Fear of financial instability – Econlib

The consensus is that the Great Recession of 2008-2009 was caused by financial instability. I believe that view is wrong, and wrote one whole book arguing that it was tight money that caused the Great Recession. A recent one Bloomberg article perfectly illustrates why it is important to understand what went wrong in 2008:

The FSOC on Friday published its first investigation into the threats introduced by non-bank mortgage companies, which have escaped the strict regulation reserved for traditional banks despite crowding them out in the market. In 2022, non-banks originated about two-thirds of mortgages and serviced most of them.

The sector’s specialized business model makes the companies vulnerable to changes in house prices, interest rates and payment delays, the report said. Non-banks rely more than traditional lenders on the value of mortgage rights, and may have high debt, short-term financing and operational risks, the FSOC notes.

“Simply put, the vulnerabilities of non-bank mortgage companies can amplify mortgage market shocks and undermine financial stability, and the council has now detailed this for the first time,” said Treasury Secretary Janet Yellen, who leads the FSOC.

Not surprisingly, this view has led to calls for greater federal involvement in the mortgage lending market, which would further exacerbate the mortgage underwriting problem. moral hazard. Previous attempts to make our financial system more stable have failed because the underlying problems are misdiagnosed. Financial instability has two main causes:

1. Monetary policy causing unstable NGDP growth.

2. Federal regulations that increase moral hazard by insuring depositors and labeling some banks as “too big to fail.”

Bankruptcies of commercial banks have policy implications as they may require a bailout of depositors by the FDIC. However, this argument does not apply to the failure of non-bank mortgage companies. There is no reason for regulators to worry about non-bank failures, as any impact on aggregate demand can and should be offset by adjustments in monetary policy.

That’s why it’s so important to accurately understand what went wrong in 2008. If policymakers properly understood the causes of the Great Recession, they would place less emphasis on preventing bank failures and more emphasis on stabilizing the path of nominal GDP. .

P.S. The same goes for the Great Depression. In the US, the two main problems were banking regulations that led to too many small and undiversified banks, and monetary policies that nearly halved the NGDP between 1929 and 1933. Countries with less restrictive banking regulations and more expansionary monetary policies did this significantly. better than the US. This summary comes from a Journal of Economic History article by Richard Grossman:

This article attempts to explain the exceptional stability exhibited by the banking systems of Britain, Canada, and ten other countries during the Great Depression. It examines three possible explanations for stability – the structure of the commercial banking system, macroeconomic policies and performance, and lender of last resort behavior – using data from 25 countries in Europe and North America . The results suggest that macroeconomic policies – especially exchange rate policies – and banking structure, but not lenders of last resort, were systematically responsible for banking system stability.

The Fed was founded as a ‘lender of last resort’. But that didn’t address the underlying weaknesses of the U.S. financial system, which wasn’t the lack of liquidity. As a result, the financial system was even more unstable during the early decades of the Fed’s existence than it had been in the twenty years prior to the Fed’s creation.

If you don’t diagnose a problem correctly, the solution is likely to be ineffective.

P.S. Some people tell me that financial instability must have contributed to what I called the “tight money policies” of 2008. Think of a truck driver who falls asleep and has an accident when the road makes a bend. In a way, the bend in the road contributed to the accident. But the driver falling asleep was the much bigger problem.