Economist Writing Every Day

The Fed was founded after a spat of banking crises.

We know that the Federal Reserve also has the goals of full employment and steady, moderate inflation. Since the 1990s, that’s meant 2%. But it’s a relatively recent addition to the Fed’s policy goals. The primary purpose was initially and always has been financial system stability.

In 2008, the Fed demonstrated that it’s willing to attain financial stability at the cost of employment. After and during the financial crisis, the Fed purchased mortgage backed securities (MBS) from private banks at a time when their value was highly uncertain (and discounted). The purpose was to replace these assets of uncertain value with less risky assets. At the time, there was resentment that these security holders were insulated from losses while the homeowners whose loans composed the MBS did not get comparable relief. I remember arguing that the Fed, with the cooperation of congress, could have just paid part of the mortgages on behalf of the homeowners such that there were fewer foreclosures and fewer personal bankruptcies. That way, both the borrowers wouldn’t default and the debt holders would enjoy stable returns.

But, the primary goal of the Fed is financial system stability. Pre-financial crisis, banks had loaded-up on securities of uncertain value with the help of regulatory arbitrage and some lending shenanigans. The Fed needed to avoid the ensuing catastrophe that was a consequence of the greater-than-anticipated realized risk. Importantly, catastrophe to the Fed is financial-sector specific. Markets losing liquidity, bank-runs, and financial sector business failures all qualify as the stuff of concern (all of which occurred). While making mortgage payments for specific mortgages would have been popular amongst many debtors, it also would have taken much more time to implement. The Fed wanted to avoid more financial instability than had already occurred. And frankly, the Fed’s first priority isn’t to take care of the public. Given the alternative between a slow popular option and a quick adequate option, the Fed has demonstrated an inclination toward the latter.

George Selgin has done good work on this. Reading the 2008-2009 FOMC committee minutes and other documents reveal that the leaders of the Fed were keenly focused on protecting banks and the credit markets on which they depended. It’s been 15 years since the financial crisis and it’s now known among macroeconomists for two things. 1) It began the Great Recession – the painfully slow, years-long recovery that followed the recession. 2) The start of the interest on reserves (IOR) – the policy of adjusting bank balance sheet composition through changes in the interest rate that they earn in exchange for not lending. Importantly, loans are tightly connected to the value of all deposits and total spending in the economy. The slow growth of NGDP was part-and-parcel of keeping banks well capitalized and it came at the cost of employment growth.

This brings to light 2 related concerns for economists:
1) Financial Intermediation
2) NGDP stability

Financial intermediation is the process of connecting borrowers and savers. That’s what banks do when they lend and borrow. They complete credit checks, vet the veracity of assets, and they minimize transaction costs in order to enable investment. This process is a pillar of economies that are characterized by impersonal trade. Losing financial intermediation would be like having a sudden loss of trust. It’s not that banks improve trust among people. It’s that banks dependably provide the equivalent of a character reference among businesses and governments who engage in various degrees of risky business. Financial disintermediation means losing access to gains from trade. This is the argument for avoiding mass bank failures. This is the justification behind the Fed interventions in credit markets to provide liquidity.

Financial intermediation has other valuable effects. Namely, bank lending increases the money supply and affects total spending throughout the economy. That means that there is a fundamental link between financial intermediation and macroeconomic stability. If debt markets seize, then M2 fails to grow or could even decline. Without a commensurate rise in velocity, the result is a decline in gross domestic income. Such is the stuff of recessions, depressions, and debt deflation-driven defaults. This link between banks and the larger economy is a great part of why the US congress passed the Federal Reserve act in 1913.

What’s the Worry?

I worry about the Lucas critique. If the policy target is preventing bank failures, then the banks that survive will face different incentives. If the policy target is to have well-capitalized banks and reserves are super-abundant, then banks cease to compete for other safe assets and are willing to increase their risk on other margins. If the MBS or other markets remain liquid due to Fed purchases, then the asset prices and yields cease to reflect the underlying quality of assets.

All of these interventions are for the sake of financial system stability. But they also change the services that the financial sector provides – namely, accurate pricing and risk evaluation. Increasingly, we’ve removed the links between financial stability and financial intermediation. The investments and trades that banks enable decreasingly have the same relevance for the larger economy that they did when markets better reflected underlying asset values.

Banks are not inherently valuable. We value them because they provide valuable services. If banks stop providing financial intermediation, then are they worth protecting?