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Fascinating post by Stephen Williams, who is a great monetary economist.  In it, he goes through speeches at the Federal Reserve from September 2007 – a few months into the burgeoning credit crisis.  In it he shows that there was a debate between the views of “inherent instability” and “induced fragility” for what was going on – this sort of trade-off was captured in the Sargent paper (at least in part) that we’ve mentioned before.

Now when I’ve described the crisis to people I’ve stuck to the inherent instability line, the trilogy of articles (*,*,*) I did on Rates Blog was supposed to give that impression to people – with the third article pointing out that moral hazard exists as a more long-term point.  According to this, the Fed and then the ECB didn’t do enough to stop a bank run due to “too much” weight on moral hazard – and this drove a deep crisis.

However, the induced fragility hypothesis is also compelling (note they could both have happened – but where you put the weight determines what policy lessons you learn).  According to this, it wasn’t until the policy actions of late 2007 and then the bail out of Bear Sterns then the moral hazard became compelling.  However, once financial institutions saw they would be bailed out, they immediately took on lots of risk – making the system a lot more fragile when the Fed finally decided not to bail out Lehman Brothers.

There is evidence for this, Lehman Brothers took on a lot of debt – highly risky debt – following the collapse of Bear Sterns.  I remember reading the paper that had this, a paper that actually said it was the bailout of Bear Sterns that made the crisis worse, but I have forgotten where it is … I’ll link when I find it.

If the spectre of moral hazard fed into the fragility of the finanical system that quickly, the justification for bailouts becomes a lot weaker – if we accept significant inherent instability in the financial sector, then regulation with a lender of last resort becomes more acceptable.  Evidence helping to determine what weights to put on these explanations will be very useful for designing regulation (or the lack of) in the post-GFC world.

Induced fragility as a medium term concept is a central part of how most economists see this crisis.  However, it is an open question about whether the bailout of Bear Sterns (and the earlier TAF) created “induced fragility” that made the collapse much worse.  More research on this issue will be pretty interesting, and will help to inform what sort of trade-off we are facing with policy.