LAST week the IMF hosted a research conference in honour of Stanley Fischer, which generated a heaping portion of fascinating monetary-policy discussion (some of which we discuss in this week's paper). As part of the festivities, Ben Bernanke gave a talk, on the 2008 crisis as a "classic financial panic" akin to the crisis of 1907. As Mr Bernanke notes, this is not a new observation; indeed, the Federal Reserve recognised the parallels early on and policy was adjusted as a result. In both cases, you had financial losses of uncertain extent (in institutions exposed to a failed copper speculation in 1907, in subprime in 2008), runs on markets deemed to be vulnerable, asset firesales to cover losses, and a broad liquidity crunch, all of which contributed to big losses in the real economy.

But I want to pick at a point Mr Bernanke doesn't dwell on, but which strikes me as quite important. He notes:

Like many other financial panics, including the most recent one, the Panic of 1907 took place while the economy was weakening; according to the National Bureau of Economic Research, a recession had begun in May 1907...

The recent crisis echoed many aspects of the 1907 panic. Like most crises, the recent episode had an identifiable trigger--in this case, the growing realization by market participants that subprime mortgages and certain other credits were seriously deficient in their underwriting and disclosures. As the economy slowed and housing prices declined, diverse financial institutions, including many of the largest and most internationally active firms, suffered credit losses that were clearly large but also hard for outsiders to assess.

When we talk about the way in which the most recent crisis unfolded, we often talk about uncertainty of the extent of mortgage losses as a cause of the financial crisis. And we discuss that uncertainty as if it were entirely about microeconomic unknowns: which banks held which securities, what mortgages were in which securities, and how much of the information used in origination (like household incomes) was reliable, for instance. But there is also considerable macroeconomic uncertainty, which may well be the more important consideration. There are a lot of loans that go bust when real output falls 3% in a year that would not if output merely grew at 0.5%.

Big crises therefore display a rather significant level of recursivity. Suppose there are brewing financial losses lurking in a financial system. Then suppose the outlook for the economy dims somewhat. Deterioration in the outlook raises expectations of likely financial losses. If the deterioration isn't addressed then crisis dynamics intensify and the outlook for the real economy worsens again. Eventually you get a break—a shift in the equilibrium. The crisis becomes acute, and the real economy suffers a major blow.

Of course, a central bank is there to prevent precisely that sort of recursivity: to correct the market's occasional mad leap from everything-is-grand to everyone-is-broke. Central banks are (mostly) willing to play that role where liquidity is concerned; Mr Bernanke trots out the wisdom of Walter Bagehot:

In both cases, the provision of liquidity in the early stages was crucial. In 1907 the United States had no central bank, so the availability of liquidity depended on the discretion of firms and private individuals, like Morgan. In the more recent crisis, the Federal Reserve fulfilled the role of liquidity provider, consistent with the classic prescriptions of Walter Bagehot. The Fed lent not only to banks, but, seeking to stem the panic in wholesale funding markets, it also extended its lender-of-last-resort facilities to support nonbank institutions, such as investment banks and money market funds, and key financial markets, such as those for commercial paper and asset-backed securities.

The intuition is that a liquidity crisis triggered by a few instances of bad behaviour can wipe out those who have behaved well; it is a market failure that can and should be addressed by the central bank. But in addition to the liquidity externality imposed by financial losses there can also be a demand externality imposed by financial losses. And it stands to reason that central banks should lean against that, as well.

Why don't they? Human error is always a possibility. The central bank might simply be behind the curve, slow to detect a worrisome demand slowdown. Or data could be slow to capture what is occurring. The central bank might take its eye off the ball: say, because soaring commodity prices are muddling the macroeconomic picture.

Or the central bank could convince itself that allowing financial losses in a troubled sector to play out is the price one has to pay to prevent moral hazard. But that would be a costly error indeed.

It's helpful to look again at American economic developments before the financial crisis and Great Recession. Output growth in 2005 (in both real and nominal terms) was quite strong (see chart). It was arguably too strong, in fact; the Fed certainly thought so, and raised the federal funds rate 175 basis points that year. Housing responded to that. The contribution to growth from residential investment fell across 2005, and by the fourth quarter housing had flipped to a drag on growth (which it would remain until the third quarter of 2009).


In 2006, growth looked healthy. Real output grew at just about the ideal pace, even as residential investment shrank at an eye-popping clip. Yet strangely the Fed kept tightening. Its benchmark rate went up another 100 basis points in 2006. By early 2007 the economy was growing below trend. What's more, further declines in residential investment seemed to be as much a symptom of that broader decline as a cause of it. Even so, the Fed didn't begin loosening policy until September of 2007, at which point the financial crisis had begun. The Fed then remained behind the curve until the acute phase of the crisis dragged down all sectors in unison. The government then threw everything including the kitchen sink at the economy, eventually putting a floor under the collapse.

In hindsight, the nasty recursive loop toward acute financial crisis was clearly operating by the second half of 2006. Why didn't the Fed step in to prevent a downward spiral? Maybe because it was slow to perceive trends or because it lacked good real time data. Maybe because rising oil prices muddied the waters. But maybe because it was extremely sensitive to criticisms of past reactions to asset prices, which struck critics as inegalitarian or as contributing to moral hazard, or both. The Fed may have thought (or behaved as if it thought) that a slowdown generated by a deflating housing sector should not be resisted, lest the bubble simply grow larger or reckless traders fail to learn their lesson.

It seems to me that this may be a very bad way to make policy. And the proof is in the pudding. I contend that the crisis itself did much more to generate moral hazard than an effort to prevent a demand collapse would have done, in two ways. First, from the onset of acute crisis in the second half of 2008, financial losses were overwhelmingly driven by macro financial and economic dynamics rather than micro dynamics. So rather than investors reaping what they sowed, everyone in financial markets lost vast amounts of money. Instead of instructing institutions to invest carefully lest they lose their shirt, the Fed encouraged firms to invest riskily, since risky bets pay off in good times and are chalked up to the uncontrollable forces of crisis in bad times.

And second, of course, the extreme danger of the crisis led the government to throw moral hazard concerns overboard entirely. After Lehman, the government had to advertise loudly and clearly that no other shaky dominoes would fall. Good and bad banks alike, they all were under the government's protection at that point (provided they were systemic enough).

The crises of 1907 and 2008 are not the only ones to fit this pattern. America's economy was also slowing well before the crash of 1929, in part because of Fed interest-rate hikes designed to teach an exuberant Wall Street a lesson. Central banks might have learned a critical lesson from recent economic turmoil: that economic disasters occur when central banks think to use weak demand to punish reckless investors or fight moral hazard. Sadly central bankers appear to be moving in the wrong direction, becoming more ready to conclude that weak demand is an acceptable price to pay for bubble prevention.

The tricky thing to know is what would have unfolded had the Fed moved in 2006 and 2007 to break the vicious financial-demand cycle. The ideal outcome would probably have been one in which the Fed focused its attention on preventing a big fall in nominal output growth. In that case the late 2000s might have looked a lot like the late 1980s and early 1990s, in the aftermath of the Savings and Loan and Latin American debt crises. Real output growth would probably have slowed even as nominal output stayed high, leading to a rise in inflation. Once the financial danger was over, the Fed might then have triggered a disinflationary recession, but with nominal rates having crept up with inflation there would be little risk of hitting the zero lower bound. It would not have been a comfortable experience. Many mortgages would have defaulted, and there would have been plenty of real financial losses and perhaps some big institutional failures. But by not allowing demand to collapse the Fed might have been able to keep problems contained and avoid a once-in-80-years economic disaster.