Economist Robert Higgs is well known for his work on the “ratchet effect.” As he explained in Crisis and Leviathan, governments expand during crises. But, when a crisis ends, the size and scope of government doesn’t revert to where it was prior to it.
I’ll add to this analysis the snowball effect. I think people can guess what it means. “Bad policy begets worse policy.” Put the two effects together and you can see how we ended up in the mess we are in today.
During the Great Recession, the Federal Reserve engaged in a major policy shift that deployed new tactics seen as necessary at the time. We became familiar with terms such as “Fed tools” and “quantitative easing.” Yet when the crisis ended, the Federal Reserve kept its permanently enlarged balance sheet in part by replacing the mortgages that people paid off with Treasuries. Rates also stayed low because of Fed policy and because of the market, which grew too afraid to lend to anyone who wasn’t “safe” (the safest borrowers, of course, are governments or entities backstopped by governments). Inflation never came, and we got used to the growth in the Federal Reserve’s influence on the economy.
The market certainly liked this and was living large without worry, certain that if anything were to go wrong, the Fed would come to its rescue. Uncle Sam was quite happy, too, with the Fed’s demand for Treasuries. What could go wrong? Nothing, we were told, since the era of inflation had ended.
Enter the Covid-19 pandemic. Republicans and Democrats went all out on spending. The Fed went all out. The Treasury went all out. In the end, we got loads of printed money, additional debt, and trillions of dollars in spending (above and beyond what was needed).
After the pandemic was over, not only did spending not go back down to its previous levels, but the Biden administration continued its expansion. No one even talked about paying down our enormous new debt, unlike in the aftermath of previous crises (remember the austerity and debt-ceiling debates last time around). Now, faced with massive inflation, the Fed had to get out of its torpor and start raising interest rates.
It’s a bummer for us, since some 30 percent of our debt has a maturity of less than a year.
This shocked many financial institutions with business models predicated on the assumption that the historically low interest rates would never go up. They did — not even that much by historical standards — and these rate increases were enough to cause a few banks to fail and for chaos to reign in the banking system. All of this under the noses of the Federal Reserve and bank regulators who apparently never even considered this eventuality.
Some people may look at this sequence of events and think that now might be the time to slow down all-out government interventions. Maybe now is the time to revise some of our assumptions. Maybe some interventions put in place during emergencies and kept long after those emergency ended aren’t a great idea. Maybe enormous regulatory bills and an army of regulators aren’t the answer to every problem.
But not our policy-makers. Janet Yellen has announced that the government will insure all deposits, thereby removing the last shred of depositor-imposed discipline for banks. What could go wrong? The calls for more regulation in the face of these abject regulatory failures are already coming. As is more spending.