While interventions by the US Federal Reserve provide much-needed liquidity support during times of crisis, which help asset prices recover more quickly, avoid deflation and softening the economic fallout, these could cause problems in the longer run, warns Professor Raghuram Rajan of the University of Chicago Booth School of Business.
Speaking at the joint dinner for the Asian Bureau of Finance and Economic Research (ABFER) and the 12th Asian Monetary Policy Forum (AMPF) on May 22, Rajan cited a 2023 paper by Ferguson, et al., which found that such interventions, while effective in the short term, may create a higher probability of further crises happening in the next 20 years. The more accommodative the stance of the central bank, there is a higher probability of a financial crisis taking place next, he adds.
As it is, the system has become “really dependent” on the US central bank to be the saviour instead of it serving as a last resort.
While asking if this is the kind of system the system wants, Rajan adds that the status quo is still okay until it “blows up”.
For instance, should the government tell the Fed to stop intervening for some reason, the implosion will be “much more severe”.
“We're reliant on the system never being tested, never been stopped in its continuous sort of greater and greater intervention,” he says.
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For instance, Rajan recalls the collapse of Silicon Valley Bank (SVB) in March 2023, where the US government conducted a series of measures to stabilise the banking system, noting that the government rolled out measures they’d taken in 2008 and 2000 “plus some more”.
During the SVB crisis, many people dismissed it as a small footnote in banking history, which Rajan disagrees with, considering that the amount of bank assets that failed in March 2023 was the largest in US history.
At the time of its collapse, SVB was the 16th largest bank in the US by total assets with a focus on serving the tech industry and venture capital firms. Apart from SVB, the US saw a total of 22 bank runs happening at the same time. What made the crisis “relatively small” was when the US Treasury opened its book and started backing the uninsured depositors and when the Fed came in with a “bunch of facilities” which expanded liquidity once again, Rajan adds.
“Once again, it was the system being rescued which kept it to be a relatively small crisis. It was not that the underlying crisis was small,” he says.
Despite already high levels of central bank reserves in the system, liquidity shortages have still taken place, including in September 2019, March 2020 during the onset of the Covid-19 pandemic, and again, during the SVB crisis in March 2023. Rajan explains that while the Fed injects liquidity, the private sector simultaneously issues more liabilities. “Put differently, the private sector is leading up liquidity at a faster pace or [at an] even faster pace than the Fed is producing that liquidity.”
“At the end of it, there isn't that much spare liquidity left. So when the Fed starts tightening again, it starts backing up at a much higher level of liquidity than in the past, because the private sector has been using it up,” he adds.
Yet, this dynamic arises due to the cost of holding idle reserves. “Because sitting on unused liquidity is very costly. If I have to hold a reserve, I’m not earning on a lot on it,” says Rajan. As a result, the private sector has taken to issuing trades against the reserve because the sector is willing to pay.
Over time, this pattern of excess credit in the system will lead to worse downturns, according to a 2013 paper by Jorda, Schularick and Taylor, which studied the effects of excess credit in 154 business cycles in 14 countries. The study found that the more credit expands, the more severe the consequences during a downturn.
To mitigate these risks, Rajan suggests central banks should not rely on just interest rate policy, but make greater use of other tools such as macro prudential tools to address financial stability. However, even with such tools, it should not be a given that central banks will step in during future crises, especially when the political establishment turns against them.
“We haven’t seen that happening in developed countries so far, but I would put it beyond the realm of possibility that someday people will say, oh, your central bank liquidity intervention is just to bail out the big hedge funds, and you don't want that,” he says.
