an opportunity for other issues like fairness to be considered.  Congress and the public would be protected from an EESA repeat; that is, a situation where Congress signs off on a plan that is immediately abandoned and provides massive economic support with checks inadequate to address the public values at stake.

The two-year time limit should also forestall the other common failure in financial crisis management:  a tendency to plug holes while allowing the underlying problems to fester and grow. Regulatory forbearance and its kin were at the heart of Japan’s lost decade and the savings and loan debacle in the United States.  They also contributed to the size of the last crisis, which grew slowly for more than year before erupting in September 2008.  It is very hard at the beginning of a crisis to appreciate the magnitude of what is to come. Wishful thinking is common and aided by creative strategies that mitigate the immediate signs of market dysfunction. Once the EGA exists, regulators will have fewer excuses to use their other powers for hole-plugging.  They will have a tool that has a long track record, supported by theory, of being able to contain financial panics no matter their cause.  And once they invoke the EGA, regulators and market participants will be all too aware of the two-year time limit and reporting requirements.  They will be denied the luxury of plugging a hole through creativity and then hoping the whole thing will magically resolve itself.

There can be no assurance of how the EGA would be used if adopted.  Any tool that provides regulators, acting under guidance from the president, discretion to intervene in markets is rightly viewed with skepticism. There are risks.  But the benefits of adopting the EGA outweigh the dangers.  Failing to plan for the next financial crisis will not prevent that crisis. It will instead leave the real economy, and the American public, vulnerable.  Either regulators will honor the limits on their authority imposed after the last crisis, causing the panic to spread, or regulators will seek to skirt those limits, undermining democratic legitimacy and enabling underlying problems to fester and do even greater long-term damage to the real economy.  Neither outcome seems like a good one.

The EGA is no silver bullet.  It will not prevent the next financial crisis.  But it does reduce the probability of a really bad macroeconomic outcome when that crisis strikes. It also increases political accountability in a way that reflects the various capacities of the different branches of government.  Now is the time to prepare for the next crisis, and the EGA should be part of that effort.

This post comes to us from Professor Kathryn Judge at Columbia University Law School. It is based on her recent article, “Guarantor of Last Resort,” available here.