To the new U.S. President:
Eight of your predecessors – almost one in five U.S. presidents -- confronted a major domestic financial crisis in the first year of their administrations, a sobering reminder that you can either harness the power of the nation’s economy, or be run over by it. Moreover, half of all presidents faced a major financial crisis at some point.
A severe financial crisis damages not only the financial system (“Wall Street”), but also the real economy (“Main Street”), in the form of lost output, curtailed R&D and capital investment, rising unemployment and bankruptcies, and the appearance of bread lines and civil unrest. According to one estimate, the economic output lost to a banking crisis amounts to 23% of GDP, a massive setback.
A financial crisis can presage regime shift—a durable change in voting behavior. Populist anger toward elites is a regular response to major domestic financial crises, exemplified by the Tea Party and Occupy Wall Street after the Panic of 2008, William Jennings Bryan and the populists after the Panic of 1893, and the Whigs after the Panic of 1837. At the mid-term elections following the eight crises profiled here, the median decline in House seats held by the president’s party was 12% — twice the average loss of seats in the House in non-crisis mid-term elections. Cleveland suffered a stunning 35% decline in the House, which remains the record today. FDR, however, experienced a gain of 2% in the House and 11% in the Senate. Regime shift could move either way, depending on how the president handles the crisis.
Save your leadership capital for only the worthiest financial crises
Today, the phrase “financial crisis” is used loosely to embrace a wide range of events: stock market crashes, bank panics, sovereign bond defaults, market closings, illiquidity, institutional collapse, and sharp currency declines.
But not all of these are worth your intervention. What should command the president’s time and attention is an event that threatens the safety and soundness of the national financial system and the real economy. Such instability is unambiguous, costly, and longer in duration.
Most financial crises are localized and have little long-lasting impact. The decline and bankruptcy of Enron in the fall of 2001 — in George W. Bush’s first year as president—potentially threatened the stability of financial and energy markets just one month after the 9/11 terror attacks. But Bush decided against any intervention. In 1998, a run on Long Term Capital Management, a hedge fund, threatened the stability of the financial system; the Fed, not President Bill Clinton, used its influence to organize an orderly liquidation of LTCM. President George H.W. Bush declined to intervene in the crash of the junk bond market following the indictment of Drexel Burnham Lambert in 1989. Various sharp but short stock market crashes in 1987 and 2010 elicited no presidential action. Thus, the staple response to smaller and more local events is for the president to do nothing and let the markets cure themselves, with appropriate regulatory oversight.
Focus on Main Street and on forestalling the next crisis
Various federal laws empower agencies such as the Federal Reserve, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Consumer Financial Protection Bureau, and the Financial Stability Oversight Council to stabilize the financial system in a crisis. Their tools include auditing and investigating, imposing capitalization standards, managing interest rates, injecting liquidity and capital into the system, and implementing “circuit breakers” to suspend trading in financial markets that are spiraling out of control. All of these are time-honored responses but are not to be implemented lightly. The dilemmas will be less about whether to implement these tactics and more about when and how.
Though powerful, the regulators are limited in the scope of their discretion. The president complements the agencies with other vectors of response. One vector entails initiating reforms of the financial system to enhance stability and forestall another crisis. Van Buren, Lincoln, Cleveland, and Roosevelt led such efforts. In June 2009, the Obama administration advanced proposed regulatory reforms that ultimately emerged as the Dodd-Frank Act in 2010, the most significant change in financial sector regulation in 76 years.
A second vector is promoting transparency. During a crisis, decision makers and the public need to know what is going on. You can promote transparency through executive orders, wise legislation, and study commissions. Transparency helps to relieve problems caused by information asymmetry.
A third vector is relieving distress and stimulating the economy. Repairing the real economy is the province of the president, for which you have the full panoply of instruments: fiscal stimulus spending, social relief, executive orders, government contracts, anti-trust and tax policy, and the “bully pulpit” for exhorting decision makers to action.
In response to the Panic of 2008, George Bush and Barack Obama deployed their administrations to nudge nearly $1.5 trillion in fiscal spending bills through Congress, stimulate the economy, bail out industrial firms such as General Motors and Chrysler, promote mergers of failing institutions, and assist distressed mortgage borrowers.
It was not always thus. Adams, Van Buren, Buchanan, Lincoln, and Cleveland did nothing for relief and economic stimulus. The tide turned with Herbert Hoover. Today voters are likely to expect some presidential intervention to address the damage to the real economy from a major financial crisis.
Quelling a financial crisis hinges on attributes of leadership
Presidential leadership in a financial crisis is a matter of asserting priorities, mobilizing a coalition, and communicating well to decision makers and the public. You alone are not in control of crisis-fighting. But you have immense influence and convening power necessary to coordinate actions across the federal government. In addition to coordinating and motivating regulators, the president must work with Congress—often with the opposition party—on legislation involving fiscal stimulus and changes in financial regulation.
Engaging the opposition, however, is both expedient and fraught with danger, since the opposition will certainly sense the potential for regime shift. Generally, presidential legislation responding to a financial crisis has garnered scant support from the opposition. Offering a response to the crisis that is partisan and polarizing is especially risky: Van Buren, Buchanan, and Cleveland all did, and their parties suffered the consequences.
The potential for regime shift poses a stark choice: Master the crisis or be mastered.
Lincoln, FDR, and Obama made broad changes in financial regulations. Reagan significantly restructured the Savings and Loan industry. FDR and Obama also harnessed their crisis momentum on behalf of social legislation.
Stay flexible; you may need to pivot
A first-year first term financial crisis calls for pragmatism and agility. FDR’s platform in 1932 advocated a balanced budget, which he abandoned in 1934. He also campaigned against federal deposit insurance, but later endorsed such legislation. Teddy Roosevelt, the trust-buster, endorsed a major merger in the steel industry to help quell the Panic of 1907. In the face of a run on the dollar in 1971, Richard Nixon abandoned the gold standard, famously saying “I am now a Keynesian in economics.”
Turning from strong ideology or campaign promises is politically risky, though voters may forgive a pivot in the face of extreme circumstances.
Do no harm
Take action commensurate with the threat and with the context. Interventions risk making the financial system less nimble and more costly and can promote moral hazard. Government intervention in crises (large and small, systemic and local) may create an incentive for risk-taking, which can amplify and accelerate the next crisis.
Also, the impact of a financial crisis will vary considerably by industry, region, and socio-economic class. It is a mistake to assume that the impact is homogeneous across the nation and world. Industries such as health care; education services; and food, beverage, and tobacco products actually grew in 2009 and 2010; in contrast, oil and gas exploration and output in automobile and furniture manufacturing fell sharply. In 1857, the manufacturing North suffered much more than the plantation South.
The president must target remedies to the crisis in ways that deal most effectively with the threat and its impact.
Robert F. Bruner is University Professor, Distinguished Professor of Business Administration, and Dean Emeritus at the Darden School of Business at the University of Virginia.