Editor’s Note: This blog post originally appeared in slightly different form on the Brookings Institution website.
In a recent Foreign Affairs article entitled “Are We Safe Yet?” former Treasury Secretary Timothy Geithner asks a series of questions: What is the underlying fragility of the U.S. system today or how “dry is the tinder?” What is our ability to limit the intensity of any crisis especially via macroeconomic responses? How adequate are our emergency response mechanisms to prevent a crisis from spinning out of control?
I would like to ponder a variant of the first question: Are we all safe yet? (I have explored preliminary perspectives on each question for a Brookings Institution blog series.) These questions can be considered on a global scale, but let me start with the U.S. given its essential role in the global system. This is timely given moves in the U.S. to roll back the Dodd-Frank Act.
How risky is the U.S. financial system?
Geithner’s analysis of the current risks in the U.S. financial system is sober but not alarmist. He correctly notes that financial regulation has materially improved the capital and liquidity buffers in the U.S. system as a whole and expanded the supervisory perimeter to include most major institutions. He emphasizes the inherent risks in the maturity transformation at the heart of modern finance — that is the practice whereby financial institutions borrow money on shorter time frames than when they lend money out, that leaves banks and other institutions vulnerable to “runs” on deposits. As financial sector experts are acutely aware, we can never know risks to the financial system with any certainty. Hence the need to assess system preparedness to respond to shocks.
Liquidity risks appear to have risen in some U.S. financial markets. Some asset prices appear extended. This is in part a result of the extended low interest rates that have been part of the macroeconomic response in the U.S. There has been growth in nonbank financial activity, in part in response to stronger regulation. However, strong memories of the 2008 crisis are probably placing some curb on the risk appetite of many players, assisted by the more intense prudential and macroprudential regulation brought forth by the crisis. As a result, the U.S. financial system risks did not figure prominently in the most recent International Monetary Fund survey of global financial risks. And the signs of strengthening demand and some welcome price pressures may reduce financial risks in the short term. The real risks in the U.S. will come in a time of prosperity and the seemingly inevitable complacency that sets in with investors and regulators.
Nevertheless, and this is a point underplayed by Geithner, there are near-term risks to the domestic U.S. financial system emanating from outside the U.S., adding urgency to his overall arguments for focusing on resilience in U.S. policy settings.
How available are U.S. macroeconomic policy tools in a crisis?
Beyond regulation, the larger risk at present is the limited firepower of macroeconomic policy to respond to any near-term shocks. Interest rates are still very low, and even with recent signs that they will soon rise, low long-term interest rates suggest that monetary policy will have less leeway in the future to respond to shocks.
This suggests that more of the burden of response needs to be carried by fiscal policy in the event of a future shock. Yet fiscal policy is constrained on both economic and political grounds. Nevertheless, fiscal policy tools would need to be deployed earlier in a shock to support demand and soften the economic and financial disruption. This course would pose fewer risks if fiscal policy were on a sounder long-term footing. Indeed, forging such a pathway or framework is an important component of overall crisis readiness.
Pro-growth structural or productivity reforms could also help economic resilience, for example, by improving macroeconomic “speed limits” and fiscal sustainability.
Are emergency powers sufficient?
Limited macroeconomic firepower would suggest even more focus than usual on the effectiveness of financial regulation in preventing or limiting the severity of crises. In particular, this suggests ongoing importance of higher capital and liquidity provisioning, intensive supervision of crisis risks and preparedness (stress tests and the like), and retaining a wider regulatory perimeter (encompassing more activity in the nonbank sector and more systemwide monitoring), to make the system safer. One hopes that any “rollback” of Dodd-Frank avoids watering down these important gains.
Geithner’s top priorities for reform to further increase the safety of the system go against the grain of most critics, right and left. They involve increasing the discretion of regulators to deal with systemic crisis events, though within clear accountability frameworks. In particular, he advocates for increased flexibility, over that allowed for in Dodd-Frank, to lend to institutions in an emerging crisis, and to use judgment in imposing losses on creditors in a failing institution (bailing-in) in a situation where this could set off a chain of dominoes in the system.
Geithner’s analysis, though, gives scope to reform aspects of financial regulation while at least not further harming core crisis prevention goals. He says nothing (deliberately, I suspect) of the Volcker Rule, which he has argued cogently elsewhere has less connection with the fragilities uncovered by the crisis. The extensive provisions covering conduct and other aspects of the finance industry’s operations involve policy trade-offs which, while important, may not centrally affect the crisis mitigation goals of regulation. Not all reform of Dodd-Frank is therefore synonymous with a return to crisis risk.
But the threat of rolling back central pillars of crisis resilience such as capital and liquidity buffers is real. If such a course were chosen, the answer to the question “Are we safe yet?” would be a resounding no, for the U.S. and global economies. Indeed, when the other macroeconomic vulnerabilities are added, the U.S. economy would be decidedly unsafe, and prone to even a relatively small shock having outsize consequences.
Geithner writes, “Financial crises cannot be forecast. They happen because of inevitable failures of imagination and memory.”
It would be a great pity if a defective collective memory led to an increase in systemic risk in the U.S. regulatory system—with possible international implications—so soon after the crisis.