Alumnus Lacker explains financial crisis in hindsight

BY GEORGIANNA PISANO-GOETZ ’15
Contributing Writer

On the evening of Feb. 12, F&M welcomed back Jeffrey M. Lacker ’77 to speak to students regarding the 2007 financial crisis. While at F&M, Lacker studied economics and has since gone on to achieve a coveted position as president of the Federal Reserve Bank (FED) of Richmond. Additionally, Lacker serves on the Open Market Committee (OMC), which operates as the policy-making arm of the Federal Reserve.

When opening up the topic of the night, “Economics and the Federal Reserve After the Crisis,” Lacker was reminded of his time at F&M. Specifically, he was reminded of something he learned in a government seminar.

“One broad insight I took away from the course was that a critical influence on the choices made by policymakers was the theory they brought to the table — their conceptual understanding of the fundamental forces at work in the world they were dealing with,” Lacker said.

That insight has since influenced Lacker’s view of the financial crisis of 2007-08, which has been reviewed time and again over the years. Nevertheless, this most recent presentation had advantages others did not. For instance, the transcripts from OMC meetings are released on a five-year lag.

“On Jan. 18 of this year, the transcripts were posted for 2007, the year the financial market turmoil began,” Lacker said.

Moreover, each review of the financial crisis has been bettered by hindsight, and Lacker’s presentation was no exception.

“Popular accounts of the financial crisis focus heavily on the events that took place later, in the fall of 2008,” Lacker said. Lacker laments that while it is true the media focused on 2008, the root of 2008’s problems stemmed from 2007.

Even as educated and practiced as Lacker is, he admits there were possible missteps during that tumultuous time. No one in the financial sector is omniscient, and Lacker and his FED colleagues are no exception.

Looking back, it is clear there were other possible routes. At the time, those involved in the FED’s decision-making process were not in possession of the knowledge they have now. However, Lacker came to F&M’s campus to share his own views, not those of his colleagues.

At the time of the crisis, Lacker was a dissenting voice who wanted for a more cautionary approach. The FED in 2007 and the years following took aggressive action to combat the financial crisis. According to Lacker, choosing this assertive path followed the assumption that the financial sector is inherently fragile and in need of aid.

“Much of the vulnerability observed in financial markets is itself the induced response of market institutions and behaviors to the expectation of government backstop support in the event of distress,” Lacker said.

While the more cautionary approach was cast off in favor of this aggressive one, the experience lent itself to a fuller understanding of the financial sector.

Fortunately for the members of the crowd who had not studied economics, Lacker did not concentrate on the minutiae that caused the financial collapse. Rather, he focused on the larger perception of the financial sector that influenced the FED’s and the federal government’s response to the collapse.

According to Lacker, the crisis can be viewed through two lenses.

“The challenge for policymakers, particularly for central bankers these days, is choosing which theories to place weight on,” Lacker said.

The lenses represent the different understandings of the banking industry. Whether or not banking is an inherently fragile structure requiring aid and support from the government or an institution capable on its own was the question raised by Lacker, who seemed to be leaning towards the latter.

“One relies on the expectation of government support in the event of financial stress,” Lacker said. “The other relies on the incentives of market participants to adopt contractual agreements that are as robust as possible to potential stresses.”

Furthermore, if the public sees banking as vulnerable to “runs” and other potential troubles, then that will affect public perception of the banking industry. This may mean, for instance, there grows an expectation for government support. Whichever lens is used, the view of the economic crisis and consequent government response varies.

“If [people] believe such [government] support is likely, then their incentive to adopt a more resilient arrangement is weaker,” Lacker said.

To put it in context, the crisis of 2007 was not the first financial crisis in American history. Since the 1970s, history has manifested an implicit government guarantee on the stability of banking. Throughout past banking failures, government aid has promoted the perception of the banking industry as one that is inherently fragile.

“This history created a situation at the beginning of this century in which it was widely acknowledged that a large fraction of our financial system was belived to be backed by explicit or implicit government guarantees,” Lacker said.

For 2007, that meant the government was in a position where it had to follow through on these expectations.
“After the crisis, attention has naturally turned to financial reform,” Lacker said.

One such reform has been to legislate this kind of banking activity and risk taking. In conclusion of his presentation, Lacker spoke briefly in support of legislation to prevent further financial calamities. For example, policy put forth in the Dodd-Frank bill will hopefully serve to limit financial irresponsibility and restrict certain imprudent behaviors.

“Title I of Dodd-Frank requires that important financial firms submit credible ‘living wills’ — that is, plans for exactly how they would be wound down in the event of bankruptcy,” Lacker said.

The paperwork would serve as a written-out procedure for the bank’s self-sustaining actions in the face of bankruptcy. This plan would be submitted to the government, but a requirement of the living will is that it would not call for any government aid.

“Credible plans for resolving large, failing financial institutions without government support can bolster policymakers’ commitment to refrain from fragility-inducing rescues,” Lacker said.

Unfortunately, Lacker persists that any law-making concerning this will suffer from internal contradictions. These contradictions stem from the legislation’s inability to address both views, inherent fragility or self-sufficiency, of the financial sector. In an attempt to legislate both, the legislation suffers.

“There’s no doubt that interpretation and implementation of this law, and other policy actions to promote financial stability, will continue to be influenced by the alternative theoretical perspectives I’ve discussed,” Lacker said.

Lacker will continue to work with the Richmond FED to better future responses to economic calamities.
“For some commentators, the crisis demonstrated that financial arrangements are inherently more fragile than we had thought,” Lacker said. “But one could just as well argue that the crisis showed how much fragility can be induced by ambiguous rescue policy.”

It is hoped that further research into the financial crisis of 2007 will eventually result in better policy from both the FED and the national government.

Questions? Email Georgianna at gpisanog@fandm.edu.

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