Economics and the Federal Reserve After the Crisis

There are two different ways of thinking about financial stability, representing alternative theories of financial market behavior. The first assumes that market institutions and behavior are fixed and that those fixed characteristics result in a financial system that is prone to instability. The second assumes that market institutions and behavior are adaptable and that financial markets respond to expectations of government support, which can provide undesirable incentives and lead to instability. U.S. financial regulatory policy seems to be largely based on the first theory. However, since the early 1970s, federal support to troubled financial institutions has been commonplace, resulting in a large portion of the financial sector being protected by the federal financial safety net, either explicitly or implicitly. The evolving safety net set the stage for the financial crisis that began in 2007. In the summer of 2007, policymakers began to perceive that the banking system was liquidity constrained. The Federal Reserve lowered the discount rate as a result, but borrowing did not increase substantially. The Fed subsequently introduced a series of programs to provide subsidized credit. An alternative reading of this period suggests that deterioration in housing markets implied a fundamental revaluation of many financial instruments related to housing. Because exposures to these instruments were distributed throughout the financial system, increased uncertainty and counterparty risk were widespread. While subsidized central bank credit might have eased some strains, extensive use of subsidized central bank credit likely also slowed down needed market corrections. The provision of subsidized credit led institutions to believe that further support would be forthcoming and changed their incentives, dampening troubled institutions’ willingness and ability to seek other solutions to the stresses they were facing, whether by raising capital or selling assets. At the same time, differing treatment of and support to individual institutions arguably increased uncertainty among market participants. The Fed and other policymaking bodies should strive to reduce the scope of the safety net and to clarify issues surrounding the failure of financial firms. A potentially promising route for winding down firms is the establishment of “living wills,” as called for in the Dodd-Frank Act.