May 20, 2013

The Federal Reserve Ignores Its Own Role in the Financial Crisis

Steven Horwitz

Senior Affiliated Scholar
Summary

Since the financial meltdown in 2008, the Federal Reserve's range of powers have expanded, as have the kinds of financial institutions it monitors and regulates. Fed Chairman Ben Bernanke is now saying that the Fed's oversight has expanded beyond strictly financial institutions to wide swaths of the economy that might, in his words, provide evidence of "emerging vulnerabilities."

Since the financial meltdown in 2008, the Federal Reserve's range of powers have expanded, as have the kinds of financial institutions it monitors and regulates. Fed Chairman Ben Bernanke is now saying that the Fed's oversight has expanded beyond strictly financial institutions to wide swaths of the economy that might, in his words, provide evidence of "emerging vulnerabilities."

The justification for all of these new powers is that the Fed is best able to prevent a repeat of the 2008 meltdown by keeping in check the potential systemic problems revealed in that crisis. But the notion that the Fed is the firefighter standing by with the hose to douse any reignited embers of 2008 ignores its own role in creating those problems in the first place.

The Fed's own policy choices were central to the housing boom and bust and the associated financial crisis. In trying to soften the possibility of a post-9/11 recession, and then wrongly worrying about deflation, the Fed expanded the money supply, dropping interest rates to unsustainably low levels in the mid-2000s. The nominal Federal Funds rate was well below the benchmark of the widely-recognized Taylor Rule. Worse, the real Federal Funds rate (the nominal rate minus inflation) was actually negative for roughly two years. A negative interest rate means people are essentially being paid to borrow.

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