Question

1. Provide one argument in favor of and one against the idea that the Fed was responsible for the housing price bubble of the mid-2000s.

2. What role did the shadow banking system play in the 2007–2009 financial crisis?

Answer 1

1. The Fed's mistake of slowing the growth of money at the onset of the Great Depression is well known. And the Fed intervened from the mid-1960s through the 1970s with unilateral go-stop shifts in money growth that led to regular recessions, high unemployment, low economic growth and high inflation. By comparison, the Fed ran a more stable, rules-based approach with a simple price-stability target through most of the 1980s and '90s and through the past decade. This ultimately resulted in lower unemployment, lower interest rates, longer expansions and stronger growth.

Unfortunately, the Fed has returned to its erratic, unilateral ways, and the results are not pleasant. It kept interest rates too low for too long beginning in 2003-05, and thus promoted excessive risk-taking and the housing boom. This then overshot the interest rate rises that were expected, which intensified the bust. Now, with inflation creeping up and the economy picking up, the Fed is moving to "too weak for too long" territory once again. Policy measures indicate that higher interest rates are required, while the Fed is signaling a zero rate through 2014.

2. In the recent financial crisis the shadow banking system (or non-bank financial system) played a vital role. Shadow banks are financial institutions borrowing on a short-term basis and investing on a long-term basis but, unlike conventional banks, they are beyond the control of traditional banking rules and do not have access to a last-resort lender or federal deposit insurance. Owing to its strategic advantages over the conventional banking system, the shadow banking system expanded considerably in the run up to the 2008 financial crisis.

The shock triggered by the collapse of the housing bubble and subprime crisis has created a run on the shadow banking system without the conventional security networks in place to secure the traditional banking system. It helped spark a credit crunch and encouraged the Government to curb it fear from an emergency response.

Shadow banks (or non-banks) are financial institutions that borrow on a short-term basis and lend on a long-term basis, but are not subject to conventional banking legislation and have no access to last-resort lenders or federal deposit insurance. Shadow banks include mutual funds on the money market, investment banks, commercial paper backed up by reserves (ABCP), and repurchase (repo) agreements.

In the financial crisis the shadow banking system played a crucial role. Shadow banking came under the purview of less government controls and protections than conventional banking. This has made shadow banking extremely fragile. Lower regulation also meant that it had a competitive advantage over conventional banks, which allowed it to grow in size and even overtake the traditional banking sector for some time. However, the recent financial crisis showed how vulnerable shadow banking was to a liquidity shock and forced a major government response.