The financial system is also exposed to such external effects, which we could perhaps call pollution. The external effects can be classified by the resulting symptom; excessive risk or excessive credit. Moral hazard arises when a bank’s owners take a big gamble with creditors’ money. While the owners might earn a huge profit by investing depositors’ savings, depositors will never earn more than the interest on their deposits. As long as the owner takes the upside and the depositor is left with the downside, the bank has an incentive to take greater risk than socially desirable. The distortion is amplified by deposit guarantees or public guarantees. When many banks or big banks play moral hazard, risk in the financial system becomes excessive. 4  Thomas Kuhn uses in his book The Structure of Scientific Revolutions (1962) this statement from Max Plancks Scientific Autobiography and Other Papers (1949). 5  Jorda, Oscar, Moritz Schularick, and Alan M. Taylor, “When Credit Bites Back”, Journal of Money, Credit and Banking, 2013, 45, pp 3–28. BIS central bankers’ speeches  3  Contagion effects between banks can also lead to a vulnerable financial system. Banks lend each other money in interbank markets and can become more closely intertwined than is socially desirable. Losses at one bank can spread through the system, creating a domino effect. The contagion effect can also be indirect. When a bank has to sell assets to redeem debt, the value of equivalent assets of other banks decline, as many experienced during the financial crisis.
This means that across a broad range of scenarios, our large-scale asset purchase program is likely to result in a lower federal debt-to-GDP ratio. To sum up, the better choice is for the Fed to pursue the policy that best achieves its mandated objectives and puts the U.S. government in a better fiscal position. This dominates a policy of fewer purchases simply so we can avoid potentially having to explain why our remittances may have fallen to zero for a short period. Issues associated with the normalization of monetary policy Finally, I’d like to talk about some of the other issues associated with the normalization of monetary policy. In general, I think it is premature to spend much time focusing on exit when we have not yet secured a sustainable economic recovery. That’s putting the cart before the horse in my opinion. That said, we nevertheless do need to understand the issues surrounding exit so that we can design the best monetary policy regime to achieve our objectives. On this topic, let me ease three concerns I hear frequently expressed. The first is that the large amount of excess reserves in the banking system will be “dry tinder” and fuel a rise in inflation. As I have mentioned repeatedly, the ability of the Federal Reserve to pay interest on excess reserves ensures that we can control the credit creation process and prevent an upsurge in inflation.