The Regulatory Confidence Cycle

Late last month, the Federal Reserve released the transcripts of meetings held by the policy-setting Federal Open Markets Committee in 2008, during the run-up to the financial crisis. Unfortunately, many of those reading the transcripts appear to be missing the big picture.

CAMBRIDGE – Late last month, the Federal Reserve released the transcripts of the Federal Open Markets Committee (the Fed’s monetary-policy-setting body) meetings from the run-up to the 2008 financial crisis. Unfortunately, too many reports on the transcripts miss the big picture. Criticizing the Fed for underestimating the dangers from the underground rumblings that were about to explode makes it seem that particular players just got it wrong. In fact, underestimating financial risk is a general problem – the rule, not the exception.

Even after the investment bank Bear Stearns failed in March 2008, Fed leaders believed that the institutional structure was strong enough to prevent a crisis. New York Federal Reserve President Timothy Geithner thought that banks had enough capital to withstand the potential losses. Likewise, Fed Vice Chair Donald Kohn told the US Senate that losses in the mortgage market would not threaten banking viability. Tellingly, academic opinion was similar. Too big to fail was no longer a big problem, a prominent view had it, as the banking laws of the previous decade had laid it to rest.

Even if some leaders failed to foresee the power of the coming explosion, they managed the aftermath as well as one could expect. Indeed, the transcripts themselves show that Fed leaders were worried about an economic downturn and were ready to employ their macroeconomic tools, but that they thought the banking system was well capitalized and could withstand more stress. And optimistic public statements – for example, by Vice Chair Donald Kohn – were often accompanied by worries that were expressed privately.

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