A decade after the acute phase of the financial crisis the Economics profession is still trying to make the case its policy recommendations helped.

As Paul Krugman observed,

So the world financial system and the world economy failed to implode. Why?

We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, reflected institutional changes since the 1930s. Shadow banking and wholesale funding markets were deeply stressed, but deposit insurance still protected a good part of the banking system from runs. There never was much discretionary fiscal stimulus, but the automatic stabilizers associated with large welfare states kicked in, well, automatically: spending was sustained by government transfers, while disposable income was buffered by falling tax receipts. [emphasis added]

Regular readers know I have been saying since before the acute phase of the financial crisis the institutional changes made in the 1930s and extended in the 1960s under the Great Society would prevent a second Great Depression.

As Professor Krugman points out, deposit insurance and the automatic stabilizers did exactly what they were suppose to do and prevented a second Great Depression.  By saying this, he lays to rest the myth the policymakers response to the Great Financial Crisis prevented a second Great Depression.

The only people who are surprised the institutional changes prevented a second Great Depression appear to be economists like Bernanke or policymakers like Geithner and Paulson.

The institutional changes also came with a playbook for exactly how to use the financial system to absorb the losses on the excess debt in the financial system and protect the real economy.  I refer to this playbook as the Swedish Model.  Under this playbook, banks are required to recognize the losses on all of their bad assets up-front.  This doesn’t require the banks be nationalized.  This just reveals which banks are viable and can generate positive earnings going forward and which need to be closed and reopened under different management/ownership.  At the same time, recognition of the losses prevents the burden of the excess debt in the financial system from falling on and strangling the real economy.  (see Iceland for how the Swedish Model is done successfully.)

So what did the policymakers do?

That said, policy responses were clearly much better than they were in the 1930s. Central bankers and fiscal authorities officials rushed to shore up the financial system through a combination of emergency lending and outright bailouts; international cooperation assured that there were no sudden failures brought on by shortages of key currencies. As a result, disruption of credit markets was limited in both scope and duration. Measures of financial stress were back to pre-Lehman levels by June 2009.

Shorter, policymakers didn’t follow the playbook and use the financial system as it is designed.  Instead, they pushed the burden of the excess debt onto the real economy.  I believe the mantra was to “foam the runway” for the banks.

I refer to this policy choice to save the banks at all costs as the Japanese Model.  This model has never been successful at ending a financial crisis and it has never resulted in a self-sustaining recovery.

Please note Professor Krugman embraces saving the banks.  It is conventional wisdom in the Economics profession saving the banks was a good idea when in fact it locks in all sorts of bad outcomes (think zombie borrowers undermining the profitability of each industry they are in).  This conventional wisdom highlights how little the Economics profession understands about the design of the global financial system and how it is actually suppose to be used to handle a financial crisis.

Meanwhile, although fiscal stimulus was modest, peaking at about 2 per cent of GDP in the United States, during 2008–9 governments at least refrained from drastic tightening of fiscal policy, allowing automatic stabilizers—which, as I said, were far stronger than they had been in the 1930s—to work.

Overall, then, policy did a relatively adequate job of containing the crisis during its most acute phase. As Daniel Drezner argues (2012), ‘the system worked’—well enough, anyway, to avert collapse.

Despite the best efforts of policymakers to the contrary, the institutional changes made in the 1930s kept the world from another Great Depression.

The policymakers did manage to make the situation worse.  They overcame the institutional changes that would have confined the crisis to the financial system.  They forced the crisis onto the real economy by their choice to protect the banks.

So far, so good. Unfortunately, once the risk of catastrophic collapse was averted, the story of policy becomes much less happy.

If Professor Krugman had bothered to study the institutional changes made in the 1930s, he would have discovered there was no risk of catastrophic collapse.

Deposit insurance eliminates this risk.

How?  Deposit insurance makes the taxpayers the silent equity partner of every insolvent bank.  This allows the central bank to act as a lender of last resort and provide all the liquidity the insolvent bank needs.

So as long as central banks were willing to perform their lender of last resort role, catastrophic collapse wasn’t a possibility.

After practising more or less Keynesian policies in the acute phase of the crisis, governments reverted to type: in much of the advanced world, fiscal policy became Hellenized, that is, every nation was warned that it could become Greece any day now unless it turned to fiscal austerity….

Governments didn’t practice Keynesian policies by choice during the acute phase of the crisis.  Fortunately for all of us, it was thrust upon them by the automatic stabilizers adopted in the 1930s.

So why did governments turn to fiscal austerity so quickly?

The claim that bad things happen when public debt crosses a critical threshold also played an important real-world role, but was less a doctrine than a claimed empirical observation.

Governments listen to an economist.  A Harvard economist whose claim was only supportable because he made a very basic error in his Excel spreadsheet.

Much to the Economics profession’s chagrin, based on this recitation of the facts about the Great Financial Crisis, it appears the profession hasn’t contributed positively to the financial crisis response.