Wednesday, January 19, 2022

Accounting for the blowout / Project Syndicate

A Project Syndicate Essay. 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. 

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? 

No wonder America is awash in debt. Everyone assumes that taxpayers will take on losses in the next downturn. Student loans, government pensions, and mortgages have piled up, all waiting their turn for Uncle Sam’s bailout. But each crisis requires larger and larger transfusions. Bond investors eventually will refuse to hand over more wealth for bailouts, and people will not want to hold trillions in newly printed cash. When the bailout that everyone expects fails to materialize, we will wake up in a town on fire – and the firehouse has burned down. 

In 2008, regulators and legislators at least had the sense to recognize moral hazard, and to worry that investors gain in good times while taxpayers cover losses in bad times. But the 2020 blowout has been greeted only with self-congratulation. 

The same Fed that missed the subprime-mortgage risks in 2008, the pandemic in 2020, and that now wishes to stress-test “climate risks,” will surely miss the next war, pandemic, sovereign default, or other major disruptive event. Fed regulators aren’t even asking the latter questions. And while they issue word salads about “interconnections,” “strategic interactions,” “network effects,” and “credit cycles,” they still have not defined what “systemic” risk even is, other than a catch-all term to grant regulators all-encompassing power. 

Regulators will never be able to foresee risks, artfully calibrate financial institutions’ assets, or ensure that immense debts can always be paid. We need to reverse the basic premise of a financial system in which the government always guarantees mountains of debt in bad times, and we need to do it before the firehouse is put to the test. 

Better regulation can bridge partisan divides. The left is correct that big banks are inefficient oligopolies that serve most Americans poorly. But it has the cause wrong. An immense regulatory compliance burden is a major barrier to market entry. 

Calls for “more” regulation are meaningless. Regulations are either smart or dumb, effective or ineffective, full of undesired consequences or well designed. We need better regulation. We need more capital, not many more thousands of pages of rules. Capital provides a buffer against all shocks, and it does not require regulators to be clairvoyant. The Fed has scandalously blocked narrow-banking enterprises and payments providers that could help serve many Americans’ financial needs. 

Before turning to healing the planet and righting injustice, the Fed should be held to account for how badly it is doing on the basic task of protecting the financial system.



  1. Why is price stability the Fed's main mandate? Certainly it's an important but so is managing unemployment.

  2. If the Fed wants to get into social engineering, I propose the Fed outlaw banking in those states that do not outlaw property zoning.

    The cost of housing in America is ruinous, and it stems in large part from property zoning and scarce supply.

    1. I beg to differ. Housing costs have skyrocketed because of the cost of building a house (replacement costs)
      When the cost of a permit to replace a wall heater is greater than the cost of the heater, this rather basic event indicates how building regulations and codes are out of control and consequently raise the price of building a new house.
      There's plenty of land so zoning is not an issue. The cost of developing the land due to government regulations is the problem

    2. Sure, many regs make a mess, but in some cities, such as L.A., 70% of land is zoned single-family detached.

      What the West Coast needs is forests of 60-story condo towers, right where people want to live.

      You can build 60-story condo tower outside Palmdale. There is plenty of land.

    3. Mr. Cole, you vastly overestimate the attractiveness of living in one of a "forest" of 60-story condo towers. Not everyone is single without children and looking for a cave to hide in.

    4. It's not just the zoning - in many cities with highest home price appreciation water and sewer capacity is very limited. This capacity is very expensive and cannot be added in small increments - and many of those cities are in such dire financial straits it would be very challenging economically and politically to sell bonds to pay for services for new development.

    5. The Fed is not, should not, and cannot be responsible for local zoning laws or failure to upgrade local infrastructure. California has ample tax income to fund any and all necessary infrastructure; it simply chooses not to fund it. As for Fed policy, debt reduces flexibility. Massive debt eliminates flexibility. As John states, humans and human institutions, including the Fed, are not clairvoyant. So building fragile structures is a failed strategy. Will we ever learn? No, probably not. In the USA, political expediency reigns supreme. Weimar, here we come.

  3. "... the Fed should be held to account for how badly it is doing on the basic task of protecting the financial system."

    While I am sympathetic to the general thrust of this essay, I have to conclude with the observation that the Scotch verdict "Not proved" applies in this case.

  4. The Federal Reserve itself says there are 4 major areas of responsibility, none of which is to influence climate change or social policies. The first is: "Conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices."

    I am archiving their current FAQ for posterity because in the future, their stated mission likely will include climate change and social policies.

  5. Great column. One question: the left wants more regulation, but the answer is more capital. Touche. What does the right want?

  6. sadly the richest don't get tired of wealth accumulation unlike times past where people like Carnegie, Rockefeller, etc actually built business...then set about helping others. Henry Ford paid his employees to make sure they could afford his car.

    Today's wall street...the recipient of MORE THAN $9 trillion of FED unlimitedly glutenous with a raw hatred of most of America and actually little interest in business and its success! Government today isn't to help people and is to enrich select cronies and itself using unlimited power and DEBT!
    Sadly I believe the next downturn with be a once in 100 year Event!

    1. -->"Henry Ford paid his employees to make sure they could afford his car."

      Sorry to say, but that's an apocryphal story. Ford had 100% daily labor turnover at the pay rate originally offered. He had to raise pay for the extremely boring assembly line work. Ford paid his employees to stop quitting. The end result was they could afford to buy his car.

      The last three downturns were 100 year events (as measured relying on Gaussian statistics)--no reason the next downturn won't be. Cheers.

  7. The difficulty for the Fed going forward in an environment of higher inflation, higher interest rates, and probably higher growth rates, is the balancing act it will have to do between tapping the breaks on our domestic economy if inflation rates climb versus the financial funding accommodation the international markets will need to keep functioning. Don’t forget that before the pandemic hit, in the Autumn of 2019, our Fed had to intervene when the financial intermediaries (banks) could not meet the run for cash/cash equivalents. With actors pulling at both ends of the monetary policy rope for tightening and loosening, the Fed will have a delicate tap dance satisfying its impetuous players.

  8. Currently inflation is the illness. Interest rates the castor oil. Any delay taking the medicine prolongs the illness. Worry about other things when circumstances improve.

  9. The Fed getting into areas where they have no business scares the bejeebers out of me. Perhaps they are moving into these areas because they can't cover their main task (price stability) and want to feel good about themselves? Pitiful.
    Plain manila Taylor rules put current interest rate targets over 8 percent. Not surprised we have inflation when interest rates are purposefully held so much lower than required.
    Pete Bias

    1. Anonymous / Pete Bias,

      8% interest rates x $28.43 trillion in federal debt = $2.27 trillion in interest payments on that debt.

      Federal receipts:

      3rd Qtr - 2021 - $2.51 trillion

      "Plain manila Taylor rules put current interest rate targets over 8 percent."

      Taylor could never be bothered to include the quantity of federal debt or how debt reduction should be achieved in his "rule". Taylor wrote his rule when federal expenditures (particularly defense expenditures) were flat / falling:


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