In this presentation, Stephen Bond dives into the role of the Federal Reserve and Central Bank played a role in the 2008 crisis, and what the long term effects of that involvement have been. He discussed primarily how there was a system that incentivized home ownership and was somewhat backed by the US government in the form of Fanny May, and Freddy Mac. However, as I was reflecting on the content of his presentation, I began to think about the founding and purpose of the Fed. If we have a good idea of what the original purpose of the Fed was, I think it makes it easier to see when they are out of line, or if they have taken on more power than they were supposed to have. So after looking at some of the history and intent of the fed, I want to review how the clash between Keynesian economics and Hayekian economics played out in the 2008 crisis. Specifically, I think the best way to look at this problem is to focus on mal-investment.
History of the Fed
To begin with lets frame the history of the USA central bank, called the Federal Reserve, which was founded in 1913 after a series of financial crises. Many people were worried about the potential for fiat money to become worthless, after there was a number bank failures. So the government created the central bank in an attempt to stabilize any swings in the economy. In theory the main job of the fed is to manage the nations money and to keep it safe. Hypothetically, this is accomplished in several ways. When there is too rapid of growth or inflation, the Fed may raise rates. Next when it is slowing down they can cut rates to encourage spending. Next the Fed can serve as a lender of last resort to banks that are unable to meet liquidity needs. Finally the Fed is supposed to monitor the health of the economy and serve as a watchdog for the entire financial system. Now that we have established what the fed was originally supposed to do, we can compare it to the powers it took on in the crisis of 2008.
Intent vs Reality
Much of the theories of the fed are based on Keynesian economics. Much of the policies are founded upon the belief that the economy needs to be guided and controlled by a central planning body. However, 2008 was just another example of this being an unsuccessful theory. As I was listening to the presentation and how it emphasized the excessive lending of these government agencies in the housing market. Basically they were lending at rates and to people that normally would not be sustained by the overall market. In essence they were clearly mal-investment. Because of the failings of the rating agencies this led to many of these bad mortgage to be used as collateral for loans. So as he spoke about, once they became worthless, there was now a liquidity crunch for many banks. This whole situation led to the fed becoming a lender of last resort and expanding its balance sheet massively to purchase these distressed assets. *This was not the original intent of the Fed, but has become almost commonplace in the modern world of finance. It also opened the door to the fed being able to have a say in many of these companies, as well as controlling the entirely of the yield curve through measures like quantitative easing. Overall this is clearly a departure from the original intent of the agency.*
Warnings for the Future
When looking back at the whole financial crisis, its easy to point fingers and see where things went wrong. However, I think that one of the best takeaways that I got from this class is that although the crisis is over, much of the “emergency powers” that were given to the fed still remain. The next crisis or crash will not be the exact same one, but I think its important that when another crash happens we are watching to see what the Fed does, and what powers it takes on. Although it has much power to change the short term future of the economy, it seems that the Hayekian economics seems to prevail. The bill always comes due. When the government favors certain types of investments such as housing in a way that the normal market wouldn’t support, it only leads to money flowing into bad investments. Not only does this lead to more damage down the road, but ultimately results in a power grab from the government bodies that claim they can prevent all downturns in the future. I think that it is important to keep an open eye to where the government is pushing mal-investment, and watch out for the Hayekian economical reaction that follows.
