The Federal Reserve’s policy-making committee squeezed the trigger this month and raised its target for the Federal Funds rate, the interest rate banks charge one another for overnight loans of reserves, by a quarter of 1 percent. December 2015 marks the eighth anniversary of this target languishing at 0.25 percent.
Most people do not appreciate how extraordinary this era has been. In the history of central banking, no other major nation has pushed short-term interest rates so low for so long.
The economy is not as vibrant as it was in the late 1990s, but it may well be that this is the best it’s going to get for some years, especially given the situation around the globe.
I’ll predict that this month’s Fed meeting will go down in economic history as a turning point, when, for better or worse, the central bank turned away from the extraordinary and sometimes panicked responses it made to the financial debacle that began to unfold in August 2007 and returned to a monetary policy regime like the one that had prevailed for the previous 30 years.
As a Fed district president who served more than 24 years in Minnesota, Gary Stern helped preside over seemingly golden years of U.S. monetary policy, with low inflation, good growth and relatively low unemployment.
Known as moderate to hawkish in terms of inflation, Stern gained a reputation for occasional dissent in favor of slower money growth, but never disagreed so predictably that his nay vote was automatically discounted. Where Stern became outspoken was the “too big to fail” issue.
Too big to fail was the idea that some banks or other financial institutions are so large and entwined in an economy that, if they collapse financially, it would throw the nation’s economy into recession or worse. Hence, when one of these institutions teeters on the edge of bankruptcy, regulators should step in and act to prevent liquidation of the business. This may involve using FDIC or Fed funds to cover some losses. The stockholders can be wiped out and perhaps top management axed. But creditors owed money should be made whole.
This was the rationale for a FDIC-Fed bailout of Continental Illinois Bank in 1984 and of the Long-Term Capital Management hedge fund in 1998. Stern argued long and hard that such bailouts created “moral hazard,” the perverse incentives for large institutions to take on excess risk, because their trading counterparts know they won’t suffer loss if the risk-bearing firm goes bust. Bailouts breed more bailouts. But Stern’s crusade was a futile one.
In 2007-2009, the Fed and the Bush administration took “TBTF” to the nth power. Yet while the economy was pulled back from the abyss of a catastrophic depression, we still went through a harsh recession.
Using easy money and low interest rates to get the economy out of this recession and back to normal levels of employment and output became Narayana Kocherlakota’s crusade after succeeding Stern in 2009. Though he had been an external adviser to the Minneapolis Fed, he was an academic and Fed outsider.
Now for five years, Kocherlakota has been an articulate and outspoken advocate of even looser money. His fellow policymakers have rejected this, but his advocacy probably was one factor among many in the long delay in raising rates. Ultimately, like Stern, his historical identification will be that of a voice crying in the wilderness.
Enter Neel Kashkari, who is succeeding Kocherlakota. Though he has a Wharton master’s degree in business administration in addition to his bachelor’s and master’s degrees in engineering, he is not an economist. Nor is he a Fed veteran. His claim to fame is that he was a rising, but still very junior, star at Goldman Sachs when its departing CEO, Henry Paulson, became Bush’s Treasury secretary and pulled Kashkari along to serve in the administration.
This was a good move. Kashkari, as Paulson’s bright “go-to guy,” managed the politically fraught TARP bailout with great skill.
The new Minneapolis president does not have the macroeconomic or monetary policy chops of his two predecessors. But he does know bailouts, and he knows it is imperative that a nation not get itself into situations in which a bailout is the least bad alternative to economic collapse.
History may look back at this appointment as a case of “cometh the hour, cometh the man.” We have weathered the financial crisis that began in 2007 and, however painfully, the recession that ensued.
So despite pious promises from presidential candidates eschewing all future bailouts, we are even more vulnerable to a financial crisis than we were in 2007. We are not that far from the rim of the abyss on which we teetered just seven years ago. Few if any politicians talk about this call for breaking up the big firms. One notable exception is Bernie Sanders, for whom reducing the power of Wall Street is a major component of his agenda.
Let’s hope Kashkari gets TBTF back on the policy table. As with his predecessors, he may face a futile quest. But he is a driven, energetic guy, and let’s hope he gives structural reform a try.