Learn from Past, Plan for Future: Central Bank’s Role in Financial Crises Is Focus of Cleveland Federal Reserve Annual Report

Central banks are responsible for fostering financial stability, and that role takes center stage during periods of financial turmoil, such as the subprime mortgage meltdown. The Federal Reserve Bank of Cleveland’s 2007 Annual Report essay, “Central Banks & Crisis Management,” offers some lessons from the past that may help guide policymakers in planning ahead to manage future financial crises.

History reveals that no nation has been immune to financial crises. According to the essay’s authors, economists Joseph Haubrich, James Thomson, and O. Emre Ergungor, the proper response to a financial crisis depends on the reasons behind the crisis and on the costs and benefits of resolving any related market failure. Central bankers must also consider possible unintended consequences of their actions.

Ultimately, financial crisis management has two goals: minimizing the depth and duration of the current episode and minimizing the probability of future crises. These goals can sometimes conflict when actions taken to manage a crisis in the short run lead to market incentives that are inconsistent with financial stability in the long run.

So how can policymakers stem a crisis without setting the stage for a future crisis? Preparation and planning can reduce the conflict between goals, enhance the credibility of the central bank, and lead to shorter, fewer, and less-severe crises.