The Fed is thus lending to businesses, large and small, to state and local governments, (something utterly unprecedented) and to purchases of asset-backed securities. The terms that are on offer are better than what would be available now on the market, but if conditions improved, the terms would be viewed by most borrowers as penalty rates. That means that, as the economy recovers, these facilities will become unattractive, and borrowing should naturally scale back. These lending-programs are carrying out the Federal reserve's "lender of last resort" role.
As was the case in 2008, this has led to criticism over the Fed having become a handmaiden of fiscal policy, buying up the bonds that the government is issuing, creating money in the process which will ultimately become inflationary. But it should be kept in mind that in spite of large budget deficits and spiraling debt to GDP ratios, we will be dealing with inflation that is too low, not too high, for many years to come. Interest rates are likely to stay low, which will mean that the interest cost of all the debt being issued will not actually prove a severe burden on government finances. That has been true for many years in Japan, where the debt to GDP ratio actually escalated to 250%. That may be a huge concern for Japan and the world, but the burden of it has not been high. Importantly, the Fed has an ability to withstand political pressure from the fiscal authorities, hence the interest rates will reflect what is needed to keep inflation low and stable and the economy operating at its potential.
Financial stability at risk
We are starting to understand the complexity and variety of the Federal Reserve’s reactions. Obviously, the causes of this crisis are different from 2008, but there are nevertheless some common issues. One of them is about financial regulation: there is a strong temptation for supervisors and regulators to loosen the regulation of the financial system right now. Do you believe that this could lead to more fragility of the financial system? We have both a rising stock of debt, a downgrade of the quality of debt, and perhaps a looser regulation. Could that be the recipe for a financial crisis in ten years’ time? What is your assessment on financial stability?
I am indeed concerned about financial stability. Good macroprudential regulation should encourage banks to build larger capital buffers when the economy is expanding, and then allow them to run down those buffers when times become difficult. The Fed is therefore appropriately allowing banks to run down capital and liquidity buffers now. Over the longer term, it will be necessary to insure that banks rebuild their buffers and not to permanently weaken financial regulations.
It is also important to remember that in the aftermath of the 2008 crisis, we did not focus enough on the non-banking financial sector, or the "shadow banking" sector. This crisis led to a meltdown in financial markets and short-term money markets came close to stop functioning, yet we had only limited reforms in the way money market funds work. We saw a financial system that did not react in a resilient way to the stresses, which makes for unfinished business in the current crisis, and reasons to worry about the stability of the financial system.
The road to recovery
You are not very optimistic about the possibility of a V-shaped recovery, and you are thinking that this ordeal might last much longer than many people think. There are two questions linked to that: what is the weakest link in the US economy? Is it on the corporate side or the consumer side ?
With the grim predictions of the Congressional Budget Office, and the potentially long time it will take for a vaccine to be widely available, the best case scenario for recovery would look like a U, instead of a V.
Much of what comes next for the US economy will depend on the public health situation, where we are yet to come up with a coherent national response.