STANFORD, Calif. (Project Syndicate)—The appointment of new members to the US Federal Reserve Board offers Americans and Congress an opportunity to reflect on the world’s most important central bank and its future.
The obvious question to ask first is how the Fed blew away its primary mandate, which is to provide price stability. That the Fed was completely surprised by today’s inflation indicates a fundamental failure. Undoubtedly, an institutional introspection is essential.
“We need to overturn the basic principle of a financial system in which the government always guarantees mountains of debt in bad times, and we need to do it before the fire station is tested.”
Yet, as interest rate policies dominate the headlines, the Fed is now more important as a financial regulator. Another big question, then, is whether he will use his formidable power to advance climate or social policies. For example, it could deny credit to fossil fuel companies, require banks to lend only to companies with certified net-zero emissions plans, or direct credit to preferred alternatives. It could also decide that it will start regulating explicitly in the name of equality or racial justice, telling banks where and who to lend, who to hire and fire, and so on.
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But before we consider where Fed regulation is going or should go, we must first acknowledge the Fed’s great failure.
In 2008, the US government made an indirect decision: financial institutions could continue to get the money they use to make risky investments largely by selling short-term short-term debt, but a new army of regulators would judge the laughingstock of the institutions” the trumps. The hope was that regulators would no longer miss subprime mortgage-sized elephants on banks’ balance sheets.
“Why bother to save money or space on the balance sheet to buy low, provide liquidity, or treat a “fire sale” as a “buy opportunity”? The Fed will only get ahead of you and take the profit away from you.”
Yet in the decade since detailed regulation and “regular scenario-based stress testing,” the Fed’s regulatory army has not once considered, “What if there were a pandemic?”
When a pandemic arrived in early 2020, the Fed reneged on the “never again” promises of 2008, this time intervening on an even larger scale. This march, brokers have proven unable to middle the plain vanilla US cash market. Thus, the Fed supported the market. Critics had long pointed to problems with the Fed’s liquidity rules, and fixing those markets would have been simple, but obvious reforms had languished.
Later, there was a run on money market funds. The Fed again bailed out monetary funds. There’s nothing easier to fix than money market runs, but the fix never happened.
The Fed has also funded new municipal bond issues and supported corporate bond prices, essentially offering all the right collateral. In 2008, the Fed and the Treasury Department balked at raising the market price of all mortgages under the Troubled Assets Relief Program. Yet by 2020, the “Powell put” had set an explicit floor for corporate bond prices — and more.
So what? It worked!
The predictable reply to this criticism will be: So what? The COVID-19 lockdowns may well have triggered a financial crisis. The flood of bailouts worked, so much so that our problem today is inflation. We don’t have to worry about systemic risk, because the Fed and the Treasury will put out any new fires with seas of new money.
“The left is right to say that the big banks are inefficient oligopolies that serve most Americans poorly. But the cause is wrong. A huge regulatory compliance burden is a major barrier to market entry.”
The problem, of course, is the incentives these policies have created. Why bother to save money or space on the balance sheet to buy low, provide liquidity, or treat a “fire sale” as a “buy opportunity”? The Fed will only get ahead of you and take the profit away from you.
If you’re a business, why issue shares when you can just borrow, knowing that the government will support your debt or bail you out, like it did the airlines? If you are an investor, why hesitate to buy fragile debt, knowing that its value will be guaranteed by another “whatever it takes” commitment from the Fed in a crisis?
No wonder America is awash in debt. Everyone assumes that taxpayers will take losses in the next downturn. Student loans, government pensions and mortgages piled up, all waiting their turn for Uncle Sam’s bailout. But each crisis requires bigger and bigger transfusions.
Bond investors will eventually refuse to hand over more wealth for bailouts, and people won’t want to hold newly printed trillions of dollars. When the bailout everyone’s been expecting doesn’t materialize, we’ll wake up to a city on fire – and the fire station has burned down.
News: Financial stability risks ‘high’ as climate, COVID and crypto dangers rise, US says
In 2008, regulators and legislators at least had the good sense to recognize moral hazard and fear that investors would gain in good times while taxpayers would cover losses in bad times. But the 2020 eruption was met with nothing but self-congratulations.
The same power that missed subprime mortgage risks in 2008, the pandemic in 2020, and now wants to be subject to “climate risks”, will surely miss the next war, pandemic, sovereign default or other disruptive event. major. Fed regulators don’t even ask those last questions.
And although they deliver word salad about “interconnections”, “strategic interactions”, “network effects” and “credit cycles”, they still haven’t defined what “systemic” even risks, aside from a hookable span to tune all-encompassing power regulators.
Regulators will never be able to predict risk, shrewdly calibrate the assets of financial institutions, or ensure that huge debts can always be paid. We need to overturn the basic principle of a financial system in which the government always guarantees mountains of debt in bad times, and we need to do it before the fire station is tested.
Better regulation can bridge partisan divides. The left is right to say that the big banks are inefficient oligopolies that serve most Americans poorly. But the cause is wrong. A huge regulatory compliance burden is a major barrier to market entry.
Calls for “more” regulation make no sense. Regulations are smart or dumb, effective or ineffective, full of undesirable consequences or well designed. We need better regulation. We need more capital, not several thousand more pages of rules. Capital provides a buffer against all shocks and does not require regulation to be far-sighted. The Fed has scandalously failed to block narrow businesses and payment providers that could help serve the financial needs of many Americans.
Before turning to healing the planet and righting injustice, the Fed should be held accountable for how poorly it performs the fundamental task of protecting the financial system.
John H. Cochrane is a senior man at the Hoover Institution.
This comment was posted with permission from Project Syndicate – why isn’t the Fed doing its job?
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