Yellen vs. the Fed critics

By Douglas Holtz-Eakin
November 13, 2013

The confirmation hearing of Federal Reserve Chairwoman nominee Janet Yellen on Thursday will be an opportune moment for Fed critics to air their grievances.  There is plenty of fodder for disagreement and debate — ranging from the Fed’s supervisory track record, to the rules for tapering large-scale asset purchases, to the criteria for ending its zero-interest rate stance.

Yet, one sure criticism is sharply at odds with the facts: That the Fed’s crisis response was an insider affair, run by and for a handful of too-big-to-fail banks.

While the Fed’s actions in response to the 2008 financial crisis are certainly open to criticism, the creation and expansion of various credit and lending programs were aimed at calming the financial markets and maintaining the liquidity of specific financial instruments. It was not about befriending winners and giving the cold shoulder to losers.

The exception that proves the rule was the Fed’s early institution-by-institution firefighting; for example, addressing the problems of Maiden Lane I-III, Bear Stearns and American International Group. In each of these cases, the Fed provided support to individual firms in order to avoid a disorderly collapse. However, as a financial “disturbance in the force” started to move through the system — slowly at first, and then rapidly — the Fed attempted to provide liquidity with the hope of containing the disruption.

The Fed was practicing an amped-up version of its lender of last resort role by “lending freely, against good collateral,” as prescribed by Walter Bagehot’s famous 1873 dictum.

When the Fed acts as the lender of last resort, it is providing temporary liquidity support to healthy, solvent institutions — not rescuing insolvent companies from failure. The support is intended to help sound, strong banks overcome periods in which they do not have enough cash on hand to meet short-term obligations.

Banks can experience these occasional episodes of illiquidity, particularly during periods of financial instability. Discount window lending, directly from the Fed, and other temporary programs to provide funding to financial institutions, are important aspects of central banking and help promote overall financial stability. Keeping solvent institutions insulated breeds confidence and supports economic activity.

In the modern financial system, satisfying liquidity needs is easier said than done. Complicated counterparty relationships between institutions, new financial instruments and the rise of the shadow banking system all add up to a less straightforward application of traditional policy tools than in Bagehot’s time.

As documented in an analysis earlier this year by the American Action Forum’s Satya Thallam, the credit and lending streams created had low barriers to entry — in an attempt to encourage wide participation among financial institutions. For example, the discount window, a source of overnight funding, was altered in several ways to encourage use: reduction of the discount rate; extension of maturities, and use of auctions to reduce the stigma that somehow the financial institution using it, was not solvent.

The Term Auction Facility, one of the earliest of the crisis response tools, dating back to December 2007 and organized under the Federal Reserve Act’s Section 10B authority, was a means of providing one-month to three-month loans — but without the stigmatizing effect of the discount window. In the end, more than 400 institutions participated in this.

Other efforts were aimed at supporting various submarkets or feeding demand for particular liquidity needs: repos, to address lending between financial institutions; central bank currency reserves, to address the dollar funding market overseas; the commercial paper market, to ensure short-term financing for financial institutions; money markets, to address mutual funds; asset-backed securities (including mortgage-backed securities) and Treasuries of assorted maturities.

Confirmation hearings provide a useful, if often theatrical, opportunity for policymakers and the public to openly debate important policy issues. Stress tests, new capital rules, strenuous supervision and “living wills” — management plans to deal with an insolvent bank — are among the Fed’s efforts to stick with its preferred approach and avoid the impact on incentives experienced by Bear Stearns or AIG-style interventions. Ultimately, firms cannot operate on the assumption that Fed interventions are commonplace.

Rather than re-litigating the exceptions, senators would be better served by a focusing on the use of those tools.

The Federal Reserve undertook a major program of providing liquidity during the 2008 financial crisis. Despite the program’s scope and novelty, the facilities used were really an extension of traditional tools that central banks have used to keep markets functioning. The deviations from that lender of last resort role, though conspicuous, were not the focus of the Fed.

Yes, the Fed helped big banks. But its efforts were broader and fairer than that narrative suggests.


PHOTO (TOP): Janet Yellen, vice chairwomen of the Board of Governors of the U.S. Federal Reserve System, is due to have her confirmation hearing to be board chairwoman on Thursday. She is shown here at the University of California, Berkeley in Berkeley, California, November 13, 2012. Y REUTERS/Robert Galbraith

PHOTO (INSERT): President Barack Obama (C) announces his nomination of Janet Yellen (L) to head the Federal Reserve at the White House in Washington October 9, 2013. Also pictured is current Fed Chairman Ben Bernanke (R). REUTERS/Jonathan Ernst


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