Robert Hetzel on Fed policy and moral hazard

The Mercatus Center has just published an excellent paper by Robert Hetzel entitled COVID-19 and the Fed’s Credit Policy. Here’s the abstract:

In March 2020, with the realization of the enormity of the threat posed by the COVID- 19 virus, financial markets exhibited unusual volatility. According to the Federal Reserve’s narrative, financial markets became dysfunctional; that narrative implies the belief that market participants could no longer assess risk appropriately. However, nothing in market volatility implies that private markets can no longer assess risk or allocate credit; nevertheless, the Fed responded with numerous programs to intervene in private credit markets. This paper examines the causes of the financial market volatility, discusses the moral hazard entailed by intervening in private credit markets, and explores whether credit market interventions could undermine the Fed’s political independence. The Fed promoted its 13(3) programs as providing resources to sectors of the economy where markets have failed to do so, but the Fed’s credit programs can only allocate credit, not increase real resources. It was monetary policy actions that calmed financial markets, not the announcement of future credit market interventions. Involvement in credit policy drags the Fed into the political arena; therefore, to maintain independence, the Fed should return to the sole job of monetary policy.

The paper is full of examples of how the Fed has increased moral hazard by bailing out financial sectors that get into trouble:

The Wall Street Journal quoted Aaron Klein, a former Obama administration Treasury official, who pointed out that “there was widespread agreement following the [2008] financial crisis that money-market funds would bear losses in the future, and post-crisis regulatory changes were meant to impress upon investors the risks they were taking” (Davidson and Michaels 2020). Klein added that “the Exchange Stabilization Fund was created to stabilize the value of the dollar, not to be used for domestic purposes.”

That didn’t last long:

To again bail out the prime money market funds, the Fed announced the Commercial Paper Funding Facility (CPFF) and the Money Market Mutual Fund Liquidity Facility (MMLF). In a Wall Street Journal article, Jonah Crane, a Treasury Department official in the Obama administration, said, “It is déjà vu. At this point, investors in money funds can just assume that the Fed is going to backstop them” (Kiernan, Ackerman, and Michaels 2020). Sheila Bair, former head of the FDIC, said, “It’s just frustrating that we never really fixed this stuff. . . . The industry lobbyists came in and persuaded regulators to do half measures. And we’re back in the soup again.”7

There are many similar examples, involving REITs and other risky investments.

Unfortunately, the economics profession seems to be increasingly dismissive of the problems created by moral hazard. My response is that economists may not care about moral hazard, but moral hazard cares about the economy.

Off topic: Craig Fratrik directed me to some interesting comments on NGDP targeting by Claudia Sahm (in a recent interview of David Beckworth):

Sahm: I think it has a lot of potential-

Beckworth: Oh, I agree with you. Absolutely.

Sahm: On that point. I will say as a little Fed factoid, I mean you were really close to getting-

Beckworth: Oh really?

Sahm: …nominal GDP targeting in the real world and I think it was in 2011 when the European crisis was brewing up and the Federal Reserve, I have the utmost respect for them in that they’re never out of ammo. Whenever their toolkit was kind of like, “Oh, we’ve tried this, we’ve tried that,” Ben Bernanke would send out a blue sky email and be like, “Okay, what’s next?” I can remember a senior officer who wasn’t supposed to tell us this but it was like a readout on an FOMC meeting, said basically if Europe had really struggled, the nominal GDP targeting was next.

Beckworth: Wow.



8 Responses to “Robert Hetzel on Fed policy and moral hazard”

  1. Gravatar of Nathan Nathan
    30. July 2020 at 23:26

    OT: Scott, if you are curios as to why the prime lfpr has fallen in the U.S over the last two decades, but risen everywhere else, this article explains why. It also goes into why investment has been low, the labor share of income has fallen among other things.

  2. Gravatar of Ray Lopez Ray Lopez
    31. July 2020 at 03:32

    Moral hazard says our Man in Havana. Well, the Greeks had modest deposit insurance of about 50k on all bank accounts, and when the 2008 crisis struck, they retroactively upped the limit to well over 100k. So no matter what governments say, it’s what they do that matters.

    I’m really surprised Sumner has not taken credit for the Fed stopping the stock market collapse in March. Shocking. It’s almost like he’s being stubborn because I’m calling for it. Not that I believe the Fed really did anything (money is always and everywhere neutral); Robinhood day traders had more impact than the Fed.

  3. Gravatar of Michael Rulle Michael Rulle
    31. July 2020 at 06:04

    Confusion is one of my strong points.

    Whatever happened to “whatever it takes”? Including the threat of even buying S&P? The Fed has not even whispered about Level targeting NGDP. I assume, but don’t know, that level targeting NGDP will require a pretty high target at some point to get back to 4%. Our current declining GDP is clearly unprecedented in its structure.

    It is the non public sector of our economy which has suffered the most——while public companies outperform relative to a “normal” massive decline in GDP——it’s as if we have two distinct economies. But how many trillions more can we use to “fill the spending and income gap” before the whole thing snaps like a stretched rubber band?

    I also wonder how many deaths have been saved——or delayed—— as the case may be? We will never know of course but I really do believe it is very few. But 1968-69, 1957, even 1918, looks better than this—economically of course.

    I also wonder how realistic a real functioning vaccine being ready by mid Fall is. But, as it stands now, at least we will have Biden.

  4. Gravatar of Garrett Garrett
    31. July 2020 at 07:23

    That Sahm quote supports the idea you explored in your Econlog post about second-best policies that they have the opportunity cost of rejecting first-best policies.

  5. Gravatar of ssumner ssumner
    31. July 2020 at 08:37

    Nathan, The article said:

    “There are millions of businesses in the U.S, most of which are small. Many of these business would if given the opportunity, borrow funds at low interest rates and use them to invest. The problem is that banks are unwilling to do so.”

    I’m skeptical, The moral hazard problems suggests that banks make too many business loans.

    Garrett, That’s right–I missed that.

  6. Gravatar of Nathan Nathan
    31. July 2020 at 10:00

    Scott, thanks for responding. But I’d ask you to read the entire article, including the material linked to at the bottom of the article.
    The only incentive I can give you is the following question:
    How many types of empression are there, one or two?

  7. Gravatar of anon anon
    31. July 2020 at 13:59

    Ray: “money is always and everywhere neutral”

    Why bother anymore? Anyone who follows the blog knows that you are intellectually bankrupt. First you say money is neutral, then you say it’s neutral because a Bernanke paper shows that it’s not neutral, then you say it’s mostly neutral but has some real effect which you dismiss as unimportant, now you’ve come full circle to say it’s “always” neutral. But no more cite to Bernanke!

  8. Gravatar of ssumner ssumner
    31. July 2020 at 20:06

    anon, He also thinks the virus was created in a lab.

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