The Fed and Moral Hazard

I have written on the topic of moral hazard before. It occurs when we adopt a policy to protect us from the consequences of certain behaviors, but the policy encourages the very behavior causing the problems.

It has been noted by others that the central bank, by having a monopoly on issuing money and by serving as the lender of last resort, ostensibly to promote and maintain financial stability, actually promotes less measured and more risky behavior on the part of banks, which causes the very financial instability the Fed was created to remove.

A new paper by Mark A. Carlson and David Wheelock, in a new working paper at the St. Louis Federal Reserve Bank, affirm this conclusion. The abstract is as follows:

As a result of legal restrictions on branch banking, an extensive interbank system developed in the United States during the 19th century to facilitate interregional payments and flows of liquidity and credit. Vast sums moved through the interbank system to meet seasonal and other demands, but the system also transmitted shocks during banking panics. The Federal Reserve was established in 1914 to reduce reliance on the interbank market and correct other defects that caused banking system instability. Drawing on recent theoretical work on interbank networks, we examine how the Fed’s establishment affected the system’s resilience to solvency and liquidity shocks and whether these shocks might have been contagious. We find that the interbank system became more resilient to solvency shocks but less resilient to liquidity shocks as banks sharply reduced their liquidity after the Fed’s founding. The industry’s response illustrates how the introduction of a lender of last resort can alter private behavior in a way that increases the likelihood that the lender will be needed.

That Carlson and Wheelock find that the Fed made the interback system more resilient to solvency shocks should not surprise. A central bank providing reserves to banks in trouble will reduce insolvency problems, almost by nature. What I find most interesting is the evidence that the Fed serving as a last resort did in fact seem to encourage behavior that increased liquidity problems, thereby creating a demand for the Fed's services. In this instance of government granted monopoly privilege, it is almost as if we have a case of the straw man view of Say's Law: the supply of emergency loans create their own demand. You can read the entire paper by Carlson and Wheelock by clicking here.

Recurrences of such financial crises' was the main ostensible reason the Fed was created. I write about the sharp contrast between Federal Reserve rhetoric and the real consequences of the Fed in the book The Fed at One Hundred.