Three Antidotes to the Brexit Crisis
Britain’s vote to leave the European Union has put a lot of stress on global financial markets: Even as I write, investors’ flight to safety has pushed the yield on U.S. Treasury bonds down to levels that I would have deemed inconceivable just six months ago. In my view, the risk that financial turmoil will damage the economy is at its highest point since the twin European and U.S. debt crises of 2011.
Financial stability is often said to be the U.S. Federal Reserve’s third mandate, along with price stability and maximum employment. If Fed wants to play this role effectively, it will have to act quickly. I see three measures that it can take.
First, the Fed should ensure that banks have enough loss-absorbing equity capital to weather whatever crises may come. To that end, it should not allow them to return equity to shareholders in the form of dividends and stock buybacks. There’s little economic cost to deferring payments to shareholders by six, 12 or even 24 months -- and the added equity will put them in a much better position to keep lending in difficult times. The measure should apply to all banks, so markets won’t read it as a signal about individual institutions’ relative strength.
Second, there’s a risk that investors’ flight to safe assets could develop into a broader credit freeze. To mitigate this, the Fed should lower its short-term interest-rate target -- a move that, by lowering the returns on safe assets, would make lending to businesses and consumers relatively more attractive. Even lowering just the bottom end of the target range for the Fed funds rate would be a good step.
Finally, the Fed should consider reviving the Term Auction Facility, which allows banks to borrow funds from the central bank with less of the stigma associated with other emergency lending programs, such as the Fed’s discount window. The facility proved effective during the 2008 financial crisis, but was terminated in 2010.
Granted, there is a risk that such steps will spook markets by signaling that the Fed is concerned about the state of the U.S. financial system. That said, as an outsider who gets much of his information from Twitter, I’d say the markets are already pretty spooked. By demonstrating that it’s paying attention to these obvious signals, the Fed can help to bolster confidence in its economic management.
One important lesson of the last financial crisis is that the guarantors of stability must be proactive if they want to be effective. It’s time for the Fed to put that lesson into practice.
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