The financial crisis of 2007 and 2008 was a watershed event for the Federal Reserve and other central banks. The extraordinary actions they took have been described, alternatively, as a natural extension of monetary policy to extreme circumstances, or as a problematic exercise in credit allocation. I have expressed my view elsewhere that much of the Fed's response to the crisis falls in the latter category rather than the former.
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Like the Fed, the European Central Bank and other central banks have pursued credit allocation in response to the crisis.
The impulse to reallocate credit certainly reflects an earnest desire to fix perceived credit market problems that seem within the central bank's power to fix. My sense is that Federal Reserve credit policy was motivated by a sincere belief that central banks have a civic duty to alleviate significant ex post inefficiencies in credit markets. But credit allocation can redirect resources from taxpayers to financial market investors and, over time, can expand moral hazard and distort the allocation of capital. This implies a difficult and contentious cost-benefit calculation. But no matter how the net benefits are assessed, central bank intervention in credit markets will have distributional consequences.
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This tension is a classic time consistency problem. Central bank rescues serve the short-term goal of protecting investors from the pain of unanticipated credit market losses, but dilute market discipline and distort future risk-taking incentives. Over time, small "one-off" interventions set precedents that encourage greater risk taking and increase the odds of future distress. Policymakers then feel boxed in and obligated to intervene in ever larger ways, perpetuating a vicious cycle of government safety net expansion.
The conundrum facing central banks, then, is that the balance sheet independence that proved crucial in the fight to tame inflation is itself a handicap in the pursuit of financial market stability. The latitude the typical central bank has to intervene in credit markets weakens its ability to discourage expectations of future rescues and thereby enhance market discipline.