By Robert F. Bruner, University Professor, Distinguished Professor of Business Administration, Dean Emeritus of the Darden School of Business, Senior Fellow of the Miller Center of Public Affairs, University of Virginia
During this spring’s financial turmoil, crisis responders moved into action mode quickly and seemingly in unison. Were we lucky or smart? Throughout history, responses to financial crises have been fraught with discord and delay. I explore this historical problem and argue that a core challenge during crises is mobilizing collective action. Perennially, this proves to be difficult, if not impossible, owing to six challenges that call for a new public policy of financial resilience, of which collective action is a key element.
A history of discord and delay
Financial crises offer cautionary tales about effective responses. Here are four prominent examples, spread over 1907, 1931, 2008 and 2020-23.
In The Panic of 1907: Heralding a New Era in Finance, Capitalism, and Democracy (2023),1 Sean Carr and I described the efforts of J. P. (John Pierpont) Morgan Sr. to quell the crisis. The nub of Morgan’s challenge was to gain a mutual-assistance pact among the shadow financial institutions of the day: trust companies in New York City. Trust companies were relative newcomers to the New York City financial community. Most importantly, they had declined to join the New York Clearing House (NYCH), a consortium of state- and nationally-chartered banks set up to pool resources against the risk of illiquidity. As the incumbent institutions—the old money, as it were—the banks viewed the newer trust companies with suspicion.
Although similar to national and state banks in their functions, trust companies were less-regulated insurgents in the financial marketplace. And they seem to have been a fractious bunch, divided on business strategy (wholesale versus retail), risk tolerance (aggressive versus conservative), age (incumbents versus insurgents) and location (downtown versus uptown).
During the Panic of 1907, New York trust companies became the epicenter of the crisis, as depositors ran on many of them and caused one of the largest to close. J. P. Morgan, the 70-year-old senior statesman of the US financial community, strove to organize the trust companies into a mutual-assistance pool, much like the NYCH. Meeting with the trust companies’ presidents virtually daily, he twice gained written agreements among them, only to see them renege. Finally, at the height of the crisis, he gained an agreement that stuck, but only by locking the door of the meeting place until all had firmly committed. Upon the announcement of this agreement, the runs began to subside.
Twenty-three years later, the lack of coordination figured prominently in another crisis. The Treaty of Versailles signed in June 1919 ending World War I had set up a dangerously unstable system of reparations and debt repayments, which John Maynard Keynes savagely criticized.2 Germany, the major obligor in the system, proved unable to stabilize its economy and generate the wealth necessary to meet scheduled payments. Twice, the reparations plan was renegotiated, only to see Germany fall behind again.
As Liaquat Ahamed described in Lords of Finance: The Bankers Who Broke the World,3 the unstable systems of payments and currencies lasted as long as they did only because the central bankers of the United States, United Kingdom, France and Germany collaborated. The leader of that collective was Benjamin Strong Jr., president of the Federal Reserve Bank of New York (New York Fed). He was a strong advocate for international cooperation within the Fed system, despite rising isolationist sentiments in the US. After Strong died in 1928, collaboration weakened. Then, with the crash of the New York Stock Exchange (NYSE) in 1929, the onset of the Depression in 1930, and bank panics and the abandonment of currency pegs to gold in 1931, the collective fell apart completely.
The crisis of 2008 strained the willingness and ability of public servants to collaborate in responding. Examples pepper the memoirs of Ben Bernanke4 (chairman of the U.S. Federal Reserve), Henry Paulson Jr.5 (U.S. secretary of the Treasury), Timothy Geithner6 (at the time, president of the New York Fed), Sheila Bair7(chairwoman of the U.S. Federal Deposit Insurance Corporation [FDIC]) and Barney Frank8 (chair of the U.S. House Financial Services Committee). At various times, Sheila Bair opposed institutional rescues proposed by Geithner, Bernanke and Paulson. “At each discussion, Treasury seemed increasingly determined to undermine any approach that would lead to the banks cleaning up their balance sheets as a primary way of regaining market confidence,” wrote Bair in her book Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself (Page 157).
However, the paramount example of the breakdown of collective action in the US was the debate over the Troubled Assets Relief Program (TARP). Paulson, Bernanke and Geithner approached Congress for a huge appropriation to stabilize the financial system. The proposal that Paulson sent to Congress in late September 2008 was a three-page document that authorized the secretary of the Treasury to purchase mortgage-related assets, an unprecedented grant of executive discretion. Paulson had not prepared the way by building a case with the public and various constituencies. Recent bailouts of financial institutions, the wide discretion requested and the huge size of the appropriation ignited a firestorm of opposition in the House of Representatives. Even Barney Frank, a supporter of the proposal and the chair of the powerful House Financial Services Committee, observed, “No one in a democracy, unelected, should have $800 billion to spend as he sees fit.” The TARP bill fell to defeat, and the Dow Jones Industrial Average (DJIA) plunged in the largest one-day point drop in its history. Recoiling from the deepening crisis, Congress enacted a revised version of the TARP legislation four days later. But divisions over TARP funding presaged the mobilizations of protest groups on the right (the Tea Party) and left (Occupy Wall Street) and the rising polarization in Congress.
In 2020, the arrival of the COVID pandemic triggered a “dash for cash” among market participants. Systemic regulators around the world displayed remarkable cooperation and mutual support: currency-swap agreements, joint timing of liquidity injections, expressions of coordinated support and other actions aimed at stabilizing markets and institutions. More importantly, monetary and fiscal policies moved in tandem to restore liquidity and stimulate economic activity.
Collective action to fight the crisis in 2020 was assisted by at least two facts. First, governments acknowledged the serious—if not existential—threat to public health posed by the pandemic. The exogenous shock helped to mobilize action. Second, in the US, the fact that the Democratic Party held the White House and both chambers of the U.S. Congress afforded a degree of unanimity among policymakers and helped spur approvals for the largest fiscal-stimulus bills in history.
By March 2023, control of the House of Representatives had shifted to the Republican Party, melting the ideological cohesion for collective action. Thus, the onus for crisis response shifted toward monetary regulators, who responded quickly and without obvious division to the runs on Silicon Valley Bank (SVB) and Silvergate Bank. In Europe, prompt responses by regulators in Switzerland led to UBS’s takeover of Credit Suisse. And earlier, in September 2022, UK regulators had intervened to ease the instability of pension funds.
It is too soon to judge the crisis responses of 2020-23 since the substantial consequences of both fiscal and monetary policies (such as inflation, economic inequality, global trade and competitiveness) will take years to play out. But critics have already questioned whether there can be too much speed and cooperation.
Why is the mobilization of collective action so hard?
The history of financial crises suggests six significant “I” challenges to the ability of democracy and capitalism to respond to financial crises.
Inefficiencies in market pricing. During a crisis, market prices tend not to reflect the intrinsic values of financial assets, making it difficult to judge whether a bank is insolvent or merely illiquid. This was an acute problem during the 2008 crisis, when novel financial securities proved hard to value.
Risk intolerance. The “dash for cash” in March 2020 represented a massive recoil in risk appetite among investors, the largest-ever run on the global financial system. In 2023, the runs on Silvergate and Silicon Valley banks were accelerated by digital technology. Sudden shifts from “risk-on” to “risk-off” challenge the ability of crisis fighters to coordinate and fashion timely responses.
Information asymmetries are pervasive in a market economy. Over time, innovation in financial institutions, markets, instruments and processes breeds growing complexities and interlinkages in the financial system. Complexities make it difficult for decision-makers to know what is going on. And interlinkages among financial institutions mean that trouble can travel. Information asymmetries can arise from systemic imperfections (the inadequacies of watchdogs or reporting systems), communications breakdowns (owing to disinformation or technological failures) or the introductions of financial innovations. The resulting problems of adverse selection (the “lemons problem”) and moral hazard cause failures in market functioning. Information problems contribute to the overshooting of market prices associated with buoyant business expansion and the undershooting after crashes. All of these information problems were influential in the Panic of 1907.
Incentives can motivate suboptimal choices. In 1931, nations exploited the gains from suspending the gold standard and embarked on beggar-thy-neighbor trade policies. Game theory shows that modest changes in payoffs associated with different strategies can tilt the likely outcome toward or further away from mutual assistance. An episode of booming growth, such as the one that presaged the Panic of 1907, can motivate institutions toward adverse strategies. And the winner-take-all prospect of the evolving consumer-deposit industry prompted a “get big or go home” mentality redolent of the 21st century.
Ideologies tend to be rigid when a crisis demands a flexible response. In 1907, an orthodoxy framed by balanced budgets, the gold standard, Jacksonian abhorrence of central banking and social Darwinism resisted the intervention of the Federal Government in financial markets. In 1931, countries waited too long to devalue currencies and suspend convertibility into gold. In 2008, Republican Party orthodoxy resisted bailouts and other assistance to firms and markets. Neither the public nor private sector is uniquely suited to resolve financial crises. Government regulators, while well-intentioned, are subject to a host of public-policy aims and tend to be slow to act. Rather like the generals who are always prepared to win the previous war, government officials tend to be guided by laws, norms and sentiments aimed at quelling the known crisis. And for its part, the private sector is exposed to the constant evolution of the capitalist economy—“the gale of creative destruction”, as Joseph Schumpeter9 called it.
Interests. This is the dark side of all crisis responses. Lurking in the background might be favoritism of the few at the expense of the many. These few could include those led by cronies of the decision-makers—such was the allegation against J. P. Morgan’s rescues or the Bernanke-Paulson bank rescues in 2008. Or a rescue could be motivated by the strategic interests of the country, a region or an industry—examples would be the government takeover of seven bankrupt railroads in 1976 and federal loan guarantees for the almost bankrupt Chrysler Corporation in 1980. The politics of government rescues of businesses often comes down to who goes to bat for you and how big a bat is swung. Framed in terms of intra-industry rivalry, divergent interests might discourage collective action. Mancur Olson10 argued that collective action is more costly and difficult to achieve as the number of players expands and their interests diverge.
Collective action and resilience
The collective-action problem will always be with us, given market inefficiencies, risk intolerance and information asymmetries as well as divergent incentives, ideologies and interests. The idiosyncrasies of each new crisis bring fresh demands for speed, flexibility and clout.
What we need is a new orthodoxy of resilience. Markus Brunnermeier’s The Resilient Society11 presents a compelling argument for the commitment of societies to strategies that build the ability to respond effectively to each new shock. Yet the resilience for which he advocates in the form of capital requirements, stress tests and safety buffers of various kinds largely ignores the cultural transformation needed among international institutions: a bias for vigilance, adaptability, speedy response and collective action. A culture of resilience must begin at the top of a system and flow down.
1 The Panic of 1907: Heralding a New Era of Finance, Capitalism, and Democracy, 2nd Edition, Sean D. Carr and Robert F. Bruner, Wiley, March 8, 2023.)
2 The Economic Consequences of the Peace, John Maynard Keynes, Ancient Cypress Press, August 1, 2019.
3 Lords of Finance: The Bankers Who Broke the World, Liaquat Ahamed, Penguin Press, January 22, 2009.
4 The Courage to Act: A Memoir of a Crisis and Its Aftermath, Ben S. Bernanke, Norton, October 5, 2015.
5 On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, Henry M. Paulson Jr.,Business Plus, February 1, 2010.
6 Stress Test: Reflections on Financial Crises, Timothy F. Geithner, Crown, May 12, 2014.
7 Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, Sheila Bair, Free Press, September 25, 2012.
8 Frank: A Life in Politics from the Great Society to Same-Sex Marriage, Barney Frank, Farrar, Straus and Giroux, March 17, 2015.
9 Capitalism, Socialism, and Democracy: Third Edition (Harper Perennial Modern Thought), Joseph A. Schumpeter, Harper Perennial Modern Classics, November 4, 2008.
10 The Logic of Collective Action: Public Goods and the Theory of Groups, With a New Preface and Appendix (Harvard Economic Studies), Mancur Olson, Harvard University Press, January 1, 1971.
11 The Resilient Society, Markus Brunnermeier, Endeavor Literary Press, August 23, 2021.