The Federal Reserve's bailouts of the financial system in 2007-09 did not help contain the crisis, but instead exacerbated it, Federal Reserve Bank of Richmond President Jeffrey Lacker said Tuesday in a speech delivered at his Lancaster alma mater, Franklin & Marshall College.
In particular, Lacker said, the Fed should not have reduced its discount rate in August 2007, a move taken in response to disruptions in the asset-backed commercial paper market.
"It seems plausible to me that the signal sent by the Fed's lending actions in August 2007 dampened the willingness of troubled institutions such as Bear Stearns and Lehman Brothers, to seek safer solutions to the strains they were facing," he said.
Because institutions expected government support, they didn't act to secure themselves from risk, he said.
"I believe that a more measured response by the Fed in August 2007 could have resulted in significantly less instability in 2008, although I recognize that I say this with the benefit of hindsight," he said.
The New York Times has described Lacker, a 1977 F&M grad, as "the Federal Reserve's most persistent internal critic," casting the sole dissenting vote at all eight Federal Open Market Committee meeting's in 2011. A large crowd consisting mostly of students attended his talk at F&M, sponsored by the economics department.
Lacker contrasted two "broad alternative views" that informed economic policymakers' thinking as the financial crisis unfolded. One considers financial markets fundamentally unstable, thus requiring government regulation and intervention. An alternative view, he suggested, is that private financial arrangements can be robust, and it is expectations of government support that lead to fragility.
"In the absence of that expectation, there would be stronger incentives to seek more robust arrangements," he said.
He praised the Dodd-Frank law's "living will" provision requiring large financial institutions to plan ahead for orderly wind-downs in case of insolvency. Doing so "can bolster policymakers' commitment to refrain from fragility-inducing rescues," he said.
During a question period, he reiterated his concerns that the Fed might raise interest rates too slowly when the economy recovers, triggering inflation. He also called the natural rate of unemployment a "moving target," sensitive to real economic shocks, and suggested it might be as high as 7 percent right now.
That contrasts with the views of Federal Reserve Board Vice Chairwoman Janet Yellen, who said in a Feb. 11 speech she sees current elevated unemployment as "largely cyclical and not structural."
If so, "then the straightforward solution is to take action to raise aggregate demand," she said.
But in remarks to the media after the speech, Lacker said keeping inflation low and stable is the Fed's primary goal and its "best contribution to maximum employment."
"I think, beyond that, what we can do is marginal and transitory," he said.
Click here to read more of Lacker's speech.