- Moral hazard inevitably creates deep incentive problems
- Has ultra-low monetary policy in the world’s biggest economies had generated the right sort of entrepreneurial activity
- The ultra-loose monetary policies pursued by major central banks, especially in the US and Japan, remain a concern
Photography by Erik Tanner
We live in an inherently messy, risky and dangerous world and there are no easy solutions,” says Timothy Geithner, the man who was at the helm of the US Treasury from early 2009 as the global economy slumped in the wake of the biggest financial crisis since the Great Depression.
When reminiscing about the decisions he took during those difficult four years as President Obama’s most senior economic official, Geithner stresses the importance of pragmatism and eschewing textbook solutions.
“We pioneered a bold set of programs which have proved largely successful, and we have learned lessons that make us better prepared for the next financial crisis, whatever form it takes,” he says.
The US implemented one the largest fiscal stimulus programs in the world in 2009 (US$787 billion or more than 5% of GDP) to ward off an even greater slump in the US economy.
Unlike Australia and New Zealand, whose banks had little exposure to the toxic US mortgages that poisoned the financial system. The US taxpayer bailed out large swathes of the banking system, insurers, and even car companies.
Geithner is adamant these policies deflected a far worse recession, however unpopular they may have been at the time.
There is far from a consensus about the wisdom of the US response, though. It has taken US gross domestic product almost four years to return to its pre-crisis highs – compared with less than two years after the 1982 recession. Likewise, the ratio of employment to the population has barely recovered from its slump immediately after the crisis and the formal unemployment rate remains above 6%.
But it is true the world’s largest economy has performed far better than Europe’s – which is mired in chronic unemployment and public debt – since 2009.
“Europe had a much harder challenge than we did and chose a different strategy: they had a misguided faith in the virtues of austerity and that markets would sort themselves out after the panic,” Geithner says.
Reflecting on financial crises
Having stepped down from the Treasury in 2013, Geithner has since joined Wall Street private equity investor Warburg Pincus. Like his predecessor as Treasury secretary, Hank Paulson, Geithner has recently published his policy memoirs. Stress Test: Reflections on Financial Crises, has climbed the non-fiction best sellers’ lists in the US (see review p26).
“I wanted to give people the chance to take a fresh look at the choices we made.
“In severe crises that include financial panics it is necessary to protect the average person from calamity, but that sometimes means acting in ways that appear unfair to the average person,” he says, referring in particular to the bank bailouts. These left the impression that some individuals reaped enormous financial rewards before a crisis their actions precipitated, and which caused great damage to the rest of the community, but they never had to pay.
A young Timothy Geithner was marked out for a stellar career. Noticed by senior economists Robert Rubin and Larry Summers (themselves US Treasury secretaries) he rapidly climbed the bureaucratic ladder at the Treasury and then the International Monetary Fund. By 2003 he was appointed head of the prestigious New York branch of the Federal Reserve System.
It was there in 2008 that Geithner first gained fame or notoriety – depending on your economic principles – and a reputation for pragmatism. He helped arranged a snap sale of the beleaguered investment house Bear Stearns in March 2008, in which investors had lost confidence because of its potential exposure to toxic mortgage securities and lack of capital.
The action was criticised on the basis that that rescue of Bear Stearns sent a signal to banks’ creditors then, and in the future, that they would ultimately not have to bear losses.
“Moral hazard inevitably creates deep incentive problems but there’s no simple or perfect way to deal with it,” he says.
The Bank for International Settlements in Switzerland – the central bank to central banks – has been among the most cogent and consistent critics of the ultra-loose monetary policies pursued by major central banks, especially in the US and Japan.
Its latest annual report, released in June, highlighted the propensity of low rates to encourage poor investments and financial risk taking. It pointed out the S&P 500 Index, the benchmark index for large-cap US stocks, has surged almost 20% in the year to May 2014, whereas expected future earnings rose less than 8%.
And it noted that issuance of high-yield bonds soared to US$90b per quarter in 2013 from a pre-crisis quarterly average of US$30b, and the investors bought these bonds at lower interest rates than they once would have.
Moral hazard inevitably creates deep incentive problems but there’s no simple or perfect way to deal with it
Australia’s Reserve Bank governor, Glenn Stevens, gave a speech in July  questioning whether ultra-low monetary policy in the world’s biggest economies had generated the right sort of entrepreneurial activity.
“If some years from now we find ourselves looking back and concluding that such ‘real economy’ entrepreneurial risk-taking has not really taken place, and all that has happened is that financial risk taking and leverage have risen, we would be disappointed,” he said.
But ultimately Stevens was on Geithner’s side, perhaps even having read his latest book: “The accounts of some of the key decision makers that have been published give even more sense of how desperately close to the edge they thought the system came, and how difficult the task was of stopping it going over.”
Geithner acknowledges the potential problems of quantitative easing but remains optimistic.“The Bureau of Industry and Security is doing its job; of course there are challenges but the US economy is in a stronger position now than before the crisis.
“In lots of ways markets’ pricing of risks is implausibly benign at the moment but the risks are not comparable to what we faced before 2008.”
Fragile economic fundamentals concerning
Until the tragic shooting down of Malaysian Airline MH17 in early July, prices in financial markets had been implying levels of risk that were even lower than those before the global financial crisis in 2008. Still fragile economic fundamentals – weak GDP growth and banks – have prompted some analysts to worry about the prospect of another implosion.
“We imposed a stress test for banks designed to ensure they could withstand a great depression – it’s not clear it makes much sense to go further than that,” Geithner says, referring to a recent bestselling book by Anat Admati and Martin Hellweg that sharply criticises the adequacy of the new capital rules imposed in the wake of the financial crisis.
He is heartened by the greater intensity of policy co-ordination among large economies, pointing out how much time he devoted to helping set up the series of summits that lead to the G20 group of countries, which Australia is hosting this year.
“These summits are a big tax on time but they are still a good investment, forcing countries to understand each other’s positions,” he says, pointing to the great success of the Pittsburgh summit in 2009 in presenting a united and convincing policy front to the world at a time of great economic challenge.
In a potential prelude to what might yet occur, the Federal Reserve’s first attempt to “taper” its quantitative easing program prompted a bout of destabilising volatility in stock and prices last year as investors feared the gradual evaporation of cheap money and artificially low interest rates.
This problem manifested itself even more strongly, however, in emerging markets in Asia and South America, which had benefited from strong inward investment flows after the GFC but were now enduring rapid outflows at the prospect of higher and safer returns back in the US.
“I understand it but it’s not in their interest for the US to run policy in a way that gives excessive weight to conditions outside the US,” Geithner argues.
“That’s a world-class problem to have compared to what they faced over the past five years”.