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.

Comments

[The Divagator]

Pretty much my position as well...though, I would like to know, is there any evidence of a 'slippery slope' here? Your position echoes mine concerning the Fed needing to take a wait-and-see approach...in other words, there needs to be marked declines in key indicators before the Fed acts, but there might be an argument that such declines take on a life of their own and become difficult to arrest if you wait too long in providing relief to the marketplace. That's the only thing I can imagine that has prompted the Fed to act now. Are you aware of any evidence or argument to be made concerning this...perhaps waiting to act lessens the Fed's ability to 'steer' thus making any action nugatory. Just a thought. Cheers.

[ChinaCoalWatch]

I agree that the Fed's policies should be determined by rules dependent on broad developments in the economy, but that does not necessarily mean the Fed cannot use present information to look forward and predict potential problems. Two large issues the Fed is rigorously considering but which get very little media play are:

1. The effect of the pending massive rate of retirement of the Baby Boomers, since many retirees will seek to extract their nest-egg from their property and move from houses to condos, on the housing market if prices stall and credit tightens.

and

2. The effect of falling house prices (and a massive number of downward revaluation appraiser appeal motions) on local and state governments, which have already increased spending and become dependent upon higher property taxes (especially to pay the pending pensions of those retiring baby-boomer public employees)

So, yes, there have been clear excesses in the real estate financial markets, but extreme volatility, panic, and an inability to write affordable new mortgages would inevitably spill into the larger economy. I don't think it's unreasonable for the Fed to be sensibly proactive given these serious mid-term risks to stability.

[Bill]

I would also agree, although I have a question.

Does anyone know whether or not the bail out was motivated in part because of FDIC insurance liability? In other words, was one of the reasons for the bail out to avoid paying out to account holders if various banks went bust?

I think that could be a concern, although I confess I have no idea if there would be FDIC insurance coverage for a significant portion of the debt. I suspect maybe there would be though, because I thought banks bought up a lot of these debts.

[Freddie Sirmans]

Just browsing the internet, your blog is very, very interesting.

[David Bissinger]

Judge Posner's citation to the 2005 Economist story regarding the housing boom probably reminds most of his readers of their awareness of the housing boom at that time. Savvy analysts began to question the financing of the housing boom back then, but one wonders if more information about the relatively opaque bond market (which includes the complex debt derivatives at the heart of the crisis) might have helped.

Despite the power of the internet, the public has little access to information about mortgage-backed bonds and bond prices. That data resides in Bloomberg terminals and other proprietary databases that cost around $1500 per month per user. See http://en.wikipedia.org/wiki/Bloomberg_Terminal.

Wider availability of information about collateralized debt obligations, collateralized mortgage obligations, and other deriviatives might have led to more rigorous study of these instruments in academia, the press, trials and arbitrations, and among policy analysts. Although low-cost dissemination of bond data would cost money (which could be charged to the industry participants), it would seem nominal compared to the costs of imploding hedge funds, collapsing lenders, and central bank intervention.

I personally did not appreciate the lack of disclosure of market data regarding debt securities until I became involved in a lawsuit involving municipal bonds. Around that time, the Wall Street Journal fortuitously posted a story about municipal-bond price reporting that described the relative opacity of the bond market. That story is reproduced at http://www.municipalbonds.com/press_release/2004_03_25.html.

In any event, most people agree that free flow of market information lies at the heart of free enterprise in general and the securities industry in particular. At the same time, many observers question the effectiveness of the rating agencies that awarded investment-grade designations to many debt instruments. See http://money.cnn.com/magazines/fortune/fortune_archive/2007/04/02/8403416/index.htm (by Bethany McLean, author of The Smartest Guys in the Room). Yet even sophisticated investors have limited the ability to scrutinize those ratings. Perhaps wider availability of bond price data and other metrics would have helped raise questions sooner.

[David Bissinger]

Judge Posner's citation to the 2005 Economist story regarding the housing boom probably reminds most of his readers of their awareness of the housing boom at that time. Savvy analysts began to question the financing of the housing boom back then, but one wonders if more information about the relatively opaque bond market (which includes the complex debt derivatives at the heart of the crisis) might have helped.

Despite the power of the internet, the public has little access to information about mortgage-backed bonds and bond prices. That data resides in Bloomberg terminals and other proprietary databases that cost around $1500 per month per user. See http://en.wikipedia.org/wiki/Bloomberg_Terminal.

Wider availability of information about collateralized debt obligations, collateralized mortgage obligations, and other deriviatives might have led to more rigorous study of these instruments in academia, the press, trials and arbitrations, and among policy analysts. Although low-cost dissemination of bond data would cost money (which could be charged to the industry participants), it would seem nominal compared to the costs of imploding hedge funds, collapsing lenders, and central bank intervention.

I personally did not appreciate the lack of disclosure of market data regarding debt securities until I became involved in a lawsuit involving municipal bonds. Around that time, the Wall Street Journal fortuitously posted a story about municipal-bond price reporting that described the relative opacity of the bond market. That story is reproduced at http://www.municipalbonds.com/press_release/2004_03_25.html.

In any event, most people agree that free flow of market information lies at the heart of free enterprise in general and the securities industry in particular. At the same time, many observers question the effectiveness of the rating agencies that awarded investment-grade designations to many debt instruments. See http://money.cnn.com/magazines/fortune/fortune_archive/2007/04/02/8403416/index.htm (by Bethany McLean, author of The Smartest Guys in the Room). Yet even sophisticated investors have limited the ability to scrutinize those ratings. Perhaps wider availability of bond price data and other metrics would have helped raise questions sooner.

[Andres Liberman]

I've read and understood (and.. have to say, agreed with) the argument that recent interventions by the Fed and other central banks may be justified by the fact that a hedge fund should not be left to fail solely due to a shortage of liquidity. That is, assuming its fundamentals are right and the business is essentialy healthy, a liquidity squeeze may put a financial institution out of business although it still may be able to operate. Unavoidably, though, big losses should be taken by those who made wrong investment decisions. What would be your answer to that argument?

[The Divagator]

Andres, the funds aren't failing "solely due to a shortage of liquidity"; they're failing because they are overleveraged and are dealing in paper that is inherently illiquid. I know the press over the weekend generally lauded the Fed's decision, but I'm still not convinced that this was the right thing to do in the long run. There's got to be two ends to the stick for these guys. The moral hazard involved is very real.

[Oliver Áéã]

After reading professor Thurow's wise opinions about China's economy, I have to admire him from the bottom of my heart.

But, cencerning several erroneous standpoints from his article, I still have to argue against him by my humble opinions.

As a college student who lives and studies in Southern China, I quite concern for motherland's economy ,and I try to consider that professor Thurow in MIT, he only thought over a few of external causes to affect China's economy, including energy problem, such as so-called electricity consumptiom and enormous population, which are actully existed in China. But, he seemed to omit most soft causes, such as a series of reforms on education, trade, legal system and financial policies etc. in nowadays or future.

In past 3 decades, China was able to reduce the gap between developed countries and itself rapidly by carrying out it's some perfect policies. There is a miracle that is obvious to all in China. In those years, American economists almost considered that China wanting to develop itself was no possibility absolutely, or very slim, except professor Coase and Friedman, who all worked in University of Chicago and won Nobel prize of economics.

[Andres Liberman]

Divagator, you have a good point, of course. Over-leveraged funds basing their liquidity on essentially illiquid papers are most likely exposing themselves to a high risk which is at the least very hard to quantify. However, my argument stems from what a short-term liquidity dry-up might do to the financial system as a whole, with a high chance of severely impacting the real world.
Quoting the last edition of the Economist,
"Lenders who cannot distinguish good borrowers from bad become less willing to lend to anyone. Even cash-rich banks will hoard their money if they fear that the interbank market will seize up and cut them off from sources of future supply." An intervention under this cirumstances I find reasonable.

[The Divagator]

Andres, alas, the rub. The logic of the intervention makes sense, but I wouldn't think it's the mark of a healthy system that the biggest risk-takers are awash with profit during good times and immune to risk when things go sour. There's going to be collateral damage to the economy at large, either now or later. Pick your poison. The good news, I guess, is that the Fed's intervention to date has been largely symbolic.

[Richard Mason]

Becker: 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

While it is true that prices remain very high, in most U.S. markets the ratio of housing inventory to sales is high and getting higher by the month. For most homeowners who tried to sell their homes last month, therefore, it seems one can only say it is not yet known what price they will ultimately get.

I would like to buy a house in Los Angeles in the next 12-18 months, but, considering price/rent or price/income ratios, it would be utterly irrational of me to make a distressed seller whole at anything remotely resembling current prices.

I hope to remain rational longer than Countrywide can remain solvent.

[jeff]

I agree with the above comments on bail outs. However, as a trader in the credit market is was readily apparent that the injection of cash each day by the Fed was not doing it's job. Bid ask spreads were much wider than normal, and the size of the quotes on each side of the spread were small.

I believe wholeheartedly in the market, but the market must remain liquid so people have the opportunity to take their loss and unwind their position. The Fed must be proactive and make sure that the wheels of the market stay greased enough to do this.

At this point in the cycle, I think it is smart to reduce borrowing costs for banks at the Fed window, but would be imprudent to lower interest rates to the borrowing public.

This whole melt down is not as bad as either the LTCM event in 1998, nor the 1987 crash. Both of those events were much more volatile, and posed a systemic risk to the economic system.

The Fed is in a very tough spot. Bernancke gets an "A" so far.

[Bernard Yomtov]

I wouldn't think it's the mark of a healthy system that the biggest risk-takers are awash with profit during good times and immune to risk when things go sour.

I agree with this. Lots of businesses fail because of lack of liquidity - that is, they run out of financing - not just hedge funds. Why should hedge funds get a bailout and not the small entrepreneur?

On the other hand, I also agree with Becker that where the problem threatens to affect the real economy, and to damage those who had nothing to do with creating it, there is a case for government action.

What troubles me is the entire process. Many who take Dr. Becker's position, including, I suspect Dr. Becker, much dislike government intervention in financial markets, and would oppose efforts to strengthen regulation of hedge funds and the like. Yet we see that misjudgments by these institutions do impact the rest of the economy, much as a bank failure pre-FDIC might have severe external effects. So the upshot is that we enable some organizations to effectively hold the economy hostage. If their bets win, they earn kingly sums. If they lose, they are protected, and earn only princely sums.

This leads me to wonder whether simple "free-market" thinking really gets us to intelligent policies on these matters.

[DanC]

While I believe that markets should be left largely alone, I agree that the Fed should have increased liquidity.

Without the steps the Fed took, I would be afraid of a liquidity trap i.e. the risk premium had grown so quickly because of fear and uncertainty in the market, that markets were having difficulty clearing. The rating agencies had failed to accurately identify the risk in financial offerings. Absent newer accurate information, the markets needed time to adjust. Normally markets left to their own, will adjust on their own. The Fed action just offered some comfort as the market adjusted.

The Fed actions in this matter were minimal, it eased a sense of panic. Also the rapid run up in short run interest rates could for many mortgage companies be the difference between solvency and bankruptcy. The Fed working to keep interest rate in line with stated goals by increasing liquidity may have saved a few companies until they could adjust assets and find alternative solutions.

I would remind others of the S&L crisis where in a relatively short period the real estate assets of many closed S&L's regained their value. Survive the initial market glut and you could do OK.

I think the moral hazard argument is a bit extreme most of the time. For example, Chrysler was a good second best solution. If Chrysler had failed, the economy, especially in Michigan, would have tipped into a very serious retreat. Giving Chrysler the money that the government would have spent on the social net expenditures for the fired Chrysler employees was not a bad short run solution. No worse then the make work jobs of the great depression. The question was where do you get the best return for your social dollar.

This of course does not mean that Chrysler should have received help forever, but as a temporary shock absorber for the overall economy, the money was well spent. It wasn't that Chrysler was too big to fail, you just wanted it to fail in an orderly manner.

I think the political process tends to do far more damage on a regular basis then these occasional big splash stories.

For example, steel tariffs based on electoral college politics rather then a sensible trade policy. Or look at sugar etc. It is these deaths by a thousand cuts that creates more moral hazards then these occasional attempt, like the Fed action, to band aid a perceived market failure.

[David Heigham]

Becker and Posners' feelings are, as usual, a good compass guide. But it is a good idea to steer by the chart as well as by the compass. The charted rocks were the potential effects of a credit famine. Injecting liquidity, at a price, gives healthy businesses time to "unwind and take their losses". It does not bail out those who are broke when they have unwound their positions. Central bank liquidity is needed for longer than usual on this occasion because many firms had allowed the slicing and dicing of risks in credit derivatives to tangle and obscure their real exposures horribly.

It is interesting that the initial really massive credit injection came from the European Central Bank, rather than the Fed. That probably helped to stabilise markets by preventing dollar weakening relative to the euro.

Incidentally, the Bank of England could largely stand aside first because British mortgage risk has not been converted into derivatives to the same extent; and secondly because the BCE and Fed credit injections gave the opportunity to let London institutions suffer through having to pay a margin to euro and dollar banks for the liquidity they needed.

But I am still puzzled as to exactly why the Fed chose to cut rates at the window.

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