Welcome to “Where is the General Theory of the 21st Century”, an interview series that explore the evolution of the post-Great Recession Macroeconomics.
We are honored to have Jeremy Stein, the Moise Y. Safra Professor of Economics at Harvard University and former member of the Board of Governors of the Federal Reserve, to explain his recent research “The Federal Reserve’s Balance Sheet as a Financial-Stability Tool” (coauthored with Robin Greenwood and Samuel Hanson).
This paper put forth the most widely-accepted argument for the Fed to maintain a sizeable balance sheet going forward. As Prof. Stein explains below, financial market stability could be at risk if too much of the supply of safe assets is from private sector providers. They argue that the financial system would be safer if the government can provide more short-term safe securities to satisfy investors’ demand and crowd-out private sector issuances.
Why do they think it the Fed who issues more reserves for investors? Why can’t Treasury take up the responsibility? More importantly, does it actually mean that the Fed’s balance sheet has to be “sizeable” forever? Prof. Stein will tell us more about all these in the interview below.
Q: EconReporter S: Jeremy Stein
| The transcript is edited for clarity. All mistakes are ours. |
In your paper “Using the Federal Reserve Balance Sheet as a Financial Stability tool,” the main argument is that more government provided short-term financial assets available in the financial market, it would make the financial market safer. Why do you think that private sector supplied money-like instruments are potential threats to the financial market?
S: What we saw in the run-up, and the subsequent unwind, of the financial crisis is that one of the problems was that financial firms had issued a lot of very short-term debt. Some were insured, but a lot were uninsured. When their solvency started to be under question, there were effectively run-like phenomena, both on some of the standard intermediaries, and a lot in the so-called shadow banking system.
For example, one of the early manifestation of the crisis was a very rapid shrinkage of the asset-backed commercial paper market. These were vehicles that have issued short-term commercial paper backed by the mortgages and other assets. That essentially is a form of short-term funding.
Our argument is that these kinds of things are encouraged by the fact that there is not that much government paper. As a result, these sorts of short-term claims are very highly-valued in the marketplace, which is another way of saying they have relatively low interest rates. So, private sector players are tempted to issue a lot of them.
What we found is that when there are more securities like treasury bills outstanding, there tend to be less private sector securities like commercial papers, and so forth. So the basic idea is that if the government makes more, it will crowds out the private sector to some extent, and that has a useful financial stability function.