Economics After the Crisis: Models, Markets, and Implications for Policy

Economic models based on financial frictions were used to justify many of the Fed's interventions during the financial crisis. Such models are necessarily abstract and stylized and their applicability to the actual situation at hand might not have received enough discussion. In August 2007, there was a significant contraction in the asset-backed commercial paper (ABCP) market. In response the Fed lowered the interest rate on discount window loans in an effort to increase liquidity in the banking system. But it's not clear that a lack of liquidity was the problem; instead, the "logjam" in the ABCP market may have been a price-discovery process. The Term Auction Facility (TAF) was launched in December 2007 to further improve the terms on which banks could get credit from the Fed. But the design of the TAF seemed inconsistent with the financial frictions it was intended to address. Overall, it's possible that financial system fragility is induced by poor policy, rather than being inherent to financial markets. Policymakers would benefit from economic research focused on validating the assumptions underlying models of financial markets and comparing those assumptions to actual observations.