Economic conditions ; Federal Reserve System

Jeffrey M. Lacker

English

Research Papers in Economics

     
Spring/Summer 2008 • Region Focus 1
JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND
Financial Stability and the Fed
T
his issue of Region Focus
features a special section
that explores the eco-
nomics profession today, its role
in society, and questions about
its future. Such a discussion is
timely, appropriate, and healthy
for a dynamic discipline that’s
been much in the news lately.
Still, the basic lessons of eco-
nomics endure: Markets tend to
organize economic activity effi-
ciently, and government inter-
vention can sometimes have unexpected and undesirable
consequences.
Given the recent events in the economy, and especially in
financial markets, it’s also useful to draw on research and
experience of the last 30 years. While that body of knowl-
edge provides a solid foundation for policy, the wide-ranging
root causes of disruptions can be difficult to determine. 
And when events require swift and direct policy responses
in real time, the job gets even tougher. The Fed’s role as
lender of last resort often faces the institution with difficult
choices when financial disruptions unfold.
In an episode of financial disruption, central bank lend-
ing may prevent a bank run and put off costly closure or
liquidation. (Bank runs occur when depositors fear that a
bank’s assets can’t cover its liabilities, and depositors cash
out en masse.) But if the financial sector is just coping with
deteriorating fundamentals, central bank lending distorts
economic allocations by artificially supporting the prices of
some assets and liabilities of some market participants.
Government support in this latter case can intensify the
“moral hazard” problem inherent in any financial safety net.
Applying this framework to recent policy actions can
help provide some perspective. As the slowdown in housing
markets and the associated decline in home prices began, it
became clear that the securities backed by mortgages 
originated in 2006 and early 2007 would perform signifi-
cantly worse than anticipated. This realization affected the
future prospects of any institution or financial instrument
with mortgage-related exposure. The recent instances of
run-like behavior, such as those that afflicted Bear Stearns in
the week leading up to its acquisition, seemed to reflect
increased concern about the quality of these sorts of 
financial products. In short, it appeared to be what we
would classify as a deterioration in market fundamentals,
not a liquidity crisis. 
Perhaps most important to the current debate is the fact
that market expectations of central bank response in times
of stress can affect the robustness of the system. In the
PRESIDENT’SMESSAGE
short-term, governments and central banks may relieve
financial market strains, but the intervention itself may
affect future choices of financial institutions. These new
expectations could make future crises more likely.
If banks and other financial institutions assume central
bank support in the future, then they are less likely to put in
place the necessary and appropriate safeguards. That 
assistance interferes with market discipline and distorts
market prices. 
If intervention is assumed, then there’s scant incentive
for banks to take costly alternative action to prevent adverse
consequences. But there is an alternative. New research 
by economists at the Richmond and New York Fed banks 
considers a scenario in which there is absolute certainty 
that no government or central bank assistance will be forth-
coming. In such a world, banking contracts would likely
include provisions that allow for suspensions of payment.
These contracts will prevent the type of run that may occur
because of the perceived quality of its assets. This sort of
contract actually has its roots in the 19th century U.S. bank-
ing panics.
The Fed’s lending policy can play a role in the stability of
financial markets. As we learn more about the causes and
nature of financial instability, I believe we should strive 
for policy that is informed by lessons about price stability
learned in the 1980s. That’s when the Fed committed 
itself to a long-term goal of maintaining a low and stable
inflation rate. We will achieve better outcomes if we can
establish credibility for a pattern of behavior consistent
with that objective.
RF_SUM_08  9/11/08  11:46 AM  Page 1
           

President's message : Financial stability and the Fed

http://www.richmondfed.org/publications/research/region_focus/2008/spring/pdf/presidents_message.pdf

President's message : Financial stability and the Fed

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