Unintended Consequences

This article by Matthew Klein is a fantastic reminder of why we need to understand incentives when designing public policy (ie. more economists, fewer lawyers).

The article shows how banking reserves dropped precipitously when the Federal Reserve was created because banks believed (incorrectly as it turned out) that the Fed would be there to support them if things went bad.

Banking Reserves

This also fits in with Milton Friedman’s analysis that the Fed was responsible for the Great Depression because they allowed the banks to fail, and Scott Sumner’s analysis that it was the Fed choking off liquidity in 2008 that led to the GFC.

This quote is revealing:

“Christina Romer found (in the late 1990s) that America’s business cycles were about as violent in the post-WWII period as they were in the pre-Fed period — a generous comparison considering the absence of both the Great Depression and the recent downturn from the data.”

If that isn’t a failure of a public institution to do its job, I don’t know what is. Contrast the great depression with the earlier panic of 1907 in which there was no Fed. Instead, JP Morgan came to the rescue of the financial system by promising money would be made available to any bank that was running short of reserves. In very short order the crisis passed. The banking system was much more robust and flexible back then because they didn’t have the automatic back stop of the government, and they were more self-reliant as a result.

As Klein points out, there is plenty of evidence that this is a pervasive problem in well meaning public policy that intends to make us safer, but instead makes us less safe.

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