Now is the right point in the cycle to raise banks’ capital requirements as called for under Dodd-Frank. The cushion would minimize the risk of a future banking crisis.
Other countries do macro-prudential policy better. Europeans have applied the counter-cyclical capital buffer to their banks. Some Asian countries raise banks’ reserve requirements and homeowners’ loan-to-value ceilings during booms, and lower them during financial downturns.
When it comes to monetary policy, the US Federal Reserve has been doing a good job; but its independence is increasingly under attack from Republican politicians. If this assault succeeds, counter-cyclical monetary policy would be impaired.
In the past, the Fed has moderated recessions by cutting short-term interest rates by around 500 basis points. But, with those rates currently standing at only 2%, such a move is impossible. That is why, as Martin Feldstein recently pointed out, the Fed should be “raising the rate when the economy is strong,” thereby giving “the Fed room to respond in the next economic downturn with a significant reduction.”
Most Fed critics disagree. In 2010, they attacked the Fed for its monetary easing, even though unemployment was still above 9%. Now Trump says he is “not thrilled” about the Fed raising interest rates, even though unemployment is below 4%. This is tantamount to advocating pro-cyclical monetary policy.
As we approach the tenth anniversary of the global financial crisis, we should recall how we got there. In 2003-2007, the US government pursued fiscal expansion and financial deregulation – an approach that, even at the time, was recognized as likely to constrain the government’s ability to respond to a recession. If the US continues on its current path, no one should be surprised if history repeats itself.
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers.