Fear of financial instability

The consensus view is that the Great Recession of 2008-09 was caused by financial instability. I believe that view is wrong, and wrote an entire book arguing that it was tight money that caused the Great Recession. A recent Bloomberg article perfectly illustrates why it’s important to understand what went wrong in 2008:

The FSOC on Friday released its first study of the threats introduced by nonbank mortgage firms, which have escaped the strong regulation reserved for traditional banks despite displacing them in the market. In 2022, nonbanks originated about two-thirds of mortgages and serviced most of them.

The sector’s specialized business model makes the firms vulnerable to changes in housing prices, interest rates and delinquency rates, according to the report. Nonbanks rely more than traditional lenders on the value of mortgage servicing rights, and they can have high leverage, short-term funding and operational risks, the FSOC found.

“Put simply, the vulnerabilities of nonbank mortgage companies can amplify shocks in the mortgage market and undermine financial stability, and the council has now laid this out in detail for the first time,” said Treasury Secretary Janet Yellen, who leads the FSOC.

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

1. Monetary policy that causes unstable NGDP growth.

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

Commercial bank failures do have policy implications, as they may require FDIC bailout of depositors.  However, that argument does not apply to the failure of nonbank mortgage firms.  There is no reason for regulators to worry about nonbank failures, as any impact on aggregate demand can and should be offset by adjustments in monetary policy.

This is why it’s so important to have an accurate understanding of what went wrong in 2008.  If policymakers correctly understood the causes of the Great Recession, they would put less focus on trying to prevent bank failures and more emphasis on stabilizing the path of nominal GDP.

PS.  The same is true of the Great Depression.  In the US, the two primary problems were banking regulations that led to too many small and undiversified banks, and monetary policy that caused NGDP to fall nearly in half between 1929 and 1933.  Countries with less restrictive bank regulations and more expansionary monetary policy did considerably better than the US.  This abstract is from a Journal of Economic History paper by Richard Grossman:

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

The Fed was set up to be a “lender of last resort”.  But that didn’t address the underlying weaknesses in the US financial system, which was not a lack of liquidity. As a result, the financial system was even more unstable during the first few decades of the Fed’s existence than it had been in the two decades prior to the creation of the Fed.  

If you do not correctly diagnose a problem, then the solution is likely to be ineffective.

PS.  Some people tell me that surely financial instability must have contributed to what I called the “tight money policy” of 2008.  Consider a truck driver that dozes off and has an accident when the road turns.  In a sense, the bend in the road contributed to the accident.  But the driver dozing off was the far greater problem.

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