Should Policy Attempt to Avoid Financial Crises

The 2008 financial crisis and the 2007-09 recession have predictably spurred interest in how policy can avoid financial crises. A prior question, however, is whether policy should avoid financial crises. The answer might seem obvious. But I argue here that if policymakers focus on avoiding crises, they will generate undesired side effects and typically fail to avoid crises in any case. My argument has four steps. First, avoiding crises is not, in and of itself, the right goal for policy. Second, as a matter of theory, the costs of crises are not necessarily large. Third, as a matter of evidence, the costs of crises do not seem to be enormous. Fourth, whatever the costs of crises, anti-crisis policies might be worse than the disease. What Is the Right Objective for Policy? The single most important objective for economic policy is a high level of income per capita, or, taking a dynamic perspective, a high growth rate for income per capita. That is, the primary objective of policy should be maximizing the size of the economic pie, because this facilitates all other goals. A second goal for policy might be reducing economic volatility, the variation in output growth around its average rate. This goal makes sense if economic agents are risk averse, but tradeoffs might exist between an economy's average growth rate and the variability of this growth rate. Changes in technology or other real shocks to the economy can improve growth over the long haul yet increase variability in the short term. The arrival of the Internet, for example, might have spurred reorganizations that initially slowed growth but ultimately enhanced it. Alternatively, oil price hikes might reduce growth and increase variability while leaving policy with few options to mediate either impact. Thus, the goal of reduced variability should be treated with caution. The crucial issue is then whether financial crises play a causal role in lowering output growth or increasing volatility. If so, then avoiding crises might make sense as an intermediate target. But if crises have only a modest impact on growth and volatility, or if crises are mainly a symptom of poor economic performance rather than a cause, then targeting crises is a less obvious goal. Are Crises Bad for the Economy? Theory The next question is whether, as a matter of theory, financial crises are necessarily bad for the economy. Popular opinion, and much of the economics profession, now takes this conclusion as given, but it is not the only defensible view. Consider, in particular, banking crises like those the United States experienced before the founding of the Fed in December 1913, or during the Great Depression, or in the 2008 financial crisis. Banking crises occur under the following conditions. One or more banks suffer losses on their loans, reducing bank net worth and impairing liquidity. If the losses are modest and the banks are small, the repercussions for broader financial markets are modest. If the losses are larger, however, and concentrated at large institutions, then further impacts are likely. The banks that suffered initial losses may call in loans from other banks, who may then suffer fire-sale losses as they try to make good on counterparty claims. What happens next? Because of the loan defaults, someone is poorer, and policy cannot change this fact. After the recent bursting of the housing bubble, for example, policy could not alter the fact that homeowners and mortgage lenders had lost considerable wealth. Policy can affect who bears the losses, via bankruptcy rules, too-big-to-fail (TBTF), and the like, but it cannot recreate the wealth that has disappeared. When realty falls short of expectations, someone takes a hit. Other than this loss of wealth, however, nothing else about the economy's path need change. Any investment project that made sense before the defaults and failures should still make sense, setting aside the possibility that defaults on one kind of loan contain information about other kinds. …