WASHINGTON -- Nearly seven years have passed since the collapse of investment bank Lehman Brothers in September 2008 triggered the global banking crisis. Although the U.S. was the epicenter of the debacle, its economy has been recovering steadily and the Federal Reserve is considering when to raise interest rates above zero. With the sudden drop in the Chinese stock market and the debt crisis in Greece clouding the outlook for the global economy, the timing of a rate increase is tricky.
It is still not clear whether the U.S. economy will regain its former vigor, or where the global economy is heading. The Nikkei asked Timothy Geithner, the former president of the Federal Reserve Bank of New York and U.S. treasury secretary who played a central role in dealing with the banking crisis, to shed light on these questions.
Q: Will the U.S. economy improve over the next year?
A: I'm worried about the many challenges we face. Americans still feel the scars of the [financial] crisis. But I'm actually an optimist about the U.S. I think the U.S. is a more stable economy than it was before the crisis, and our financial system is much stronger than it was. The U.S. economy is resilient and dynamic. I think there's a reasonable chance that the U.S. continues to grow at a relatively moderate pace for the next few years or so. The economists believe that the potential growth of the U.S. is somewhere close to 2%. We should be able to grow modestly above that for a period of time.
Q: When will the Federal Reserve start raising interest rates?
A: The Fed will begin to tighten when they think it makes sense. That's their judgment. I don't get to make those judgments. And their view is likely to change over time, just because the future is somewhat uncertain.
Q: How do you assess overseas risks, such as the slowdown of the Chinese economy and the Greek crisis?
A: Outside the U.S., growth is more uneven and many countries outside the U.S. are still in a much earlier stage of recovery, or they're slowing. So I agree generally that the growth from outside the U.S. is not going to be a major source of strength, and it could be a source of weakness.
China is going through this very difficult transition as they rebalance, and that has to involve a period of slower growth. And I think the reforms they're doing in China seem very-well designed to try to improve the longer-term growth prospects.
China has to go through a set of broader reforms to create a more mature market for capital. The ability to raise capital in the form of equity and bonds is an important source of strength for an economy. You have to create a framework for the capital markets that have the right level of disclosure, so that people can evaluate companies, and have a set of protections for the individual investor.
And I think the drama of the last few months just reinforces the importance of those reforms, and hopefully will help strengthen the momentum for those kinds of reforms.
In Europe, a lot of challenges remain, but I think they're in stronger shape than a few years ago, despite Greece.
Q: The spillover from higher interest rates is a serious problem for the world economy and the financial markets, isn't it?
A: It doesn't have to be that damaging to the world economy, although there's always this risk. Most countries have the independence to set monetary policy. That makes them less affected by the U.S. Fed than when most economies tied their currencies to the dollar. And the global financial system is stronger than it was. That's true in emerging economies, too, which have much higher reserve levels and better balance sheets. I think probably that the world could absorb the effects of whenever the Fed decides to move without that much damage.
Q: What kind of measures are needed to re-energize the U.S. economy?
A: What people have been talking about in Washington for years is a mix of public investments in infrastructure, education, etc., reforms to improve incentives for investment, combined with long-term fiscal reforms. We need to work to address huge disparities in access to quality education and income. The Obama administration has improved the safety net in the U.S. with reforms to health care and we are in the process of promising reforms to public education systems. That's a very good [start].
Q: Can the U.S. recapture the economic growth it had before the crisis?
A: We're in a period where people are pessimistic about growth around the world, but a lot of that pessimism is just rooted in the aftereffects of the crisis. It's a consequence of the process you have to go through to bring down debt to income, and take leverage out of the financial system, and adjust to a period of overinvestment in housing. They're good for the long run, but they tend to slow the economy in the short term. I think that a lot of the disappointments we saw were the result of those transitional headwinds. I don't think there's evidence, somehow, to support the conclusion that the U.S. has to be resigned to a longer period of much weaker growth.
Even though we're a younger country [than Japan], we also have demographic changes. Lower productivity growth has lowered estimates of our potential growth rate. Whether you are an optimist or a pessimist about the growth outlook, you should still be in favor of public investments in infrastructure, improving education and other reforms to improve growth.
Q: Another problem for the U.S. is the political gridlock. How can it cope?
A: The U.S. is a very pragmatic country, and I'm sure we'll rediscover the capacity for pragmatism political compromise again. Even in a period when people have been so concerned about the divisiveness in the political system, there's been a tremendous amount of reform through legislation, not just in the last few months on things like TPA (trade-promotion authority), but before that, on financial reform and health care reform.
Q: You published a memoir last year that explained why Lehman Brothers was allowed to collapse. Can you talk about that?
A: Fundamentally, our challenge is that we went into this crisis with very limited authority. The only authority that existed in September of 2008 that allowed the government of the United States to provide assistance to a nonbank was the Federal Reserve, and its authority was very limited.
We thought the only option we had, given the financial conditions of Lehman, was to try to arrange a buyer and help facilitate an acquisition. We ran an auction, but there were very few willing buyers, in fact, only one potential [buyer] at the end, and the British authorities were unwilling to let Barclays buy Lehman.
Q: Did the bailout of Bear Stearns affect the discussion?
A: The Bear Stearns case was similar in some respects to Lehman. We chose to run an auction to find a willing buyer. The world was very fragile then, but nothing like the fragility of September 2008. So there was more willingness at that point for people to take risks. We could help facilitate the acquisition by JPMorgan.
The mood of the country then was against any further interventions because they did not understand how bad the crisis was at that point. It's a good lesson, because it's very dangerous to let large institutions fail in the midst of a panic.
Q: The most important thesis in your memoir is that the "moral hazard fundamentalists and Old Testament populists" were wrong to oppose the bailout. How can we ensure that financial authorities are able to take the steps needed in a crisis?
A: The instinct to let financial institutions bear the consequences of taking on too much risk is the right instinct and the right policy in a typical moderate crisis, but in times of exceptional crisis to do so is like pouring oil on a fire. You have to give the financial authorities the ability to take unpopular action to protect the nation. We had to undertake TARP (Troubled Asset Relief Program).
Before the crisis, we certainly did allow [financial institutions to accumulate] too much risk. There was a boom going on in nonbank institutions, such as securities firms and government home-loan entities, which were outside the supervisory scope of the financial regulators. There was probably too much trust mistakenly placed in the U.S. financial system because it had been relatively stable for so long. And as a result, regulations for nonbank institutions had not been strengthened.
Q: Another lesson is the need to prevent the formation and collapse of bubbles and the expansion of international imbalances, right?
A: It's important to recognize that you can't eliminate the inherent vulnerability of markets ... to financial crises. You can do a lot of things that can reduce your vulnerability to crisis and reduce the intensity of crises. You can reduce the buildup of leverage in the financial system and the risk that investments are financed in very dangerous ways. We have transformed the nature of those limitations on risk in the United States, both through the stress tests in the crisis and the subsequent reforms to capital requirements.
Ultimately, however, you can't eliminate the vulnerability [to] crises. If you want to protect the economy from crises, you still have to have the emergency authority.
Q: How do you answer critics who say the unconventional policies taken during the crisis damaged the U.S. economy and financial markets?
A: No one wanted to do them but they were vastly better than the alternative. And they made the economy much stronger. And they were effective in preventing economic collapse.
At the time, and even today, some people think that the result of those policies is going to be hyperinflation, or the end of the dollar's role in the global financial system, or the U.S. is becoming a kind of Greek economy. I think this reflects a misdiagnosis of the scale of the challenge -- and also a misunderstanding about the effect of what we did. The policies we adopted made the economy stronger, not weaker, and we allowed the weakest parts of the system and the economy to be washed away in the crisis.
The size of the financial shock to the American wealth in the fall of 2008 was about five times greater than what began the Great Depression. In this crisis, because we were much more aggressive in acting, the crisis was terribly damaging but much less damaging than it could have been and much less damaging than the Great Depression. We were worried about all the risks in what we were doing, but we tried to choose the most effective outcome to protect the economy.
Q: So you support almost every action taken during the crisis, such as the Troubled Asset Relief Program and quantitative easing?
A: Absolutely. I am very confident and fully support the decisions we made at the time.
Interviewed by Nikkei Washington Bureau Chief Hiroyuki Kotake