Should Central Banks Intervene During This Financial Crisis? Becker
The Fed, the European Central Bank, and the Japanese Central bank have all been pumping liquidity into the global economic system through easing borrowing in overnight money markets in order to stem the lending crisis brought on by heavy default rates on sub prime loans. The Fed on Friday also lowered the rate they charge to banks, and encouraged them to use this rate to borrow for longer than overnight, especially with sub prime loans as collateral for their borrowing.
By contrast, the British Central Bank has not taken any special steps, and the head of that bank, Mervyn King, and some other economists have argued that trying to stem the crisis by making loans cheaper and more available is an unwarranted bailout of financial institutions. This could create a risk-called "moral hazard"- which means in this situation that hedge funds and other financial companies might lend recklessly in the future in the expectation that they would be helped again by Central Banks if they get into trouble. Others have argued that the financial system has to go through a crisis to eliminate all the reckless investments that have been made during the past few years.
I have been a strong opponent of bailouts of individual companies since I do not believe in the "too big to fail" justification when applied even to large manufacturers, financial intermediaries, or service companies. In particular, I was against the Fed's putting pressure on private investors to bail out Long Term Capital during the financial crisis of the late 1990's. It would be a further mistake for the Fed or other Central banks to come to the assistance of hedge funds or other lenders that may be in financial difficulties because they excessively invested in assets of dubious value. They should bear the consequences of their mistakes. In particular, no assistance should be given to home lenders or others who might go bankrupt because it made an excessive number of highly risky mortgage loans to borrowers with dubious credit.
To be sure, in the environment of the past several years of very low interest rates, sharply rising housing prices, and new instruments for managing and aggregating risk, it is easy to understand why loans to finance home ownership spread to borrowers who in the past would not have been considered sufficiently credit worthy. Many of these loans have turned sour because interest rates have begun to rise sharply, especially on low-grade mortgages, and because of the steep slowdown in the increase in housing prices. Yet f the discussion of this experience typically forgets that most homeowners who can no longer meet mortgage payments and may have to sell their homes will get back more than they paid because housing prices remain well above what they were when they bought their homes with cheap loans.
So is laissez faire the right option in this case, and the Fed and other central banks should not offer any special help? I would have absolutely no doubts that this is the right policy if the major risk of the present situation were that some hedge funds and other financial institutions would experience sharp rundowns in their assets and even bankruptcy. However, the Fed's recent intervention was driven by the fear that the weakness in financial markets will spread to the real economy, and will adversely affect employment, investments, and general welfare in the United States. The same justification would apply to Europe and Asia as well. The avowed goal of such interventions would not be to help individual companies or borrowers, but rather to stabilize the complicated and interconnected economic system.
Such an approach by the Fed and other central banks is not foolish, and may be right, but I believe they should continue to be guided by the criteria that have served them very well during the past couple of decades. That is, their policies should be determined by rules dependent on broad developments in the economy: unemployment, the growth in GDP, and the inflation rate. Central banks should intervene by lowering interest rates only when these broad economic indicators begin to slip badly. Since unemployment continues at low levels, and inflation is still modest, the U.S. GDP growth rate is the only major indicator that has worsened- output in Europe, Japan, and most of the rest of the world has continued to grow at a brisk pace.
I conclude that central banks should be especially vigilant for signs that the damage is spreading to fundamental economy indicators, but should refrain from any special actions until that time. Otherwise, central bank policy would get confused between rules that depend on broad developments in the economy, and discretion that is affected by development in the housing market, the market for credit, or other specific markets.