The Fed: Firefighter or Arsonist?

The central bank ignores the large role it played in igniting the 2008 financial crisis.

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Steven Horwitz is a Mercatus Center Affiliated Senior Scholar and the Charles A. Dana Professor of Economics and department chair at St. Lawrence University in Canton, NY.

Since the financial meltdown in 2008, the Federal Reserve's range of powers have expanded, as have the kinds of financial institutions it monitors and regulates. Fed Chairman Ben Bernanke is now saying that the Fed's oversight has expanded beyond strictly financial institutions to wide swaths of the economy that might, in his words, provide evidence of "emerging vulnerabilities."

The justification for all of these new powers is that the Fed is best able to prevent a repeat of the 2008 meltdown by keeping in check the potential systemic problems revealed in that crisis. But the notion that the Fed is the firefighter standing by with the hose to douse any reignited embers of 2008 ignores its own role in creating those problems in the first place.

[See a collection of political cartoons on the economy.]

The Fed's own policy choices were central to the housing boom and bust and the associated financial crisis. In trying to soften the possibility of a post-9/11 recession, and then wrongly worrying about deflation, the Fed expanded the money supply, dropping interest rates to unsustainably low levels in the mid-2000s. The nominal Federal Funds rate was well below the benchmark of the widely-recognized Taylor Rule. Worse, the real Federal Funds rate (the nominal rate minus inflation) was actually negative for roughly two years. A negative interest rate means people are essentially being paid to borrow.

This influx of cheap credit from the Fed gave lenders the funds they needed to provide mortgage loans. That credit – combined with the willingness of government-sponsored enterprises like Fannie Mae and Freddie Mac to buy up and securitize those new mortgages without having to face a true profit/loss test in the market – were key causes of the housing boom. Easy credit and low rates fueled housing flippers and speculators like never before.

With housing prices moving ever upward, and the explicit and implicit backing of the Fed and Treasury behind the process generating it, it was no surprise that we saw a dizzying array of new financial instruments and a degree of recklessness that stretched beyond the control of regulators. When housing prices eventually fell, the instruments premised on rising housing prices collapsed as well, endangering institutions across the economy. It is tempting to blame this on greedy financiers, but they were simply responding to the poor incentives created by the Fed, Congress and others.

[Read the U.S. News debate: Has the Federal Reserve Overstepped its Mandate?]

So while the Fed maintains that only it can prevent the serious problems arising from "systemic risk" of the sort we saw in 2008, it continues to ignore its own major role in creating that risk. Absent the cheap credit after 9/11, there would have been no fuel for the fires from which the Fed now claims to be saving us. 

Although putting out fires is certainly a good thing, the Fed's attempt to clothe itself in the glory of saving the day rings false; we should be very cautious of taking fire prevention advice from an arsonist.

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