calvin mccarter

Nathan Tankus recently wrote about the quandary faced by central banks and regulators. The essential problem is that when the government saves the financial system with a bailout, it sets a bad precedent. After the crisis, financial actors will be incentivized to engage in risky behavior, believing that a future bailout is likely. So, once the crisis is over, legislators often attempt to reduce this moral hazard by restricting the central bank from repeating its past actions in future crises. But these limitations can make it more difficult for central banks to contain future crises.

This is a really tricky problem, but we can find inspiration from outside the realm of finance. In particular, it's interesting to look at situations where people did bad things in the past that need to be deterred in the future, but punishing those people would have too much collateral damage, and it's not even clear where to draw the line about who and what to punish because “Moloch does it.” One example is how China addressed the Cultural Revolution after it was over. To enable economic growth, it needed to be clear that another Cultural Revolution would never be allowed to happen again. But sending this message by litigating responsibility would cause too much turmoil that would also detract from rebuilding the economy, and so it was necessary to basically forgive those responsible and memory-hole the whole episode. The solution in China's case was a pseudo regime change: bringing a Party victim of the Cultural Revolution, Deng Xiaoping, into power and allowing him to wholly restructure economic policy.

Analogously, one might argue that the Fed should do what is necessary to ensure financial stability now — even if it sets bad precedent. But then, in the aftermath, instead of adding new limitations to Fed powers that are both of doubtful credibility (and thus still pose moral hazard) and also possibly overly restrictive during an actual emergency, one should instead create a new institution NotTheFed. Because NotTheFed is not the Fed, the bad precedents of the Fed no longer pose moral hazard, and NotTheFed can credibly pinky-promise to not follow Fed-set precedents. Meanwhile, because NotTheFed is a clean-slate institution, it will not be hamstrung by pesky 13(3) rules during the next crisis. In other words, this pseudo regime change in the regulatory system reduces moral hazard in the boom part of the cycle, while giving NotTheFed more flexibility during the next financial bust.

Of course, the problem with this scheme is that once NotTheFed sets bad precedent, you'll need to dismantle it and repeat the cycle with NotNotTheFed, which (logicians tell us) equals The Fed.