Restraining the Fed

Gerald O’Driscoll writes:

Mr. Obama’s task is made all the more difficult because there has been a perfect storm of bad policies and practices. Laudable goals, such as fostering more homeownership, went terribly awry. Financial services regulation has failed at its most basic task, protecting the soundness of the system. And a dysfunctional compensation system has given corporate managers incentives to take excessive risks with investors’ money.

None of the policies and practices that are now widely criticized suddenly appeared in the past decade. But they were kindling for a financial firestorm that needed only an accelerant and a spark. Both were provided by a policy of easy money that came in response to the bursting of the dot-com bubble in 2000-01, the ensuing recession, and the Sept. 11 attacks.

At first Fed easing was in order. The central bank needed to counter the “irrational exuberance” of the dot-com bubble. And by May of 2000 the Fed had done that by raising the fed-funds target to 6.5%. That needed to come down when the bubble burst. Aggressive cutting brought it to 2% in November 2001.

The problem is the rate remained at 2% or less for three years (for a year it was at 1%). During most of this period, the real (inflation-adjusted) fed-funds rate was negative. People were being paid to borrow and they responded by often borrowing irresponsibly.


The subprime saga follows a familiar pattern. Easy credit begets a boom and then the inevitable tightening of credit bursts the bubble. What is not familiar is the scale of the devastation wrought in this boom-bust cycle.

Never before had financial markets evolved such a complex superstructure of interlinked securities, derivatives of all kinds, and special-purpose investment vehicles. Professor Gary Gorton of the Yale School of Management has best described that complexity in his paper “The Panic of 2007,” published by the National Bureau of Economic Research. He makes clear that as this system evolved there was not a sufficient guard against systemic risk.


The point is not to deflate asset bubbles, but to avoid them in the first place. Imposing a commodity standard is a practical response to the repeated failures of central banks to maintain sound money and financial stability. What would be impractical is to believe that the next time central banks will get it right on their own.

Read the whole thing.

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