Scott Sumner described Ramesh Ponnuru’s NYT’s op-ed yesterday, which blamed the Fed and tight money for the financial crisis, as “the single best piece on monetary economics to appear in a major publication since the Great Recession began….” I winced when I read it.
Surely the bank run occurred because of 1) fear of declining real-estate prices; 2) the inherent instability of the self-reinforcing feedback loop of bank runs; 3) the difficulty of assessing the value of collateral; and, 4) the inability to understand how banks would withstand stress in the face of credit default swaps and other untested innovations.
Does anyone serious believe a 2-point drop in the short-term rate from 2% to zero would have motivated lenders (other than the Fed) to continue lending to banks in the face of those issues?
Given the inherent instability of bank runs, I suppose anything is possible. But zero percent rates are a two-edged sword. And it’s hardly obvious that the Fed, and not markets, sets rates. After all the Fed raised short-term rates in December and rates fell.
It’s hard to imagine private sector lenders making zero-interest loans to troubled banks in early September 2008, or banks rushing to the Fed to borrow cheap money to lend to such lenders. The run occurred because markets were closed to such borrowers at much higher rates.
Perhaps Ponnuru’s op-ed says little more than, with the benefit of 20:20 hindsight, the Fed should have taken many of the extreme measures in August of 2008 that it took after September—$1.5 trillion of loans to fund withdrawals despite $15 trillion of government guarantees. It’s true that with the benefit of 20:20 hindsight, we would all be a lot wiser.
From my perspective, populists on the left and right have successfully obscured the truth about the inherent instability of banking and the enormous value of the Fed as the lender of last resort. The Left blames the crisis on misaligned incentives, corruption, and stupidity, which they believe more regulation will solve. The Right thinks the free market will rein in the inherent instability of banking without a significant slowdown in growth. Both are mistaken.
On the broader issue of loose monetary policy, even Bernanke is finally coming around to the conclusion that unless the Fed commits to inflicting price inflation on risk-averse savers after the economy recovers—i.e., makes an increase in the money supply permanent—expanding the money supply has little effect on growth or inflation in a recession and its aftermath.
It’s surely true that if the Fed committed to expanding the money supply until savers capitulated, at some level of recklessness risk-averse savers would stop saving (although, apparently not $4 trillion of recklessness), but at what cost in the long-run? A lot of other economic activity would surely slow down too.