The Courage to Act: A Memoir of a Crisis and Its Aftermath

First, in periods of recession, deflation, or both, monetary policy should be forcefully deployed to restore full employment and normal levels of inflation. Second, policymakers must act decisively to preserve financial stability and normal flows of credit.

During a recession, banks lend more cautiously as their losses mount, while borrowers become less creditworthy as their finances deteriorate. More cautious banks and less creditworthy borrowers mean that credit flows less freely, impeding household purchases and business investments. These declines in spending exacerbate the recession.
More generally, our work underscored the importance of a healthy financial system for the economy. For example, it implied that recessions are worse when households and businesses start with high debt levels, as falling income and profits make it more difficult for borrowers to pay their existing debts or to borrow more.

Likewise, if a country’s banking system is in bad shape at the outset of a recession, the downturn will likely be worse. In extreme cases like the Depression, a banking collapse can help create a prolonged economic slump.

It seemed to me that the lack of credit after the collapse of the banking system had to have played a significant role in the slump as well. More than 9,700 of the nation’s 25,000 banks failed between 1929 and 1933.

If AIG failed even with the loan, the financial panic would intensify, and market confidence in the Fed’s ability to control the crisis could be destroyed.

We would charge a high interest rate on the loan and take an ownership stake in the company of nearly 80 percent, so taxpayers could benefit if the rescue worked.