On What the Fed Hath Wrought (So Far)

A gut-wrenching two weeks in the credit markets have been capped by unprecedented moves by central bankers. The ECB’s offer of an unlimited infusion to member banks the week before last was followed last Friday’ by the Fed’s discount rate cut, which included stern warnings that those who needed it better use it and a volte-face on its interest rate posture (a bias towards tightening suddenly became a promise that the Fed would provide more liquidity if conditions warranted). The Fed, ECB, and Bank of Japan are continuing to inject funds, albeit at a lower rate.

Opinion about the wisdom of the central bankers’ actions is coalescing into what we will characterize, broadly, as four views. Note that while some commentators may engage in nuanced fence-straddling, for the most part, the positions are well-defined.

For the purpose of simplicity, we’ll focus on the Fed, although these comments apply to some degree to other central bankers.

First is the group that thinks that central banks should do whatever it takes to keep the markets afloat. The most extreme and vocal advocate is Jim Cramer, followed closely by Don Luskin, but they have some intellectually respectable company, such as economist Thomas Palley (albeit with caveats that would set Cramer off):

In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the economy will tank. Moreover, this fear deepens the greater the level and burden of debts. Worse yet, such intervention creates a problem known as “moral hazard” that can aggravate the need for rescues. Having the Fed intervene to prevent financial meltdowns tacitly puts a floor under financial markets. That floor acts as a form of insurance for investors and speculators, who knowing that they are protected against large losses then channel more funds into even higher risk investments and loans….

The threat posed by the current crisis is such that the Fed should meet this demand. That means immediately cutting rates and continuing to judiciously provide emergency liquidity. However, once the storm passes Congress and the Fed must address the systemic problems and policy distortions that have been exposed by the current crisis.

The second group is the cold water Yankees who think that any liquidity infusion is a bad idea. They see the Fed and its buddies as having enabled massively underpriced credit, which has in turn led to asset bubbles. While they don’t deny that a refusing to mitigate the credit contraction will cause considerable pain, including a recession, they argue that lowering interest rates now will rescue the perpetrators as well as the victims, merely delaying the day of reckoning, and will set the stage for either even more massive bubbles and an eventual economic collapse, or serious inflation.

They are the true heirs of Puritan Jonathan Edwards, fond of fire, brimstone, and punishment of the guilty. From Edwards’ “Sinners in the Hands of an Angry God“:

That they were always exposed to destruction; as one that stands or walks in slippery places is always exposed to fall. This is implied in the manner of their destruction coming upon them, being represented by their foot sliding. The same is expressed, Psalm 73:18. “Surely thou didst set them in slippery places; thou castedst them down into destruction…they are liable to fall of themselves, without being thrown down by the hand of another; as he that stands or walks on slippery ground needs nothing but his own weight to throw him down.

Now despite the moralistic overtones, this group (members include Nouriel Roubini, Andy Xie, Michael Panzner, Marc Faber) has some logic behind its righteous-sounding views. Roubini’s critique is particularly sophisticated. He has pointed out that the credit contraction isn’t simply a liquidity crisis but also a solvency crisis. More credit can’t salvage insolvency and might well fuel more speculation. In addition, he points out the problem of uncertainty: intermediaries don’t know the risk exposures of their counterparties, which makes them reluctant to trade with them. No amount of liquidity will solve an information problem.

Other observers, including ones who are not card carrying bears, are skeptical of the efficacy of the Fed’s actions. A typical comment comes from Markham Lee:

It doesn’t change much and in many ways, it’s just a placebo. Lower rates can’t truly raise investor confidence when investors worldwide are still losing money due to mortgage debt securities, loan defaults, and accelerating losses. In addition, hedge funds and other institutional investors are still over-leveraged on mortgage debt securities, etc.

Once the excitement dies down and bad news related to mortgage lenders, retail bank loan losses, and credit markets continues to pour in, we could see things reverse drastically.

We’re on a potentially dangerous sliding slope right now, because if the Fed decides to “fix” the credit crisis via multiple rate cuts. It’s basically sending the message that the Fed is going do what it can to create the level of confidence required to enable the credit markets to function as if it was 2004. The long-term consequences of this action would be rather disastrous as low rate cuts coupled with bad business practices are what got us into this situation

The third camp is the realists. They don’t disagree that too much cheap credit for too long has caused this mess, but they think a cold turkey approach creates too much collateral damage. Similarly, central bankers can’t sit around and let markets seize up. Their whole raison d’etre is to promote the soundness and safety of the banking system. It’s not acceptable for them to let major players go belly up on their watch.

This view is particularly strong at the Financial Times, where its well regarded economics editor Martin Wolf and commentator Martin de Grauwe have both takes a page from Walter Bagehot, who advocated that central bankers needed to create some pain even as they were alleviating a crisis. They should lend, but at penalty rates, and only against good collateral.

As Martin Wolf explained:

“At particular times a great deal of stupid people have a great deal of stupid money . . . At intervals . . . the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured, and there is ‘panic’.” Walter Bagehot….

The correct policy response is…well known. It was laid down by Bagehot himself from his observation of the evolution of the Bank of England. The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.

In providing money to the markets last week and this, the European Central Bank, the Federal Reserve, the Bank of Japan and other central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.

De Grauwe, using the Bagehot standard, criticized the ECB’s action as indiscriminate; it’s not clear what he would have thought of what the Fed did. Most observers think the discount rate cut was mainly symbolic; the more important move was the statement that signaled it was willing to inject more liquidity, which some regard as shrewd (reassurance may avert the need for action); others as unwise.

Willem Buiter (among other things, a member of the monetary policy committee at the Bank of England) and Anne Siber (advisor to the Committee for Economic and Monetary Affairs of the European Parliament) hew more tightly to the Bagehot line and, say quite bluntly at VoxEu that the Fed blew it:

The Fed’s 17-8-07 move was a missed opportunity. It should have effectively created a market by expanding the set of eligible collateral, charging an appropriate “haircut” or penalty interest rate, and expanding the set of eligible borrowers at the discount window to include any financial entity that is willing to accept appropriate prudential supervision and regulation.

In response to the credit and liquidity crunch that has recently spooked global financial markets the Federal Reserve reduced, on Friday 17 August 2007, its primary discount rate from 6.25 percent to 5.75 percent. The discount rate is the rate that the Fed charges eligible financial institutions for borrowing from the Fed against what the Fed deems to be eligible collateral. It is normally 100 bps above the target Federal Funds rate, which is the Fed’s primary monetary policy instrument and which is currently 5.25 percent. We believe that this cut in the discount rate was an inappropriate response to the financial turmoil.

The market failure that prompted this response was not that financial institutions are unable to pay 6.25 percent at the discount window and survive (given that they have eligible collateral). The problem is that banks and other financial institutions are holding a lot of assets which are suddenly illiquid and cannot be sold at any price. That is, there is no longer a market that matches willing buyers and sellers at a price reflecting economic fundamentals. Lowering the discount rate does not solve this problem; it just provides a 50 bps subsidy to any institution able and willing to borrow at the discount window.

What the Fed should have done
Instead of lowering the price at which financial institutions can borrow, provided they have suitable collateral, the Fed should have effectively created a market by expanding the set of eligible collateral and charging an appropriate “haircut” or penalty. Specifically, it should have included financial instruments for which there is no readily available market price to act as a benchmark for the valuation of the instrument for purposes of collateral.

There is no apparent legal impediment to doing this….

The fourth view comes from those who believe the problem needs to be reframed and that the solution isn’t simply a matter of interest rate policy but of the larger regulatory framework, which needs to acknowledge and manage the risk of asset bubbles. That likely means more regulation of investment to (at a minimum) limit speculation to those who can afford to take losses.

Australia’s former Reserve Bank Governor Ian MacFarlane (who to our knowledge is the only central banker to successfully prick an asset bubble) pointed out the dilemma central bankers now face, namely, the lack of a mandate to address asset inflation. Basically, asset bubbles appear to make everyone richer, so puncturing them is unpopular, since they not only create a reduction of asset values, but also slow the economy, thus creating real costs when the degree of danger is uncertain and unprovable. Stephen Roach of Morgan Stanley has more recently echoed some of MacFarlane’s views.

Similarly, Henry Kaufman worried last week about the failure of market discipline to produce healthy outcomes, which means that regulation is necessary.

But despite Kaufman’s belief that more regulation was unpopular and therefore not viable, there seems to be increasing recognition that it may indeed be necessary. Admittedly, the calls are coming first from the liberal end of the political spectrum (witness this piece, “End the Hedge Fund Casinos” by Robert Reich), but if the crisis deepens, these views will become more mainstream.

The balance that needs to be found is between healthy speculation that helps lubricate financial markets, and unhealthy speculation that sucks capital into dubious investments. Now there isn’t, and probably can never be a precise definition of the difference between one and the other. Like pornography, however, most people will recognize it when they see it (taxi drivers and secretaries leveraging their paltry net worths are among the telltale signs).

However, even now it’s not hard to point to a few things that in retrospect might have put a damper on the recent speculative frenzy. One is that the old “prudent man” and “prudent investor” rules that used to guide fiduciaries’ behavior appear to have gone out the window. If an institution used a fund consultant to invest in products it didn’t understand, it somehow can escape liability.

The formal reimposition of some commonsensical standards that have gone by the wayside might go a considerable way towards addressing the problem. One would be to prohibit fiduciaries from investing in funds or vehicles that fail to disclose their holdings (meaning assets and liabilities) to them on at least a quarterly basis. Pension funds have no business making blind investments. A second would be find some way to put teeth back into the prudent man and prudent investor standards, say by requiring that fiduciaries understand their investments (ie, no outsourcing it). Third would be to increase the threshold for “qualified investors” which has remained static since the early 1980s despite the CPI more than doubling in that time period.

Now these are merely off the cuff suggestions, and some may regard even such relatively minor proposals as the investment equivalent of the unpopular Sarbanes-Oxley rules. But a former corporate general counsel points out that 85% of Sarbox’s requirements were already embodied in general corporate law but were being widely disregarded. Hence the need for seemingly new legislation to improve compliance.

An improved securities regulatory regime may similarly emphasize new respect for old rules that have been widely ignored to our collective peril.