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3
MacroeconomicConsequences
of
Financial Crises
1.
Lawrence
H.
Summers
2.
Hyman
F!
Minsky
3.
Paul
A.
Samuelson
4.
WilliamPoole
5.
Paul
A.
Volcker
1.
Lawrence
H.
Summers
Planning for
the
Next
Financial Crisis
It used to be said that a repeat of the depression of the
1930s
was inconceiv-able now that governments better understood how to manage their economies.Yet, both Latin America and Europe have suffered economic downturns dur-ing the 1980s on a scale comparable to the 1930s. And, in
1987,
the world’sstock markets suffered the greatest one-day drop in their history. It is littlewonder that the possibility of financial crisis with major economic conse-quences has again emerged as a major cause for concern.The problem of planning for financial crisis has much in common with theproblem
of
planning for war. We are fortunate in that the worst disasters wecan contemplate are much worse than those with which we have had experi-ence. While certain principles may be robust, technological changes reducethe relevance of historical experience and create new threats. With financialcrisis
as
with war, prevention is much better than cure. But in neither case canprevention and cure be cleanly separated. Credible government commitmentsto defend financial institutions can deter speculative attack just as crediblethreats
of
reprisal can discourage military attack. But, policies that deter at-tack also encourage reckless behavior. Thus critics argue that excessivelystrong military force breeds adventurism and that excessively generous de-
The author
is
indebted
to
David Cutler
for
research assistance and
to
J.
Bradford
De
Long
for
useful discussions.
135
 
136
Lawrence
H.
Summers
posit insurance leads financial institutions to take unwarranted and dangerousgambles.Because of their inability to do experiments, and the paucity of relevantprecedent, military planners make extensive use of war games. By followingout the logic of various constructed scenarios, they evaluate the efficacy ofalternative strategies.
I
use a similar mode
of
analysis here in consideringappropriate government policy once financial crisis comes.
For
the most part,
I
ignore issues of maintaining a stable and sustainable policy environment andissues relating to the prudential regulation of financial institutions. Instead,
I
concentrate primarily
on
lender-of-last-resort strategies. Only in
so
far
as
commitments made by lenders of last resort affect the likelihood
of
crisis do
I
touch
on
the issue
of
crisis prevention as opposed to crisis cure.The paper is organized as follows. Section
3.1
describes and tries to drama-tize the three stages
of
the canonical “Kindleberger”
(1978)
crisis and consid-ers its relevance in the current environment.
I
conclude that technological andfinancial innovation have probably operated to make speculative bubbleswhich ultimately burst more likely today than has been the case historically.However, other institutional changes have made it less likely that financialdisturbances will be transmitted to the real economy. The most important arethe presence of automatic stabilizers and deposit insurance, and the FederalReserve’s recognition
of
the potentially disastrous consequences
of
a majordecline in the money stock.Section
3.2
takes up the critical issue of lender-of-last-resort policy.
I
dis-tinguish four positions
on
the appropriate behavior of public lenders of lastresort. The first
luissezlfuire
position, which has enjoyed a mild revival inrecent years, holds that there is
no
reason for public intervention in financialmarkets, that private institutions could and would perform the lender-of-last-resort function if there was
no
public interference. The second,
monetarist
position holds that the only appropriate role of the government is to insulatethe money stock from developments in asset markets.
In
large part, this canbe done through open market operations directed at maintaining a stablemoney stock without any need for the authorities to intervene
on
behalf
of
specific institutions. The third,
classical
position follows Bagehot
(
1873)
inseeing a clear but limited role for a public lender of last resort.
On
the classicalview, last-resort lending is appropriate only to solvent banks, at
a
penalty rate,for short time periods according to a preannounced plan.The fourth,
pragmatic
position is the one embraced implicitly if not explic-itly by policymakers in most major economies. It holds that central banksmust always do whatever is necessary to preserve the integrity of the financialsystem regardless of whether those who receive support are solvent or cansafely pay a penalty rate. This position concedes that some institutions maybecome too large to fail. While lender-of-last-resort insurance, like any othertype of insurance, will have moral hazard effects,
I
argue that these may be
 
137
Macroeconomic Consequences
of
Financial Crises
small when contrasted with the benefits of protecting the real economy fromfinancial disturbances.Section 3.3 asks how a financial crisis could affect the real economy in thepresence of a sufficiently aggressive lender of last resort. This would be mostlikely if the provision of liquidity was itself destabilizing. Suppose foreignerslose confidence and rush to get out of dollar assets in U.S. financial institu-tions. Such a situation would be difficult for the authorities because the actionsnecessary to preserve the health of financial institutions would conflict withthe goal
of
preventing a currency collapse. Conversely, the high interest ratesnecessary to avert a collapsing currency would tend to create financial dis-tress.Section 3.4 concludes by assessing the magnitude of the crisis risk and bysuggesting steps that might make financial crisis less likely.
3.1
The
Canonical Crisis
Perhaps the best definition of
a
financial crisis is the one offered by Gold-smith (1982) in commenting on Minsky (1982). He defines a financial crisisas “a sharp, brief, ultra-cyclical deterioration of all or most of a group offinancial indicators-short term interest rates, asset prices, (stock, real estate,land) prices, commercial insolvencies and failures of financial institutions.”On this definition, even very sharp declines in asset values such as the two-thirds decline in U.S. real stock prices between the beginning of 1973 andsummer of 1974 does not represent a financial crisis. Nor do widespread finan-cial institution failures such as the
S&L
crisis unless they occur suddenly andlead to widespread failures of financial institutions.On a narrow definition, the incidence of financial crisis has surely dimin-ished over time. After noting that “a disinflation
or
a deflation may be longdrawn out. Nominal wealth may decline, real debts may rise, but these
are
notfinancial crisis,” Anna Schwartz (1986) goes
so
far as to claim that “no finan-cial crisis has occurred in the United States since 1933, and none has occurredin the United Kingdom since 1866. All the phenomena of recent years thathave been characterised
as
financial crisis-a decline in asset prices of equitystocks, real estate, commodities; depreciation of the exchange value
of
a na-tional currency; financial distress of a large non-financial firm, a large mu-nicipality, a financial industry,
or
sovereign debtors-are pseudo-financialcrisis.”The issue of what constitutes a financial crisis is semantic. But Schwartz isclearly correct in her implication that the financial stresses
of
recent yearshave had relatively little effect on real economic activity. The situation is verydifferent than that of a century ago, when financial panics and sharp declinesin economic activity often coincided. Perhaps the critical question about fi-nancial crises is whether financial instability no longer affects the real econ-
of 00

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