The 2008 financial crisis was the most damaging economic event since the Great Depression, for both the United States and much of the global economy. Although the U.S. economy emerged from it more quickly and in better shape than many other economies did, the crisis imposed tragically high costs and left deep economic and political scars. To help prevent another crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. These and other reforms have added a considerable margin of safety to the U.S. financial system.
But how safe is that system today? The answer is important, because although the United States may not face a major crisis anytime soon, it is certain to at some point. The choices policymakers make in advance of that event and in the moment will have a major impact in determining the magnitude of the economic damage. Indeed, the U.S. financial system’s vulnerability to a crisis depends not only on the strength of the regulation designed to prevent one but also on how much freedom policymakers have to respond when prevention fails. It’s just as in medicine, where the public’s health depends not just on immunizations, nutrition, and checkups but also on hospitals, surgery, and emergency care.
Determining whether the system is now safer requires looking at three different dimensions of the question. The first involves trying to assess the underlying fragility of the system today. How much dry tinder, so to speak, is there in terms of short-term liabilities, and how much privately owned capital is available to absorb losses in an economic downturn? The second involves the ability to limit the intensity of a crisis. How much fiscal capacity does the government have to cushion a fall in private demand, and how much monetary scope does the Federal Reserve have to lower interest rates? The third dimension has to do with the other powers necessary to prevent a financial crisis from spiraling out of control.