Kevin Warsh Priorities: Eichengreen Analysis

BERKELEY – President Donald Trump’s choice of Kevin Warsh to potentially succeed Jerome Powell as Federal Reserve chair signals a coming shift in priorities, with a heightened focus on the risks of moral hazard within the financial system.

Kevin Warsh, President Trump’s pick for Federal Reserve chair, is known for his concerns about moral hazard.

Warsh’s Focus: Curbing Risky Behavior at the Fed

A potential change in leadership at the Federal Reserve could mean a more cautious approach to balance-sheet expansion and a greater emphasis on preventing banks from taking excessive risks.

• Warsh is deeply concerned about moral hazard – the idea that the Fed’s actions can encourage reckless behavior by financial institutions.
• He believes expanding the Fed’s balance sheet can inflate asset prices and lead to fiscal irresponsibility.
• While acknowledging the dangers of financial meltdowns, Warsh prioritizes mitigating the risks associated with the Fed’s interventions.

Now that US President Donald Trump has chosen Kevin Warsh as his appointee to succeed Jerome Powell as Federal Reserve chair, it is time to take Warsh’s ideas seriously, if not literally. Warsh is preoccupied with moral hazard, the concern that Fed balance-sheet expansion encourages risky behavior by banks, inflates asset prices, and promotes fiscal profligacy.

The Debate: Moral Hazard vs. Financial Meltdown

The core of Warsh’s thinking revolves around a fundamental tension: the need to prevent financial crises versus the potential for the Fed’s actions to inadvertently create new risks. He argues that continually expanding the Fed’s balance sheet – essentially printing money to buy assets – can incentivize banks to take on more risk, knowing that the Fed will step in to bail them out if things go wrong. This creates a dangerous cycle of risk-taking and intervention.

However, this perspective isn’t without its critics. Some argue that focusing too heavily on moral hazard could paralyze the Fed in the face of a genuine financial emergency, potentially leading to a catastrophic meltdown. The challenge, then, is finding the right balance between preventing reckless behavior and ensuring the stability of the financial system.

What is moral hazard? It’s the risk that a party will take more risks because someone else bears the cost of those risks. In the context of the Fed, it refers to banks taking on excessive risk knowing the Fed might intervene to prevent a collapse.