I’ve been reading through the recently released transcripts of the Federal Reserve meetings during the financial crisis and there are many noteworthy features which seem relevant for students of the crisis and modern monetary policy.
First, not surprisingly, there is a lot of confusion in most of these meetings. This is to be expected given the volume of data that the board was receiving, the noise in the data and the sometimes conflicting nature of the statistics. I think it’s virtually impossible for economists today to look back and give a fair assessment of the Fed’s interpretation of the data at the time. We have the burden of hindsight and the luxury of being able to casually contemplate possible courses of action – neither of which were available to the Fed in 2008. I know that Matthew Yglesias, Brad DeLong and Paul Krugman have weighed-in on some of the policy makers but I don’t really think this is fair. If I think a coin flip is going to turn up heads and you think it’s tails, it is not really fair to say “well it turned out to be heads so you were a fool and I was a hero.”
Second, I am struck by the amount of detailed discussion of the architecture of the financial system in the transcripts. I’m sure many of you are thinking “duh — what else do you think the Fed discusses at its meetings?” Well, I agree, but the contrast with academic treatments of monetary policy is stark. As I wrote in a previous post, in my assessment, many macroeconomic researchers have been far too concerned with the details of price rigidity and far too indifferent about the details of financial arrangements. It seems that these details were occupying center stage during the financial crisis and we had better start to get a better picture of how these arrangements interact with monetary policy actions if we hope to respond appropriately to the next crisis.*
Third, as many commentators have pointed out, there were people who were concerned about inflation. This seems odd given what we know followed (and odd given that a bit more inflation would be welcome news today) but, at least to a small extent, it was part of the data at the time. Some commodity prices, and oil in particular, were both rising which seemed odd given what policy makers were hearing from lenders. Jim Bullard has an interesting recent presentation on this in which it seems like he is arguing that oil supply shocks may have shaped the Fed’s assessment of the problem that summer.
Finally, the Fed was clearly viewing the crisis both as a liquidity crisis and as a solvency crisis. At the time, many market observers felt that the crisis was primarily one of solvency. Problems in the loan markets were seen by many as being tied to counterparty risk (“I won’t lend to you because I don’t trust that you will be able to pay me back). This view led many to advocate for the realignment of the TARP funds toward equity injections rather than asset purchases. While I am sure that solvency played a large role in the crisis, I am also convinced that liquidity problems were a big part of the story (I won’t lend to you because I don’t trust the collateral you are offering me). On this dimension the Fed was perhaps ahead of the curve both in its understanding of the problems and in efforts to address the situation. The many liquidity facilities put in place, in particular the TSLF which traded Treasuries for non-standard collateral (“other stuff” in the words of one of the governors), were key to stabilizing many of the markets at the time.
* One detail of which I wasn’t aware deals with the resolutions of Repo contracts in the event of a bankruptcy for a financial institution. Most Repo contracts are exempt from automatic stay in bankruptcy proceedings. That is, if I borrow from you with a Repo, you would own the collateral in the event that I go bankrupt. This is one of the features that makes Repo contracts so attractive. For other collateralized loans, you might think that your loan is secured by specific collateral, but, if I go bankrupt, you won’t be able to get access to the collateral until the bankruptcy proceedings have been completed (or worse – you might find out during the proceedings that someone else has a claim to the same assets which supersedes your own). However, this exemption from automatic stay does not necessarily apply if the borrower is a brokerage firm. When a brokerage firm fails, it will likely fall under the Securities Investor Protection Act (SIPA) which does not make exemptions for Repos in automatic stay. When Lehman was failing, the Fed was concerned that many of the Repos would be tied up by SIPA which could cause the problem to spread to any institution that had Repo contracts with Lehman. (See here for details, in particular footnotes 5 and 29.)