Swimming in Money
Before it moves on to climate change, inequality, and racial issues, the Fed should have to think just a little bit about the evident failure of its existing financial regulation.
Capital Thinking · Issue #1020 · View online
Accounting for the blowout / Project Syndicate
John H. Cochrane | The Grumpy Economist:
Why Isn't the Fed Doing its Job?
The nomination of new members to the US Federal Reserve Board offers an opportunity for Americans – and Congress – to reflect on the world’s most important central bank and where it is going.
The obvious question to ask first is how the Fed blew its main mandate, which is to ensure price stability. That the Fed was totally surprised by today’s inflation indicates a fundamental failure. Surely, some institutional soul searching is called for.
Yet, while interest-rate policies get headlines, the Fed is now most consequential as a financial regulator. Another big question, then, is whether it will use its awesome power to advance climate or social policies.
For example, it could deny credit to fossil-fuel companies, demand that banks lend only to companies with certified net-zero emissions plans, or steer credit to favored alternatives.
It also could decide that it will start regulating explicitly in the name of equality or racial justice, by telling banks where and to whom to lend, whom to hire and fire, and so forth.
But before considering where the Fed’s regulation will or should go, we first need to account for the Fed’s grand failure.
In 2008, the US government made a consequential decision: Financial institutions could continue to get the money they use to make risky investments largely by selling run-prone short-term debt, but a new army of regulators would judge the riskiness of the institutions’ assets.
The hope was that regulators would not miss any more subprime-mortgage-size elephants on banks’ balance sheets. Yet in the ensuing decade of detailed regulation and regular scenario-based “stress tests,” the Fed’s regulatory army did not once consider, “What if there is a pandemic?”
When a pandemic did arrive in early 2020, the Fed repudiated the “never again” promises of 2008, this time intervening on an even larger scale.
That March, the dealer banks proved unable to intermediate the market for plain-vanilla US Treasury securities. So, the Fed propped up the market.
Critics had long pointed to problems with the Fed’s liquidity rules, and fixing these markets would have been simple, but obvious reforms had languished. Later, there was a run on money market funds. The Fed bailed out money market funds once again. There is nothing simpler to fix than money-market runs, but the fix never happened.
The Fed also funded new municipal-bond issues and propped up corporate bond prices, essentially offering a whatever-it-takes guarantee.
In 2008, the Fed and the Department of the Treasury had balked at the idea of raising the market price of all mortgages under the Troubled Assets Relief Program. Yet in 2020, the “Powell put” had established an explicit floor for corporate bond prices – and more.
The predictable rejoinder to this critique will be: So what?
The COVID-19 lockdowns might well have triggered a financial crisis. The flood of bailouts worked, so much so that our problem today is inflation. We do not need to worry about systemic risk, because the Fed and the Treasury will just put out any new fires with oceans of new money.
The problem, of course, is the incentives these policies have created. Why bother keeping cash or balance-sheet space to buy on the dip, provide liquidity, or treat a “fire sale” as a “buying opportunity?” The Fed will just front-run you and take away the profit.
If you are a company, why issue stock when you can just borrow, knowing that the government will prop up your debt or bail you out, as it did for the airlines? If you are an investor, why hesitate to buy shaky debt, knowing that its value will be guaranteed by another “whatever-it-takes” commitment from the Fed in bad times?
John H. Cochrane