Although the Treasury’s Office of Financial Research (OFR) has been tarred by partisan accusations and, some say, actions, its 2020 financial-stability report is astonishingly progressive.  As we noted in our in-depth analysis, the agency posits a new definition of financial stability, one dependent as much on economic opportunity as market and financial-company resilience.  If OFR keeps talking this way, the Biden Administration and even the Fed might start to listen – they surely should.

As OFR rightly observes, “A deep and broad body of research reveals considerable historical and contemporary evidence that the coexistence of financial sector development and economic opportunity reflects more cause and effect than coincidence.”  This is a no-news insight when it comes to industrial development, but OFR goes on to expound a new meaning of financial-system development to encompass broad-based financial stability.  Looked at this way, it isn’t enough for the very biggest banks to be robust and the stock market to climb ever higher.  Instead, all this must happen, but small and mid-size banks must also prosper, financial products must be efficiently delivered from top to bottom across households and businesses, and high-risk providers and products must be effectively outlawed no matter where they arise in the financial system.

Financial stability with an appreciation of economic opportunity creates a functioning financial system which, as OFR outlines, deters adverse selection and moral hazard so capital finds and then builds productive innovation.  The OFR paper does not go on to say so, but it clearly intends and I will say that adverse selection and moral hazard that financialize economies undermine financial stability and thus curtail the productive innovation on which equitable growth depends.  One can thus have a highly-developed financial system in some senses, but one that is damaged or incomplete due to growing risk that threatens economic growth.  Sound familiar?

But, academic evidence substantiating the importance of sustaining financial stability to ensure economic opportunity is not enough.  Given COVID’s hard lessons about linkage, it’s essential to go from observation to action.

So far, no financial-stability assessment from any global authority measures financial stability with an eye on economic opportunity.  I thought this so glaring in the Financial Stability Board’s sanguine assessment of big-bank regulation that I sent a comment letter.  For starters, the FSB measures the social cost of bank regulation not by looking at whether under-served households can access opportunity-essential, sound deposit, payment, and loan services.  Instead, social costs are considered those that bother banks.  These may well turn into costs that hurt vulnerable consumers and broader economic opportunity – I think the sharp shift to nonbank financial intermediation and resulting corporate leverage hint more than strongly at such an outcome.  But, unless or until the FSB considers it, policy will be unchanged, financial stability will remain as fragile as COVID proved it to be, and economic opportunity will go backward still farther and faster.

The Federal Reserve Board’s most recent financial-stability report is similarly myopic.  Even though there is ample evidence that economic inequality is a driving and likely the most predictive cause of financial crises, Fed analytics pay it no heed.  As a result, efforts to ensure stability and thereby growth consistently backfire.  Much in our EconomicEquality blog shows how financial policy has unintentionally, but nonetheless directly, destroyed economic opportunity.  See for example an early post on a BIS study finding that quantitative easing had an immediate, beneficial impact on financial stability and growth, but ultimately did nothing but spark a persistent, sharp increase in equity prices.

Now the Fed has of course ramped up QE to a still more fevered pitch.  Markets are responding as happily as before but no “wealth effect” from all this presumed financial stability has evidenced itself in the ever-worse equality data.  Indeed, the FSB’s own financial-stability report cited rising equity prices as a growing financial stability threat due to the absence of underlying prosperity supporting sustained corporate profitability.

For as long as the Fed thinks of financial stability as markets and thus props up markets instead of supporting broad-based economic opportunity, the U.S. will grow more unequal and financial stability will be a still more fleeting concept.