US policy rates and financial stability

In the wake of the financial crisis, some US policy makers understood that the economics profession had erred in not taking debt aggregates and financial stability into account when conducting macroprudential regulation and making economic policy. As a result, increasing research and policy focus has been directed at how to maintain financial stability. Yet, not everyone gets it. Some people want the Fed to continue down the path of loose monetary policy and easy money that created the crisis and completely disregard financial stability.

A perfect example of this kind of thinking comes from Ryan Avent at the Economist. Ryan has been a loud proponent of dovish Fed policy, arguing at each stage of the game that the Fed is not doing enough to reduce unemployment and boost the real economy. His latest critique of the Fed is in that vein. But it goes right to financial stability.

If you want to know why the Federal Reserve is undershooting both its inflation target and its maximum employment mandate, cast your eye toward Jeremy Stein. Mr Stein is a Harvard economist and Fed governor. And since assuming his role at the Fed in 2012, he has led the intellectual charge within the Federal Open Market Committee to place more emphasis on financial stability as a monetary policy goal.


Mr Stein is effectively taking ownership of the Fed’s move toward tapering. Long-term unemployed Americans should address their letters accordingly.

Why not laud the governor for his efforts? Who could be against financial stability, particularly given disastrous recent experience? Well, financial stability is a fine goal, as far as it goes. But Mr Stein’s particular approach to that goal strikes me as deeply flawed and very likely to prove counterproductive.


Let me be clear about what is happening here. Mr Stein assumes that easy policy raises financial vulnerability and that financial vulnerability raises the risk of an unemployment-increasing shock. Once one assumes that, showing that tighter policy might be justified even when unemployment is above desired levels is mathematically trivial. Everything is built on the assumption that easy policy = financial danger. Incredibly significant consequences flow from that assertion. But is it right?


What is most remarkable about all of this is how swiftly and silently the FOMC is moving in Mr Stein’s direction. The governor is drawing some hugely significant conclusions from rather tenuous beginnings, and the FOMC is following his lead with scarcely any public debate—and certainly with a bare minimum of public communication about how this particular view of the nature of financial stability is influencing policy.

Let’s unpack this a bit. First, let me say in Ryan’s defense that his last comments about the move to a third and unstated Fed policy goal of financial stability without any public debate is worrying. The Fed has two legal policy goals – and that’s price stability and maximum employment – full stop. The Fed can’t just add a third goal to its mandate without any public debate and adequate oversight by Congress about how this is being done. Doing so de-legitimizes the Fed and makes it a target of political debate. SO I agree with Ryan on this issue.

And Ryan also makes some good points in his essay about deregulation, inflation and labour’s share of income when he writes:

Is it entirely a coincidence that both public and private borrowing exploded around the time that central banks tamed inflation in the early 1980s? (And if it is, and the financialisation of the economy that grew out of deregulation is instead to blame, then why isn’t that—regulation—the first line of defence against financial excess?) Tight labour markets and higher inflation appear to be associated with a higher labour share of income, and a corresponding squeeze on the returns to capital. 

But, the point missing in Ryan’s piece is the acknowledgment that low rates are no panacea for large increases in debt aggregates that are destabilizing. Ryan makes it seem as if the Fed should keep rates low to compensate for all that ails the economy, without any discussion of the negative side effects that doing so makes. In fact, he dismisses the arguments made by Stein that keeping rates too low for too long is negative for financial stability.

And this is where I have a problem. Conventional macroeconomics completely disregards banking and financial instability in its modelling. And to the degree conventional macroeconomics does introduce financial stability, banks and private debt aggregates into its models, it’s as an addendum, a bolt-on that’s not core to the model.

But the vast majority of money is created by financial institutions in the private sector through the granting of credit. And this credit is converted into government IOUs by dint of the banking system’s legal authority to convert bank IOUs into government IOUs on demand. Bank IOUs are traded between banks as if they are government IOUs, effectively making bank IOUs money in the same way dollar bills are money. That’s why the bank credit creation process is important. And that’s why when banks stop accepting IOUs from other banks because of fear that those IOUs will not be readily converted into government IOUs at par because of default risk, we have to fear the consequences.

Money in your bank account is a BANK IOU, transformed to government one by government’s backstop of regulated banks. A financial panic is really just a mass realization that most of our money is NOT government IOUs but IOUs from institutions that can default. The reason people get liquid in a crisis i.e flee to government securities is because government IOUs are the best IOUs within a sovereign currency area since governments in sovereign areas don’t face solvency risks. The lender of last resort role is really about transforming private IOUs into government IOUs at a price. The question is the price. The Fed and the BoE transformed bank IOUs into government IOUs at a low price against dodgy collateral. That’s not Walter Bagehot in action. It’s a subsidy for imprudent and insolvent lenders at the expense of everyone else.

And this is what easy money is all about. It is about subsidizing risk and leverage. And when you subsidize risk and leverage, you promote more risk and more leverage. That’s why we are where we are. And that’s why more easy money will lead yet again to another crisis.

Moreover, unlike what Ryan says, it’s not just about inflation. The United States had low inflation in the 1950s and 1960s and the debt aggregates in public and private debt were lower than they are today. Certainly deregulation plays a big role in the increase in debt aggregates but I put most of the blame on the subsidization of risk and leverage by the Fed’s asymmetric monetary policy.

The bottom line here is that we are asking too much of monetary policy. We are living in a monetarist world where the government intervenes but only in monetary terms. Whenever there is a problem the Fed will fix it. Inflation too high? No problem – the Fed will rescue us. Unemployment too high? No problem – the Fed will take care of it. Deflation’s a risk, you say? No problem – The Fed will print money and fix that too. It doesn’t matter if interest rate policy is out of bullets. The Fed has plenty of tools in its arsenal. People say we gave up the monetarism experiment under Volcker. I say no, we are still living through monetarism right now. Because it’s all about the Fed. That’s pure monetarism.

It’s not all about the Fed. We have rejected the Keynesian view which advocates fiscal policy dominance and the Austrian view which advocates no intervention. The Fed is the only game in town. And as surely as the sun rises every day, over-reliance on monetary policy will end in over-leverage, excessive risk and bubbles… and eventually financial instability, a crash, recession, lower long-term growth, higher unemployment, and tears.

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