August 24th, 2021

Legitimacy Gap

We live in the age of the central bank. The financial crisis of 2008 and the COVID-19 crash of last year have made visible the central role of the US Federal Reserve and its overseas counterparts in the international financial system, and their dramatic actions earned them applause for avoiding a second and third Great Depression. Rescuing banks and preventing financial collapse are the tasks of central banks, and their success brought relief to the economy. But these actions bore a distributional impact. Most of the financial policies adopted in response to the crisis—quantitative easing, bond purchases, and low interest rates—have protected wealth without creating opportunities to accrue new wealth for those who don’t possess it. As the “K-shaped“ charts of the 2020 recovery made plain, a market rebound did not spell economic wellbeing for ordinary people.

The outsize role of central banks—especially the Fed—in the international financial system has led to some of skepticism about central banks and their independence.

 Full Article

June 2nd, 2021

Risks and Crises

Market makers and risk managers after 2008

In the 1945 film It’s a Wonderful Life, banker protagonist George Bailey (played by Jimmy Stewart) struggles to exchange his well-functioning loans for cash. He lacks convertibility—known as liquidity risk in modern finance—and so cannot pay impatient depositors. Like any traditional financial intermediary, Bailey seeks to transform short-term debts (deposits) into long-term assets (loans). In the eyes of traditional macroeconomics, a run on the bank could be prevented if Bailey had borrowed money from the Fed, and used the bank’s assets as collateral. In the late-nineteenth-century, British journalist Walter Bagehot argued that the Fed acts as a “lender of last resort,” injecting liquidity into the banking system. As long as a bank was perceived solvent, then, its access to the Fed’s credit facilities would be almost guaranteed. In an economy like the one in It's A Wonderful Life, the primary question was whether people could get their money out in the case of a crisis. And for a long time, Bagehot’s rule, “lend freely, against good collateral, but at a high rate,” maintained the Fed’s control over the money market and helped end banking panics and systemic banking crises.

This control evaporated on September 15, 2008, with Lehman Brothers’ collapse. On that day, an enormous spike in interbank lending rates was caused not by a run on a bank, but by the failure of an illiquid securities dealer.

 Full Article