Bonds, Currencies, Stocks

Moral Hazard: The Federal Reserve And Financial Markets

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One of the problems with central banks acting as a lender of last resort is that of moral hazard. With the cost of bailouts spread out across society and benefits concentrated to a few large firms, the temptation to engage in excessively risky behavior is ever-present. Financial firms have become so used to getting their way from the government that they assume the Fed will bail them out of every difficult spot that comes along. The Federal Reserve’s monetary policy of the past eight years has been one huge bailout, funneling trillions of dollars of easy money to Wall Street, boosting stock prices, and creating bubbles throughout the economy. This loose monetary policy has led to such malinvestment that the economy will definitely fall into a recession or depression once the Fed takes away the punch bowl. Stock markets realize that the economy’s fundamentals are unsound, that firms are reliant on cheap central bank money for their continued performance, so the specter of Federal Reserve rate hikes and monetary policy normalization is leading to panic.

In the days before the creation of the Federal Reserve System, banks still had to deal with the problem of a lender of last resort. If a bank was solvent (its assets were greater than its liabilities) but was temporarily illiquid (didn’t have cash on hand or assets that could be readily liquidated to get cash) what would happen? What if this temporary liquidity problem were only for one day and the bank had payments coming due the next day that would it enable to pay back what it owed? It didn’t make sense to force a bank into bankruptcy just because it was temporarily unable to pay its transfers to other banks, so banks formed clearinghouse associations to remedy those situations. Banks would pay a certain portion of their reserves to the clearinghouse, normally housed at a large bank, to be drawn on in case of a temporary liquidity problem. If a bank found itself at the end of the day unable to pay checks drawn on its accounts, it could borrow money overnight from the clearinghouse, paying it back the next day with interest once it had money again.

Naturally these clearinghouses, like any form of insurance, could lead to moral hazard. Because the risks were being being dispersed over the membership of the clearinghouse, an individual bank might be tempted to play a little fast and loose, dipping into clearinghouse funds on a regular basis in order to balance its accounts. The solution to this was to charge banks rates that were high enough to discourage regular resorting to the clearinghouse, encouraging banks to use them only as a last resort. But banks don’t like paying market interest rates, so they lobby for government-sponsored or controlled central banks. A clearinghouse can only lend if its members agree to set aside reserves, and it can’t lend any more than those reserves. Central banks have no such limitations as the money they create and lend to banks literally comes from nowhere. It can lend to its heart’s content and at rates far lower than clearinghouses, with their market-based rates, would charge.

This ability to act as a unlimited lender of last resort has been used often, but never before to the extent that it was during the financial crisis. While the past century saw unprecedented interventions by central banks, recent central bank actions such as quantitative easing and negative interest rates would make the creators of the Federal Reserve System blanch with fright. The fact that markets panic at the thought of the Fed shutting off its pipeline of easy money should give warning that the US economy is fundamentally unsound. Moral hazard is endemic to Wall Street today and the expectation of bailouts continues to pervade the thinking of financial markets. Too many people when talking about “Too Big to Fail” focus on the “Too Big” and not the “To Fail.” Despite rhetoric that “Too Big To Fail” is over, when the rubber meets the road the Fed will undoubtedly step in to prevent a large bank from failing and taking down the financial system. The only way to end “Too Big To Fail” is to end the institution that incentivizes excessive risk-taking, enables banks to grow impossibly large, and keeps those big banks from failing: the Federal Reserve System.


Courtesy of the Carl Menger Center for the Study of Money and Banking

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