Question

Explain why quantitative easing to stabilize the US economy was considered a moral hazard (i.e., why will QE paid in 2008 will cause future banks to behave badly).

Answer 1

The experience of the financial crisis of 2008 and the role of the central bank in reviving the economy and preventing it from going deep down the recessionary phase by initiating quantitative easing (QE) by purchasing mortgage-backed securities (MBS)—decidedly not government security suggest that central bank intervene in such dire situation and take unusual steps and prevent the financial system from collapsing. The U.S. Federal Reserve Bank also did not stop with one round of quantitative easing. When $2.1 trillion worth of MBS purchases failed to keep asset prices aloft, QE2 was rolled out in November of 2010. And in December 2012, the Fed debuted QE3. To put all of this into perspective, in 2007, prior to the crisis, the Federal Reserve system held approximately $750 billion worth of Treasury securities on its balance sheet. As of October 2017, that number had swelled to nearly $2.5 trillion. Moreover, the Fed still maintains over $1.7 trillion of mortgage securities on its books, where previously, it held effectively zero.

If market participants know that the central bank can, and indeed will, step in to prop up asset markets in times of crisis, it can present a great moral hazard. Later referred to as the “Greenspan/Bernanke put,” investors and financial institutions alike began to rely on central bank interventions as the single stabilizing force in many markets. The rationale is that even if economic fundamentals pointed to a slow recovery and persistently low inflation for the real economy, a rational actor would still eagerly purchase assets knowing that they should get in before the central bank operates to bid prices progressively higher. The result can be excessive risk-taking fueled by the assumption that the central bank will do everything in its power to step in and prevent a collapse in prices.

The irony is that markets will begin to respond positively to negative economic data because if the economy remains subdued, the market is given to understand from the experience of the financial crisis of 2008 that the central bank will turn on the QE.

This is why QE paid in 2008 will cause future banks to behave badly