Crisis management

Limiting Central Banking

Since 2007, and especially over the past year, actions of public officials have blurred the lines between monetary and fiscal policy almost beyond recognition. Central banks have expanded both the scope and scale of their interventions in unprecedented fashion. This fiscalization risks central bank independence, thereby weakening policymakers’ ability to deliver on their mandates for price and financial stability. In our view, to find a way to back to the pre-2008 division of responsibilities, officials must establish clearer limits on what central banks can and cannot do.

In that division of official labor, it is fiscal authorities that ought to make the unavoidably political choices that directly influence resource allocation. And governments should not conceal such fiscal actions on the balance sheet of the central bank. In a democracy, doing so lacks legitimacy and would become unsustainable….

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The Fed Goes to War: Part 3

For the second time this century, the Federal Reserve is a crisis manager. In this role, policymakers can lend to solvent but illiquid intermediaries (as the lender of last resort). They can backstop financial markets (as a market maker of last resort). And, when all else fails, they can take the place of dysfunctional private-sector intermediaries.

During the first financial crisis of the 21st century, the Fed’s response shifted from one role to the next as the crisis intensified. Yet, even compared to that massive crisis response, the Fed’s recent moves are breathtaking—in speed, scale and scope.

Indeed, with its most recent announcements on April 9, the Federal Reserve is committed to an unprecedented course of action to ensure the flow of credit to virtually every part of the economy. In carrying out its obligations under the newly enacted CARES Act, the Fed is effectively transforming itself into a state bank that allocates credit to the nonfinancial sectors of the economy.

Yet, picking winners and losers is not a sustainable assignment for independent technocrats. It is a role for fiscal authorities, not central bankers. Instead of using the Fed as an off-balance sheet vehicle for the federal government, we hope that Congress will shift these CARES Act obligations from the Federal Reserve to the Treasury, where they belong….

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Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

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