Speech

The Fed’s Role in Maintaining Financial Stability UniversityofCentralArkansas Conway,Arkansas April24,2003 I’m delighted to be here to speak at the theoperationofthefinancialsystem.Iaskthis University of Central Arkansas. I’m gradu- basicquestion:Whatsortsoffinancialinstability ally making way around the state to the arethedirectresponsibilityoftheFederalReserve various campuses; perhaps over the next Systemandwhatsortsaretheresponsibilityof few years I’ll manage to speak at all the other othersorsimplyaconsequenceofthebehavior ArkansascampusesI’venotyetvisited.Ihopeso. ofhighlycompetitivemarkets?Inparticular,itis Ihavealong-standinginterestinunderstand- amistaketoassumethateveryfinancialproblem inghowandwhyfinancialmarketssometimes isevidenceofapolicyfailure,orrequiresapolicy becomedysfunctional.WhenIfirststartedstudy- response. ingeconomics,inthelate1950s,thesubject Beforeproceeding,Iwanttoemphasizethat seemedtobeaspecialtopicineconomichistory. theviewsIexpressherearemineanddonot Andthatremainedmyviewthroughgraduate necessarilyreflectofficialpositionsoftheFederal school.AboutthetimeIbeganmyfirstuniversity ReserveSystem.Ithankmycolleaguesatthe appointment,in1963,financialmarketsbeganto FederalReserveBankofSt.Louisfortheirassisbecomelessstable.Theissuesintheearly1960s, tanceandcomments,especiallyAltonGilbert, forthemostpart,centeredonthegoldstandard DavidWheelock,MarkVaughan,andBill andinstabilitiesintheBrettonWoodssystemof Emmons.Iretainfullresponsibilityforerrors. fixedexchangerates.Butbeforetoomanymore yearshadpassed,boutsofinstabilitybeganto appearinthedomesticfinancialmarkets. FEDERAL RESERVE Occasionalepisodesoffinancialinstability RESPONSIBILITIES seemnowtobethenorm,andindeedinrecent yearsoperationofournation’sfinancialsystem TheFederalReservehasthreemainresponhasbeensubjecttosubstantialshocks.Apartial sibilities.Oneistocontributetomaximumsuslistwouldincludethesuddenstockmarketcrash tainableeconomicgrowthbymaintaininglow of1987andtheslow-motioncrashstartingin andstableinflation,orpricestabilityforshort. early2000.Thelistwouldalsoincludethefinan- Thesecondisregulationandsupervisionofbanks cialmarketdisruptioninthefallof1998,after andtheirholdingcompaniestocontributetosta- RussiadefaultedonitsbondobligationsandLong- bilityofthebankingsystem.Thethirdisprovision TermCapitalManagementexperiencedsevere ofpaymentsservicesincludingdistributionof pressuresthatbroughtthefirmtothebrinkof currency,clearingofpaperchecks,andelectronic disorderlycollapse.Andwhocanforgetthesevere paymentsservices.Successinthesethreeareas stressinthepaymentssysteminthehoursand contributesto,butdoesnotguarantee,stability daysfollowingthe9/11terroristattacksinNew ofoutputandemployment.Successcertainly YorkandWashington? doesnotguaranteestabilityofpricesinfinancial Mypurposethiseveningistoaddresstherole markets,aswehaveseenfromtheperformance oftheFederalReserveinmaintainingstabilityin ofthestockmarketinrecentyears.Despitethis 1

FINANCIALMARKETS fact,itisalsotruethatFedfailuretoachieveits ofdepositorsranontheirbankstowithdrawcurgoalshasahighprobabilityofdestabilizingprices rency.Overtimebanksdevelopedwelldefined infinancialmarkets. mechanismsfordealingwithsuchbankruns whileavoidingdisruptioninthepaymentssystem. Thesemechanisms,whichwerecoordinatedby SELECTIVE HISTORY OF theclearinghousesthroughwhichbankscleared checks,includedlendingcurrencytosomeof FINANCIAL PROBLEMS thebanksundergreatestpressurefromdepositor ThebestwayIcancommunicatewhatit runsandissuingtemporarycertificatesthatmemmeanstopreservefinancialstabilityistodescribe bersoftheclearinghousescoulduseforsettlement eventsduringseveralperiodsinournation’shis- amongthemselves. torywhenthenationwasnotabletomaintain Duringsomeoftheseperiodsofbankruns, financialstability.Ifsomeoftheseexamplesseem bankswereabletomeetthedemandsoftheir oldandoutofdate,thatisbecausewemustuse depositorsforcurrency,thusavoidingdisruptions suchexamplestoexploretheimportanceofprice inthepaymentssystem.Duringotherperiods, stabilitygiventhatthenationhasenjoyedlowand however,theseprivateremediesforbankruns stableinflationformostofthelast20years. werenoteffectiveinpreservingtheoperationof Ibeginwiththefallof1907,thelastepisode thepaymentssystem.During1873and1893, ofamajorbreakdowninournation’sbanking membersoftheclearinghouseinNewYorkCity systempriortotheformationoftheFederal respondedtorunsbytemporarilyrefusingtopay Reserve.Bankingproblemsinthefallof1907 currencytotheirdepositorsondemand. wereacatalystforstimulatingchangeintherole Theseperiodsofsuspensionofcurrencypayofourgovernmentintheoperationofthenational mentsinvolvedmajordisruptionsinthepayments financialsystem.TheUnitedStatesdidnothave systemofthenationbecauseatthetimemuch acentralbankatthattime—theFederalReserve commerceinvolvedpaymentwithcurrency.Itis beganoperationsin1914—anddidnothavefed- importanttorealize,however,thatdisruptionin eraldepositinsurance,whichwasestablishedin thefinancialsystemwouldhavebeenworsein the1930s.Withnofederaldepositinsurance, 1873and1893ifbankshadnotsuspendedcurthewillingnessofpeopletoholdbankdeposits rencypaymentstodepositors.Runsonbankscredependedontheirconfidenceinthestrengthof atedakindofimplosionofthebankingsystem, thebanks. asbanksattemptedtoquicklyselltheirassetsto NewYorkCitywasthenation’sfinancial obtainthecurrencydemandedbytheirdepositors. center,asitremainstothisday.Themostimpor- Suspensionofcurrencypaymentsstoppedthe tantstockexchangeinthenationwaslocatedin implosionofthebankingsystem.Eventhough NewYorkCity,andtheuninterruptedoperation bankswereabletoresumecurrencypayments ofthestockexchangedependedonshort-term todepositorswithinaboutamonthofthesusloanstostockbrokersbybankslocatedinNew pensionsin1873and1893,theseperiodsofsus- YorkCity.Businesseslocatedthroughoutthe pensionofcurrencypaymentscreatedmajor nationsettledtransactionsamongthemselves disruptionsineconomicactivityintheUnited withdraftsdrawnuponbankslocatedinNew States. YorkCity.Disruptionstotheoperationofthe Nowconsidertheexperienceof1907.EconbanksinNewYorkCitycreateddisruptionsin omicactivitypeakedinMay1907.Inthefall, thenation’spaymentssystem. eventsuniqueto1907ledtoarunonamajor Priorto1907,therehadbeenaseriesof trustcompanyinNewYorkCitythatwasnota episodesinwhichadversedevelopmentsunder- memberoftheclearinghouse.Membersofthe minedtheconfidenceofthepublicinthefinancial clearinghousedecidedtowithholdaidfromthe strengthofbanks.Atthesetimes,largenumbers trustcompany.Thatdecisionappearstohavebeen 2

TheFed’sRoleinMaintainingFinancialStability anunwiseone,asfailureofthetrustcompany debtincreasedinrealterms.Forexample,ahousetriggeredrunsonmembersoftheclearinghouse. holdthathadtakenoutamortgageinthe1920s Whentheprivateremedieswerenoteffectivefor mightbeunabletomakethemortgagepayments copingwiththedepositorruns,membersofthe aswagesfell,evenassumingthatthehomeowner clearinghousedecidedtosuspendcurrencypay- remainedemployed.Ofcourse,manybecame mentstotheirdepositors. unemployed.Eventuallymanybusinessesand Asin1873and1893,thesuspensionofcur- householdsdefaultedontheirdebtobligations, rencypaymentsinthefallof1907stoppedfurther underminingthesolvencyoftheircreditorsand reductionsinbankassets,butatthecostofamajor theconfidenceofdepositorsinthefinancial disruptioninthepaymentssystemthataggravated strengthoftheirbanks. theeconomicrecessionthathadstartedinMay TheU.S.bankingsystemexperiencedaseries 1907.Thisepisodeandmanyothersdemonstrate ofdepositorrunsduringtheearly1930s.The clearlytheconnectionbetweenbankingstability FederalReservefailedtooffsetthereservesthat andstabilityofoutputandemployment. bankslostthroughcurrencywithdrawalsbytheir Thepoliticalbacklashfromthe1907bank- depositors.Banksnolongeremployedtheirpreingpaniceventuallyledtotheformationofthe Fedprivateremediesforruns,becausethey FederalReserveSystemin1914.Thefoundersof expectedtheFederalReservetodealwithruns. theFederalReservebelievedthatanimportant Thiswasaperiodofpolicydrift;neitherthe functionofthenewcentralbankwastoprovide FederalReservenorthebanksthemselvesacted currencytobankstomeettemporaryincreases tohalttheimplosionofthebankingsystem. incurrencydemandbybankcustomers.TheFed Pressureonthebanksbecamesogreatthatin providedassistancebymakingloanstomember March1933,shortlyafterhisinauguration, banksthroughtheFed’sdiscountwindow. PresidentRooseveltdeclaredabankingholiday TheUnitedStatesexperiencedseveralminor fortheentirenation.Everybankinthenation recessionsinthe1920s,butnogeneralizedfinan- wasclosedforatleastafewdays.Government cialproblems.ItappearedthattheFederalReserve authoritiespermittedbankstoresumeoperations wasworkingasintended.Butthen,inOctober astheycertifiedthebankstobeinsoundfinancial 1929,thestockmarketcrashed.Thecrashwasa condition.Customersofthousandsofbanksthat majorshocktotheU.S.financialsystem,butitdid didnotresumeoperationhadtheirbankdeposits notitselfnecessarilyleadtotheGreatDepression. frozenuntilthefailedbankswereliquidated. OneviewoftheonsetoftheGreatDepression ThedisruptionintheoperationofthepayassignsmuchoftheblametotheFederalReserve mentssysteminMarch1933wasgreaterthan System,whichfailedinitsmandatetomaintain duringtheearlierperiodsofsuspensionofcurpricestabilityandasoundbankingsystem.The rencypayments.Duringtheperiodsofsuspension FederalReservepermittedthemoneysupplyto ofcurrencypayments,bankshadremainedin fallsharplyduringtheearly1930s,leadingto operationandprocessedpaymentsinitiatedby sharplyfallingpricesofgoods,services,and theirdepositorsintheformofchecks.Inshort, wages.Theconsumerpriceindexdeclinedabout in1933,theFederalReservepresidedoverthe 25percentbetween1929and1933.Thisexperi- largestbankingcrisisinthehistoryoftheUnited encewithdeflation,aswelltheJapaneseexperi- States.Thenation’sresponsewastoestablisha enceinthe1990s,demonstratesconclusively systemoffederaldepositinsurance,tomake thatamajordeflationisextremelydamagingto bankingpanicslesslikelyinthefuture. bankingstabilityandeconomicactivity. The1930sillustratethedamagethatdeflation Businessesandhouseholdsthathadborrowed cancreateinaneconomy;the1970s,theperiod fundsinthe1920spriortotheonsetofdeflation oftheGreatInflation,illustratesthedamageof in1930didnothavesufficientcashflowtomeet highinflation.Theinflationbegantotakerootin theirdebtobligations.Aspricesandwagesfell, 1965,slowlyatfirst.Then,theentiredecadeof 3

FINANCIALMARKETS the1970swasaperiodofrelativelyhighU.S. TheepisodesoftheGreatDepressionandthe inflation.Thelowestyear-over-yearpercentage endoftheGreatInflationshowclearlythedamage changeintheconsumerpriceindexwas3.3per- fromanunexpecteddeclineintherateofinflacentin1972,andeventhatperformancewasan tion.Inthefirstcase,inflationwentfromabout artificialresultofwage-pricecontrolsthatcould zerotoroughly–10percentperyear;inthesecnotbesustainedinthelongrun.Theinflationrate ondcase,inflationwentfromroughly10percent roseeveryyearfrom1976,whentheinflation toroughly4percentperyear.Inflationitself ratewas5.8percent,to1980,whentheinflation causesmanydifficulties;thelessonistoavoid ratewas13.5percent. inflationinthefirstplace,toavoidboththeprob- Risinginflationduringthe1970shadadverse lemsfrominflationandfromitsending. effectsonthefinancialsystemforseveralreasons. Therelativelylargegapbetweenlong-term Whereasdeflationintheearly1930sdamaged interestratesandtheinflationrateduringmuch borrowersbyincreasingtherealvalueofdebt, ofthe1980smaybeinterpretedasanindicator oftheinflationaryexpectationsofinvestors.Along inflationinthe1970sdamagedlendersbydecreasperiodofrelativelylowinflationwasnecessary ingtherealvalueofdebt.Loansnegotiatedwhile toconvinceinvestorsthattheeconomywouldnot inflationwasrelativelylowinthe1950sandearly repeattheinflationaryexperienceofthe1970s. 1960swererepaidindollarswithlowerpur- Whileexperienceofthe1930sillustratesthe chasingpower,thusunderminingthefinancial adverseeffectsofdeflationontheoperationof strengthoflenders. ournation’sfinancialsystem,theexperienceof Afterapersistentriseintheinflationratefor the1970sand1980sillustratesthedamagethat severalyears,businessesandhouseholdsbegan canresultfromapersistentriseintherateofinflatoborrowonthebasisofexpectationsthathigh tionfollowedbyanabruptslowingofinflation. inflationrateswouldcontinueindefinitely.Inter- Savingsandloansassociations(S&Ls)were estratesthatborrowerswouldhaveconsidered especiallyvulnerabletorisingandthenfalling extremelyhighafewyearsearlierappearedmore inflationinthe1970sand1980s.Forseveral acceptableinlightoftheirexpectationofcontindecades,theseorganizationshadremainedprofuedhighinflation. itablewhileassumingagreatdealofinterestrate Therateofinflationdeclinedsharplyduring risk.TheriskarosewhenS&Lsattractedfunds theearly1980safteranaggressivetighteningof intheformofshort-termdepositsprovidedby monetarypolicyinlate1979.Theconsumerprice householdsandlentfundsintheformoflongindex,whichrose13.5percentin1980,increased term,fixed-rateresidentialmortgages.TheS&Ls only3.2percentin1982.Thisabruptslowingof werevulnerabletosharpincreasesinmarket inflationputfinancialpressureonthebusinesses interestrates;asratesroseduringthe1970s,S&Ls andhouseholdsthathadborrowedatrelatively hadtoincreasedepositratesbutwerestuckwith highinterestratesinanticipationofcontinuing thelowerratesonlong-termmortgagesissuedin highinflation.Ofcourse,somebusinessesand earlieryears.Bythetimethegovernmentgot householdscouldrefinancetheirdebtasinterest aroundtodealingwiththeproblemofthebankratesdeclinedduringthe1980s,butnotallcould ruptS&Ls,thecosttothetaxpayerswasabout becausetheywerelockedintolong-termobliga- $150billion. tions.Perhapsreflectingexpectationsthatinflation WhiletheproblemsoftheS&Lscreateda wouldriseonceagain,long-terminterestrates messforthegovernmenttoresolve,itdidnot declinedmuchmoreslowlythandidtherateof causeabreakdownintheoperationofthepayinflation.Theinterestrateon10-yearTreasury mentssystem,becausethepubliccontinuedto securitiespeakedat15.3percentinSeptember havefaithinfederaldepositinsurance.Wemust 1981andremainedabove10percentuntil gobackto1933tofindanexampleofabreakdown November1985. intheoperationofournation’spaymentsystem. 4

TheFed’sRoleinMaintainingFinancialStability AlthoughtheFederalReservedidnotregulate andnewtechnologies.TheFed’sresponsibility theS&Ls,lessonsfromthatunhappyexperience istomaintainasteadygeneralpriceleveland werenotlostonbankingregulatorsandCongress. nottotakeapositionontheappropriatenessof Congressactedtostrengthenregulationofdeposi- individualprices.Wehaveampleevidencethat toryinstitutionsintheFederalDepositInsurance stockpricescanfluctuatesubstantiallyeven CorporationImprovementActof1991. whilethegenerallevelofgoodspricesisstable. Avoidinginflationarydisturbancestoeconomic activityandtofinancialmarketsisamajor SCORE CARD ON CONDITIONS achievementofthelast20yearsorso. FOR FINANCIAL STABILITY AsI’venoted,theU.S.economyinrecent yearshasexperiencedfinancialshocksthathad IstheFedachievingitsobjectivesofmoderthepotentialtobecomemuchmoreserious.I’ve ateinflationandfinancialstrengthforthe emphasizedthattheFedplaysacriticalrolein nation’sbankingindustry?Since1992,theyearmaintainingfinancialstabilitythroughitspolicies over-yearpercentagechangeintheconsumer topromotepricestability.Thebaselinecondition priceindexhasbeenwithinarangebetween1.5 ofpricestabilitymakesitmuchmorelikelythat percentand3.5percent.Excludingthevolatile marketresponsestoshockswillnotcumulateto foodandenergycomponentoftheCPI,therange largerandmoregeneralproblems. hasbeenbetween2.1and3.3percent.Thispat- Thereisanotherpartofthestory,though,that ternofinflationratesdoesnothavethekindsof Ihavenotemphasizedsofar.ThatpartistheFed’s adverseimpactsonthestabilityofthefinancial roleinrespondingtoanyparticularshockinwhatsystemthatweobservedinmanyearlieryears. everwayisappropriatetodealwiththeshock.For Inaddition,variousmeasuresindicatethat example,thecollapseoftheTwinTowerson9/11 thebankingindustryisinrelativelystrongfinanledtotheunavoidableclosureoftheNewYork cialcondition.Iwillciteonemeasure,theratio StockExchangeandthegovernmentsecurities ofequitytototalassetsforallbanks.Thisratio, markets.Thephysicalclearingprocessforpaywhichwas6.4percentin1990,was8.5percent mentswasdamaged,whichmeantthatbanksand in1998,andhasrisenfurtherto9.2percentin firmswithbillscomingduecouldnotinfactmake 2002.Thestrengthofthebankingsystemwasan thepayments,eventhoughtheyhadamplefunds. importantsourceofstabilityinthefallof1998, Forexample,howdoIgethomefromtheairport afterRussiadefaultedonitsbonds.Thatstrength ifI’mrelyingontheATMtogetcashtopaythe hasalsobeenimportantinlimitingtheextentof taxidriver,andfindthattheATMisbroken?The therecessionof2001andhelpingtosustainthe fundsareinmyaccount,butIcan’tgettothem. economyinthefaceofthelargedeclineinthe equitymarkets. Becausethepaymentssystemforlargedollar Finally,duringrecentyearstheFederal electronictransferswasbrokenon9/11,those Reservehasimplementedapolicyofensuring relyingonreceivingfundstomaketheirownpaythatdefaultbyoneormorebanksthatareinvolved mentscouldnotobtainthefundstheywereowed. intheoperationofsystemsforsettlementoffinan- TheFedlentmassiveamountsoffundssothese cialtransactionswouldnotdisruptthesettlement paymentscouldbemade.TheFed’sactionswere oftransactionsbythesesystems.TheFedacted tunedtotherealitiesoftheparticularproblem. vigorouslytomaintainoperationofthepayments So,theFed’sresponsibilityistwo-fold:First, systemfollowingtheterroristattacksof9/11,and tomaintainthesolidbaseofpricestabilityand, hassincestrengtheneditsprocessesfurther. second,torespondasneededtooffsettheeffects Inanentrepreneurial,marketeconomybusi- ofshockswhentheyoccur.TheFedhasnoway nessesandhouseholdsareguidedbypricesignals topreventallshocks,butitcanlimitthecollateral andexpectationsofprofitsfromnewmarkets damagethatwouldotherwiseflowfromthem. 5

FINANCIALMARKETS ThenationisfortunatethattheFederal Reserveisgenerallyeffectiveinminimizing collateraldamagefromunpredictableshocks. Minimizing,though,isnotthesamethingas eliminating.Animportantitemofunfinished businessistoexaminechangesingovernment policyandmarketpracticethatmightreducethe likelihoodandseverityofshocksinthefirstplace. Butthatisthesubjectofanotherlectureanother day.Indeed,thesubjectissolargethatitdeserves severallecturesonseveraldays. 6