Responding to Financial Crises: What Role for the Fed‪?‬

The key issue in addressing the topic of what to do in the event of a financial crisis is time inconsistency. It seems to make sense in the middle of a financial crisis for someone to bail out a failing firm or firms. The inconsistency is that, however sensible a bailout seems in the heat of crisis, bailouts rarely make sense as a standard element of policy. The reason is simple: Firms, expecting aid if they end up in trouble, hold too little capital and take too many risks. As every economist understands, a policy of bailing out failing firms will increase the number of financial crises and the number of bailouts. Along the way, the policy also encourages inefficient risk management decisions by firms. In writing the previous paragraph, I at first began by saying, "everyone knows that a policy of bailouts will increase their number." But a cursory examination of federal policy proves that not everyone knows. Federal disaster relief policy is exhibit A, but every company, financial or otherwise, knows that if it gets into trouble it is at least worth a major effort to attempt to secure a bailout because there is always a significant probability of success. Given this state of affairs, in place for many decades despite economists' pleadings, I think the most important issue is not how to respond to financial crises but, rather, how to avoid financial crises in the first place.