Governments as Shadow Banks: The Looming Threat to Financial Stability

Governments often have short-term horizons and are focused excessively on the level of current economic activity, disregarding whether financial-sector regulation designed to achieve it leads to long-term instability. Their short-term objective can be well served through policies governing competition and risk taking in the financial sector. By allowing excessive competition, providing downside guarantees, and encouraging risky lending for populist schemes, governments can create periods of intense economic activity fueled by credit booms. This way, governments effectively operate as "shadow banks" in the financial sector, a moral hazard that can have even more adverse consequences than risk-taking incentives of the financial sector. This government role appears to have been at the center of recent boom and bust cycles, especially in the housing sector in the United States through the presence of government-sponsored enterprises (Fannie Mae and Freddie Mac), and continues to pose a threat to financial stability.