Panics and the Regulatory Catch-22

A sudden, en masse cash withdrawal from financial institutions by panicked depositors can be disastrously destructive for the real economy.1 This type of panic is not, of course, unique in threatening catastrophic harm to society; war, disease, climate-related disasters, and other calamities may pose significant risks and demand policy measures aimed at prevention or preparedness. Panics are, however, distinct from other threats in two ways that merit attention. The first is that once a panic is underway, even a competent government response tends to undermine public faith in key societal institutions.2 Second, panics are preventable in ways that other threats may not be.

What should the government do when a panic threatens? Allowing it to run its course can throw the country into a depression.3 Even when the government ultimately intervenes to stop a panic, allowing it to play out for even a short time can have a profoundly negative economic impact.4 Panics force financial institutions to stop lending and to sell assets at “fire-sale” prices, which in turn raises effective interest rates across the economy.5 As former Fed chair Ben Bernanke has explained in reference to the great financial crisis (GFC) of 2007-08, “the sharp contraction in funding in the shadow-banking sector forced a painful disintermediation, which in turn depressed prices and raised yields on virtually all forms of private credit, not just troubled mortgages.”6 This dynamic has a profoundly depressive effect on the real economy. Bernanke compares this explanation to other causal theories of the recession that followed the GFC,7 and concludes that “the factors most strongly associated with the financial panic – the run on short-term funding and the panic in securitization markets – are … by far the best predictors of adverse economic changes in a range of macroeconomic indicators.”8