In the context of actions taken to support the financial system, the Federal Reserve and other government agencies have provided considerable support to banking organizations and other large systemically important financial institutions. The employees and executives of those institutions have benefitted from our intervention. In a perfect world we would be able to prevent those individuals and institutions from benefitting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone. The Great Depression represents an important example of the consequences of inaction. Recall that during the Great Depression the unemployment rate rose to 24 percent. It is generally accepted that the authorities at that time, by not responding sooner and more forcefully, contributed greatly to the severity and duration of the Great Depression. In contrast, during this crisis, the Fed and other agencies acted much more aggressively to ward off a total collapse of our financial system – liquidity was restored to markets and the banking system was recapitalized much more quickly. These aggressive actions helped to prevent the type of deep and protracted crisis that occurred during the 1930s. Going forward, the Federal Reserve and other regulators need to move aggressively to change the system so we don’t ever find ourselves in this position again.
This again suggests that there is a role for supervision and regulation in the bubble prevention process. For example, it might be appropriate for the Federal Reserve – working with functional regulators such as the SEC (Securities Exchange Commission) – to monitor and limit the buildup in leverage at the major securities firms and the leverage extended from these firms to their clients and counterparties. Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage. 1 Whether it would be more effective to limit leverage directly by regulatory and supervisory means or via monetary policy is still an open question. But it is becoming increasingly clear that a totally hands off approach is problematic. I also believe we could have done better in our supervision of the large complex commercial banking organizations.