The Federal Reserve Responds to Crises: September 11th Was Not the First Christopher J. Neely he terrorist attacks of September 11, 2001, HOW DO CRISES AFFECT THE had two immediate consequences: They ECONOMY? T took an enormous human toll and they Stock market crashes, in general, the Russian created a potentially serious crisis for the economy default, and the September 11th attacks were associ- through their impact on financial markets. The ated with sudden, substantial revisions in expecta- Federal Reserve reacted to the potential economic tions about future economic and financial variables. crisis by providing an unusual amount of liquidity Although each episode had unique causes and fea- and reducing the federal funds rate more than tures, they were all accompanied by liquidity crises would be expected from levels of output and infla- in financial markets that could have disrupted 1 tion. This was not the first time, however, that the economic activity and threatened price stability. Federal Reserve responded quickly and forcefully These financial crises are caused by some combina- to unusual conditions in financial markets that tion of a simple physical disruption of the financial system and/or sudden uncertainty about economic threatened to spill over to the real economy. Indeed, conditions. Those problems manifest themselves the September 11th attacks reminded us that prob- in lower asset prices, which, in turn, create balance lems in financial markets can disrupt the whole sheet problems for financial institutions.2 economic system. Financial institutions are wedded together in a This article describes the Federal Reserve’s complex system of payments that makes the system reactions to crises, or potential crises, in financial vulnerable to the failure of large banks or hedge markets. The crises considered are periods of sud- funds.3 And some parts of the system, like specialists den revision in expectations or physical disruption on Wall Street and hedge funds, are highly leveraged, that threaten the stability of the economic system meaning that they typically borrow most of the through asset price volatility. The Federal Reserve money with which they purchase assets.4 If asset has responded to financial crises in three main ways: (i) The Fed has provided immediate liquidity through 1 Although the Federal Reserve can achieve price stability over the long open market operations, discount window lending, run, financial crises that generate extreme economic conditions might create pressures to follow other policies. For example, a banking and regulatory forbearance; (ii) the Fed has lowered collapse could potentially create deflation and a liquidity trap that the federal funds target over the medium term; (iii) might require the Fed to commit to inflate the currency for some years. the Fed has participated in foreign exchange inter- 2 Mishkin (2001) discusses financial crises in the context of foreign vention with the U.S. Treasury. exchange crises in emerging markets. The next section of the article explains how 3 Hedge funds pool investors’ money to invest in a variety of financial instruments. By limiting participation to wealthy investors and large sudden changes in asset prices or asset price uncer- institutions, they avoid most regulatory controls and do not register tainty spill over into the rest of the economy. Next, with the Securities and Exchange Commission. the article explains how the Federal Reserve Bank 4 A specialist is a firm charged with making a market—being prepared to can use its tools to help minimize the impact of the buy or sell a stock on their own account at a reasonable spread—when there is temporary excess supply or demand for a stock. Larger imbal- uncertainty and physical disruptions of crises. Finally, ances between supply and demand at a given price might require the several recent episodes—the stock market crash of specialist to halt trading temporarily, until a new opening price can be established. Ordinarily, specialists make money from the spread that 1987, the Russian default, and the September 11th compensates them for the service of providing liquidity to the market all attacks—are examined as case studies. the time. In 1987 there were about 50 specialist firms (Santoni, 1988). Christopher J. Neely is a research officer at the Federal Reserve Bank of St. Louis. Charles Hokayem, John Zhu, and Joshua M. Ulrich provided research assistance. Federal Reserve Bank of St. Louis Review, March/April 2004, 86(2), pp. 27-42. © 2004, The Federal Reserve Bank of St. Louis. MARCH/APRIL 2004 27 Neely R EVIEW Figure 1 Real Gross Private Domestic Investment During Recessions Percent Change from Year Ago 60 40 20 0 –20 –40 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 NOTE: The figure shows the year-to-year percentage change in real gross private domestic investment in the United States. Shaded bars denote recessions. SOURCE: Bureau of Economic Analysis. prices decline significantly, the value of the firm’s can hobble the economy because the financial liabilities (i.e., loans) can exceed the value of its system provides intermediation; that is, it matches assets, in which case the value of the firm to its people who wish to save money with firms who owners (equity) becomes negative and the firm goes want to invest that money in productive activities. bankrupt without additional capital. But if a hedge Other industries can have disruptions or slowdowns fund goes bankrupt, it will be unable to make pay- with little effect on other business. If the financial ments to the banks from which it has borrowed system stops functioning, however, savers aren’t money, which might make them insolvent as well. matched with investors and investment falls in every Or, firms might find it necessary to ration scarce sector. And investment is traditionally the most liquidity to make only particularly important pay- volatile component of output. Figure 1 shows that ments during periods of illiquidity. In this event, U.S. recessions (shaded bars in the figure) are always some debts will not be settled on time. The danger accompanied by a large falloff in investment. that one’s counterparty will fail to settle a transaction A fall in stock prices can also affect the real econ- is called counterparty risk. Fear of counterparty omy through its influence on the credit-worthiness risk can cause financial gridlock, where firms and of firms. When a firm’s stock price falls, the value individuals refuse to enter into financial transactions. of the firm to its owners declines. The owners—who Failure of counterparties to make payments can also have limited liability—then have an incentive to lead to systemic risk—where the health of the whole borrow money to take risky but potentially profitable financial system is endangered by the possibility of actions; as owners they keep any gains but their domino-style bankruptcy. losses are limited to their equity stake. Naturally, A breakdown of the financial system itself will though, no one would want to lend money to firms immediately affect the whole economy because with low equity because this incentive to take risky economic activity depends on the efficient function- gambles makes the loan too risky (Bernanke and ing of the payments system. If one cannot be assured Gertler, 1989; Calomiris and Hubbard, 1990). that one will be paid, then there is little incentive Falls in equity can also affect economic activity to work or to sell. through trade credit. Trade credit is the practice in In the medium term, such financial breakdowns which buyers take delivery of goods and pay for 28 MARCH/APRIL 2004 FEDERAL RESERVE BANK OF ST. LOUIS Neely them later. A firm with low equity might be unable believe that the Fed should not try to target asset to get trade credit to continue operations.5 prices—like stocks—or prevent their adjustment. Financial crises in the United States that exacer- I believe it is very important that the Federal bated 19th century recessions contributed funda- Reserve not take a position per se on the mentally to the formation of the Federal Reserve level of prices in asset markets, especially System in 1914 (Dwyer and Gilbert, 1989).6 Prior to the stock market. It is very easy to be wrong the creation of the Federal Reserve System, the U.S. about the appropriate level; this judgment economy was beset by occasional banking panics, ought to be left to the market. particularly the severe 1907 banking panic, which directly motivated the creation of the Federal —William Poole, President of the Federal Reserve System in 1914 (Federal Reserve Bank of Reserve Bank of St. Louis (2001) Minneapolis, 1988). Indeed, leaving aside the question of whether One of the most important responsibilities for the Federal Reserve knows the fundamental value the new central bank was to provide an elastic supply of stocks, the Fed’s tools might be inappropriate for of currency to banks to meet temporary increases the task. The Federal Reserve potentially has two in currency demand. One of the most prominent tools with which it could influence stock prices: sources of such temporary increases in currency (i) It could use open market operations to influence demand was banking panics. In other words, a pri- stock prices through interest rates, or (ii) it could mary goal of the Federal Reserve System was to administratively adjust margin requirements for avert banking panics. Deposit insurance, prudent stock markets.8 Margin requirement changes have regulation, and the Fed’s own willingness to act as been rare in recent history, so their effects are not a lender of last resort have made banking panics well understood. And monetary policy is a very blunt almost unheard of since the Great Depression.7 instrument with which to change equity prices.