Public Confidence and the Great Financial Crisis of 2008 INSS Insight No.

82,
November 28, 2008
Even, Shmuel

Severe financial crises are connected to national security. They impinge on a state's national resilience
and its ability to realize its national objectives: they impose budgetary constraints on the defense system,
limit political maneuverability, jeopardize the public welfare, increase crime, and are liable to invite
dangerous social processes. Therefore it is important to deal with them swiftly, firmly, and from a
comprehensive systemic perspective.

Today the world finds itself in the midst of a large scale financial crisis unprecedented since the
Great Depression of 1929 – the most profound financial crisis in the modern era. During the Depression,
unemployment in the US reached 25 percent, and in Germany, 40 percent. The social ramifications of the
Great Depression aided the rise of fascist regimes, foremost among them the Nazi regime, and spread
support for communism. The present crisis is currently nothing like the Great Depression, but their
underpinnings are identical: a crisis of public confidence. Then too the crisis did not stem from some
external event such as war, but rather from corrupt internal systems. Then too the banks supplied credit
and mortgages to all clients, and cheap capital led to a steep increase in demand for real estate, financial
assets, and easy money. When the bubble burst the banks collapsed, and a significant percentage of the
public lost their savings and incomes, and in many cases their homes.

Crises of this kind have two partially overlapping components: a financial dimension, and a
subsequent real economic crisis. The damages of the economic crisis – a sharp drop in product and
investments – have far-reaching implications, such as a steep decline in national income, a sharp rise in
unemployment, and growing poverty. These trends demand changes in priorities on the national agenda.

The crisis repercussions reach Israel somewhat belatedly, albeit with increasing urgency, and
therefore it behooves Israel's economic leaders to learn the lessons of the US crisis. What happened in the
United States? The first to fail were the financial institution's managements. The financial crisis began in
2007. It was then that the financial institutions began to disclose – gradually, and without sufficient
transparency – losses today estimated at upwards of one trillion dollars. Some of these losses were due to
the marketing of complex financial products based on mortgages extended to high risk borrowers without
sufficient security. The insurance companies compounded the problem by insuring the debt payoffs. The
immediate profits were enjoyed by company heads in the form of enormous salaries and bonuses. When
borrowers were hard-pressed to make their payments, the shaky and corrupt structure collapsed.

Second to fail were the oversight and control institutions, which apparently ignored risky,
unprofessional deals within the financial system. The credit rating companies were likewise lax in
vigilance, yet now have added fuel to the fire by lowering the companies’ ratings after the fact.

Finally, the American administration failed in neglecting to control the capital markets and not
managing the crisis, which only further contributed to the worsening of the downwards spiral. For a full
year, the administration showed no involvement in the crisis, and when it became involved it acted rashly.
Consider its decision not to bail out Lehman Brothers, which prompted the public to withdraw large sums
of money from the banks. From September 16-26, for example, customers of Washington Mutual Bank
withdrew $16.7 billion from their accounts, causing the bank’s collapse. Since the beginning of the crisis,
at least 19 American banks have collapsed in a similar manner. Since the collapse of Lehman Brothers,
the administration has been careful to take over such institutions or to ensure their mergers with other
banks.

Another mistake was the administration’s decision to allocate a part of the $700 billion bailout
package to the purchase of toxic securities – very high-risk debt, in effect throwing good money after bad.
The administration reversed itself and did not in fact make this move, but public confidence was still hurt.

Despite the seriousness of the situation, it would seem that the global market is not suffering a
severe shortage of funds: monetary interest is at an all time low, wealthy nations are injecting capital into
financial institutions, and the public’s bank deposits are increasing as the result of sales on the stock
market and withdrawals from mutual funds and pension funds. The problem is low financial flow: the
longer companies are starved of their financial oxygen, the more they are forced to cancel projects and
fire personnel, and some of them are folding. And so the crisis deepens. There is low monetary flow
because of a crisis of confidence and a decrease in the public’s sense of economic security. The public
then reduces consumption and balks at the capital market. Therefore, restoring public confidence is the
major challenge faced by market leaders in Israel and elsewhere.

The Strategy for Israel

Until the resolution of the crisis on the global market, Israel must formulate a strategy focused on
minimizing damage and containing the ramifications of the crisis. Strengthening public confidence must
play an essential role in the strategy, perhaps through some of the following confidence building steps:

a. Deepen employment confidence, a step that may reduce the decline in consumption. Example:
freeze job cuts in the public sector.

b. Commit publicly to the stability of the system's financial institutions, including all banks.

c. Enhance control and oversight of the capital market: impose limitations that will reduce public
corporate spending in the form of bonuses, high salaries, and transactions with interested parties.
Likewise, enhance control over institutions managing public funds, and set a rate for
management fees consistent with the results.

d. Reduce market failures: consider the establishment of a fund that would acquire corporate bonds
from various pension funds on the basis of social considerations (effect on pensions and
employment savings), on condition they meet pronounced economic criteria (e.g., corporations
with high real capital of their own encountering problems of liquidity). Such a fund would allow
these institutions to avoid the sale of these securities on the stock exchange, which otherwise
causes the prices to plummet. In addition, back bonds of government controlled corporations,
such as the Israel Electric Company, that the pension funds invested in as if they were
government bonds. It is important to avoid the creation of a non-selective safety net that might
involve the acquisition of toxic assets and compensate for relatively risky savings strategies that
were profitable in the past.

e. Allow the theoretical sale of securities at the end of 2008, in order to prevent a wave of sales
based on tax considerations.

f. In the decision making process, avoid rash decisions, leaks, delays, and zigzagging. All of these
negatively affect public confidence.

Another important component is extending assistance to the business sector, which represents
the key to restoring rapid growth. For example,

a. Consider the establishment of government funds to give loans to companies based on both social
and economic considerations.

b. Hasten government payments to the private sector.

c. Shorten bureaucratic and regulatory processes, including assistance in mergers and acquisitions.
 d. Unfreeze land and assist companies in financing residential construction. At this stage, it is
necessary to wait with the allocation of funds to large infrastructure projects. By the time these
are planned and approved, the companies are liable to go under.

The forthcoming change in the American administration represents an extraordinary opportunity

to restore public confidence, which in turn would facilitate the curbing of the economic crisis sooner than
would be expected. Otherwise, the great financial crisis of 2008 is liable to turn into the Great Depression
of 2009. For its part, Israel has the means of mitigating the damage it is liable to incur from the crisis. The
American case demonstrates that decisions to infuse money are by themselves not a solution. The key lies
in restoring public confidence.