Emergency lending has always been the central bank’s Achilles heel, and it is a power that is most frequently abused.
A specter haunts the Federal Reserve: the specter of financial crisis. Not an actual crisis, but the fear of one.
The recent report to Congress by the Federal Reserve Board of Governors makes this clear. Due to the economic malaise caused by COVID-19, “financial-sector vulnerabilities are expected to be significant in the near term. The strains on household and business balance sheets from the economic and financial shocks since March will likely create persistent fragilities,” the Fed warns.
But the evidence is far from clear that we almost had another financial panic. Yes, there were significant problems in the markets. Though they were liquidity problems, well within the competence of the Fed’s ordinary powers. Instead, the Fed adopted a host of extraordinary powers, each of which sets a worrying precedent. The Fed’s report reads more like an ex post justification for irresponsible overreach than an explanation of macro-economically prudent actions.
Let’s be clear, markets were in rough shape in March and April. It’s true, as the Fed’s report claims, that stock prices and Treasury yields were collapsing. It’s also true that the spread between corporate and government debt yields widened significantly. These are classic signs of a liquidity shortage. While liquidity shortages can morph into full-blown financial crises, they need not do so. Other indicators of financial distress suggest things were not as bad as the Fed claims. The Treasury-Eurodollar (TEDS) spread and the Financial Stress Index were elevated to around 2001 levels, but were not close to 2008 levels. The Fed should have focused on satisfying the market’s demand for liquidity, which would have been enough to save the financial system from insolvency. Instead, it began experimenting with a host of loan programs that, due to their size and scope, come with major long-run risks.
Much of the Fed’s response to COVID-19 was authorized by Congress in the CARES Act. The Fed is a creature of Congress, and we cannot fault the Fed for following Congress’s directives. But we can fault it for the misleading way it frames its diagnosis and treatment. The Fed has started, or will shortly start, making direct loans to large corporations, small- and medium-sized businesses, and state and municipal governments. The Fed is supposed to focus on monetary policy. But these new policies, which directly allocate credit, are fiscal, not monetary. The Fed skirted the fiscal-monetary line in 2008. Now it has brazenly stepped over that line.
There are two big problems with the Fed’s new credit policies. First, there’s no reason to think the Fed is especially competent at making loans. If these loans don’t perform, taxpayers will end up paying for it. Second, Congress now has a much stronger incentive to micromanage the Fed. Because the Fed is engaged in de facto fiscal policy, Congress may try to use the Fed’s balance sheet to achieve political goals. This violates central bank independence, as well as Congress’s responsibility to make fiscal decisions through the deliberative process of budgeting and spending.
The Fed could have fought COVID-19 in a way that respected monetary policy best practices. The Fed was right to expand its balance sheet massively through open-market purchases. If it wasn’t enough to stabilize markets, the Fed could simply have bought more. This is the Fed’s traditional role: getting markets the liquidity they need, but letting markets, not a government agency, allocate that liquidity. Instead, the Fed decided to play at being a retail bank. The various loan programs set a troubling precedent. Markets and government both are worse off as a result.
Emergency lending has always been the Fed’s Achilles heel. Throughout its history, this is the power most frequently abused. Fed officials are prone to elastic interpretations of their mandate. This is why Fed officials are hyper-sensitive about financial crises, as exhibited by their most recent Congressional report. The truth is that they are grasping at whatever explanation can give their actions the pretense of prudence.
Central banks are good at one thing only: providing the market the liquidity it needs, when it needs it. Every time they try to go beyond open market purchases, the result is decreased effectiveness and accountability. Unfortunately, we are watching this process play out once again. Until and unless the Fed stays in its lane, market stabilization and political independence will fall by the wayside.
Alexander William Salter is an economics professor in the Rawls College of Business, the Comparative Economics Research Fellow at TTU’s Free Market Institute, and a senior fellow at the American Institute for Economic Research’s Sound Money Project. Follow him on Twitter @alexwsalter.
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