An article in today’s Wall Street Journal, “Insider Joins Critics of the Fed, Faulting Credit-Crisis Programs,” discusses at some length a recent speech by Richmond Fed president Jeffrey Lacker in which he took issue with some of the Fed’s recent financial services industry rescue efforts. The article itself failed to do justice to his speech, which was more nuanced than the usual “bailing out banks creates moral hazard” argument.
In fact, as we’ll discuss, the expanded charter of the Fed calls into question the appropriateness of its independence. It is increasingly making resource allocation decisions which are political in nature and should arguably be debated and determined in that realm.
In his London speech, Lacker defined two types of bank runs: non-fundamental, when the institution is sound but hit by a liquidity crisis, versus a fundamental run, where depositors and creditors wanted out because they know someone would wind up holding the bag. In the latter case, speed of exit is a virtue, since the laggards are the ones who run the risk of not recovering their assets.
The problem with central bank intervention is two-fold. It may not always be possible to parse out whether a crisis is fundamental or non-fundamental in nature. However, when a crisis is fundamental (or as we like to say here, a solvency rather than a liquidity crisis), Fed assistance distorts relative asset prices and delays the relevant markets finding clearing prices. As Lacker stated:
The ideal central bank lending policy would require making clear distinctions between different possible sources of bank or financial distress. If an episode of financial disruption is a true liquidity crisis, like a non-fundamental run on the banking system, then aggressive central bank lending can, in theory, stem the crisis and prevent unnecessary insolvencies that impose real losses on the economy. Lending when in fact the financial sector is just coping with deteriorating fundamentals, however, distorts economic allocations by artificially supporting the prices of some assets and the liabilities of some market participants. Moreover, it is likely to affect the perceptions of market participants regarding future intervention, and thus alter their incentives and future choices.
But Lacker made a second set of observations, which the Journal breezed by: the existence of a central bank safety net leads banks to neglect cheap risk reduction measures they could take on their own.
For instance, the big reason that bank runs happen is that depositors go to yank all their funds out at once, when those institutions are set up to handle only a comparatively small proportion of those holdings being withdrawn on any day. But most customers don’t need that much liquidity on a daily basis and can be given incentives to sacrifice such quick trigger access. As Lacker points out:
The intuition behind the classic bank run story is that banks are susceptible to runs because depositors are free, at any time, to claim all of their money on demand. This is a contractual choice, and one that makes some sense given depositors’ demand for short duration, liquid savings instruments. But if a bank can restrict its depositors’ ability to demand their funds on the spot in certain circumstances – in the event of heavy demands for withdrawals, for example – then the bank will be less susceptible to a run. And there is ample precedent for deposit contracts with such characteristics. In 19th century U.S. banking panics, banks preserved their liquidity, individually, by suspending the convertibility of their deposits into currency. They also had recourse to collective actions through the issuance of loan certificates by clearinghouses in the major cities, which allowed the clearinghouse members to meet their interbank obligations and customers to make interbank transfers without drawing on banks’ scarce supplies of currency.
While Lacker’s candor is refreshing, he has not teased out the full implications of his observations. Supporting the prices of some assets has the effect of enriching certain interests at the expense of others. Similarly, shifting risk from individual banks onto the central bank is believed to be worthwhile because any collective costs are assumed to be lower than that of a financial crisis. But the degree of risk transfer we’ve seen in the last year, which seems close to a “heads I win, tails you lose” game for the financiers, again raises question of fairness and resource allocation.
Axel Leijonhufvud, in a Centre for Economic Policy Research paper “Keynes and the Crisis,” (hat tip Richard Alford) does a first-rate job of analyzing what the credit market upheaval has revealed about the limitations of various economic models and institutional arrangement. In particular, he found that it called into question the central premise of modern central banking, including central bank independence (emphasis his):
There are two aspects of the wreckage from the current crisis that have not attracted much attention so far. One is the wreck of what was until a year ago the widely accepted central banking doctrine. The other is the damage to the macroeconomic theory that underpinned that doctrine.
Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level.5 Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.
This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measure by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is right. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.
A second tenet of the doctrine was central bank independence. Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.
Transparency of central banking was a minor lemma of the doctrine. If monetary policy is a purely technical matter, it does not hurt to have the public listen in on what the technicians are talking about doing. On the contrary, it will be a benefit all around since it allows the private sector to form more accurate expectations and to plan ahead more efficiently. But if the decisions to be taken are inherently political in the sense of having inescapable redistributive consequences, having the public listen in on all deliberations may make it all but impossible to make decisions in a timely manner.
When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.
Consider as examples two columns that have appeared in the Wall Street Journal in recent weeks. One, by John Makin (April 14), argued that leaving house prices to find their own level in the present situation would lead to a disastrous depression. Policy, therefore, should be to inflate so as to stabilise them somewhere near present levels. If the Fed were to succeed in this, it might not find it easy to regain control of the inflation once it had gotten underway, particularly since some of the support of the dollar by other countries would surely be withdrawn. But in any case, the distributive consequences of Makin’s proposal are obvious to all who (like myself) are on more or less fixed pensions. The other column, by Martin Feldstein (April 15), argues that the Fed had already gone too far in lowering interest rates and is courting inflation. He wasin favour of the Fed’s attempts to unfreeze the blocked markets and restore liquidity by the unorthodox means that Volcker had mentioned.
The likely prospect for the United States in any case is a period of stagflation. The issue is going to be how much inflation and how much unemployment and stagnation are we going to have. To the extent that this can be determined or at least influenced by policy the choices that will have to be made are obviously not of the sort to be left to unelected technicians.
There has been a great deal of hostility towards the Fed, as witness by comments here and on other blogs, and by the existence of sites such as “Bernanke Panky News.” A lot of that is Greenspan backlash. Having become too willing to take credit for general economic prosperity (and having taken too much interest in the performance of the stock market, something no previous Fed chair gave a fig about), he became the focus of anger over the credit crisis. While the Fed bears significant responsibility, messes this big have many parents.
But there has been another thread mixed in with this: resentment at the Fed salvaging the banking industry, with contingent and real costs, in the form of higher inflation, per Alford’s and Leijonhufvud’s analysis. Now that many of those actions may indeed have been the best among a set of bad choices (although I suspect economic historians will conclude the Fed cut rates too far too fast). However, the big issue is that they involved consequences of such magnitude that they should not have been left to the Fed. I was amazed, and was not alone, when Congress did not dress down the Fed in its hearings on the Bear rescue for the central bank’s unauthorized encroachment into fiscal action (ie., if any of the $29 billion in liabilities assumed by the Fed in that rescue comes a cropper, the cost comes from the public purse). So the frustration isn’t merely about outcomes, it’s about process, about the sense of disenfranchisement. And that will only get worse as this crisis grinds along.
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Yves,
You express surprise that Congress didn’t dress down the Fed for the unauthorized fiscal encroachment in the Bear bailout.
Well, in line with yesterday’s release of the Rockefeller report about Bush lying the country into war, perhaps Congress will dress down the Fed — five to six years from now.
Voters in a democracy are not collectively especially bright but they are reactive: quite consistently, they punish a political party in office if the economy is bad, and cuddle a political party in office if the economy is (or seems to be) good. Certainly in American history, this is the salient dynamic determining elections over the last three generations; not the only dynamic, but the salient one. Politicians, by contrast, are not particularly stupid about getting elected and staying that way. They are quite willing to go to the lengths of mendacity to make the economy look better than it is. Even more, they are all too eager to have anyone else be seen as responsible for bad economic news. Human shields, as it were, ” . . . To absorb the blast,” not that it ever really works.
Congress and the Executive have no stomach whatsoever for going NEAR the present economic crisis. Leaving the matter to ‘experts’ is exactly what they all hope and pray for now. Even more than the Congress’s fade-to-black on this is the complete absence of Administration involvement beyond zany news conferences now and again. When it comes to real, hard political decisions, our shephards are sheep; with their backs to the storm, no less. They all like having power until problems get real, then they like vacations and ‘time to reflect.’ The conservatives don’t seem to believe in government, and so won’t act, while the liberals don’t believe in accountability, and so don’t act. Radicals can’t get elected, so they can’t act. When the voters start believing in government, we’ll get some shephards who believe in accountability. Then we’ll get some decisions out of policy ‘deciders’ other than the Fed, not before.
Lacker’s distinction between fundamental and non-fundamental is of dubious value. Most liquidity problems start with the perception of solvency problems. And the distinction between the perception and the reality of solvency problems is itself a continuum rather than a binary alternative. Ultimate realizable asset values depend on present value discounting that is inherently perceptual. Liquidity is inextricably linked to solvency.
It’s also doubtful that Bagehot specifically meant “non-sterilized intervention”. This is a false comparison, since it is unlikely that ancient monetary systems were evolved to the point of distinction between concepts of sterilized and non-sterilized intervention.
So JKH, I agree with you in principle that for the _actors_ in a money crunch Lackn’ers fundamental/non-fundamental distinction is of little material relevance. For policy actors such as Fed governors and voting members, it is a material distinction since their actions will differ substantially between addressing liquidity and solvency, both on the level of individual institutions and system-wide. The Feds convinced themselves from July to November that they had a liquidity problem; that gave the upper hand to the ‘let them drink rates’ crowd, who persuaded their peers to pour basis points upon the conflagration. It wasn’t until too late—some in December, most by February—that the Feds acknowledged that they had a solvency problem. Then they stacked bonds on the conflagration to try and smother it. This ‘fundamentalist’ fumbling led to slow and mistaken policy actions. I mean, no one’s perfect, but still, perceptions did matter.
Now, the Fed’s policy for solvency problems is, Let the Markets’ Do It, i.e. absorb insolvent institutions ‘with a little help.’ The Fed doesn’t have a policy for system insolvency: that kind of problem is too fundamental for technocrats, but the politicians won’t take it up, so here we sit, getting naught but stiff upper lips, an excess of sheep dip, and muted bleating.
“Most liquidity problems start with the perception of solvency problems”
Dont we live in a world where the future is unknowable? Therefore market players actions dictate future fundamentals.
Just like if I shoot someone he is dead.
The perception issue is a double- edged sword. A Berkleyian riposte being if no one saw the queues would N. Rock have beentaken under wing?
Lacker says in previous times a bank would find its own remedy… one that would no doubt so damage its reputation that it would disappear.
The Q when is a drama a systemic crisis that justifies the “democratistion” of private hazard is quite appropriate.
Some… and recent actions appear to suggest it is when any bank with retail deposits or IB significant counterparties or impacts on pricing and “liquidity” in certain markets.
Lacker is pointing out that the practice and perception were different once and presumably could be so again.
This time around it would appear that too many were feeding in the same manner at the same trough to admit enough private rescues and and failures. But this reality does not make actions to remedy the consequences nor the actions that led to the consequences, perceptually, systemically nor morally right.
I don’t believe that monetary policy decisions should be made by Congress, that would be a nightmare. Also, exigent circumstances require speed and agility, something Congress does not possess.
That having been said, actions like the bailout of Bear Sterns are, IMO, something that should have required Congressional approval.
One other thing to consider when talking about Fed independence – are we talking specifically about the FOMC and the board of governors, or about the Federal Reserve System itself, including the member banks?
“For instance, the big reason that bank runs happen is that depositors go to yank all their funds out at once, when those institutions are set up to handle only a comparatively small proportion of those holdings being withdrawn on any day.”
But in the case of Bear Stearns it was not depositors. Rather, it was the other financial institutions who got frightened and pulled their lines of credit, virtually overnight. Changing depository agreements will keep Grandma from pulling her money just because she heard a rumor, but it won’t keep Scrooge & Marley from making huge margin calls.
Unlike the Great Depression, individuals have been surprisingly disconnected with this crisis; other than the Northern Rock incident, it has not been individual depositors who have forced institutions under. Rather, it has been the network of relationships between the institutions which have proven to be the weak point, and it has been rumors flying through that network (based, as pointed out above, on very real solvency concerns) that have been bringing down institutions.
“I don’t believe that monetary policy decisions should be made by Congress, that would be a nightmare. Also, exigent circumstances require speed and agility, something Congress does not possess.”
Monetary policy decisions, perhaps not. But what about the management of the economy? If I am reading Yves correctly, that is the complaint–that the Fed has taken over management of the economy, which is not, strictly speaking, within its purview. Congress has the power over the economy, but Congress was content to sit idly by and watch while Alan Greenspan unilaterally took over much of the control of the economy during his tenure. That has proven to be a huge mistake.
I too had hoped that Congress would reclaim some of its authority during the Bear Stearns hearings, but it clearly did not do so. I suspect that the members of Congress are too frightened of the crisis to face it directly, and the plan is to leave the Fed “managing” the crisis back here in Washington while they are on the campaign trail. I do not think it will be that easy, and I do think the voters will notice, and I do think that there will be consequences for the shirking of responsibility come November.
I completely agree with Leijonuvfud’s line that democracies cannot afford to make leave essentially political decisions to technocratically controlled bodies, like independent central banks.
I wrote a piece on this theme on openDmeocracy.nehttp://www.opendemocracy.net/article/responsible_recessionst in early April called Responsible Recessions that emphasises the “responsibility hazard” that most of us are in as voters. It was, utlimately, a call for us to take social responsibility for the recessions we suffer:
“
Central banks should not be depoliticised, turned into mere administrators of a rule in this way. That is because the judgments that they must make – do we give a shock to a failing economy? do we dampen exuberance? – need to be part of the social compact. Did all of us together feel that we were implicated in the 2001 decision, or in the subsequent decisions not to raise interest rates as the asset price bubble took off? Now that the expensive rescue of the financial sector is upon us, do any of the rest of us feel that this is part of a social process we controlled?
No. Many of us are now enjoying our own moment of “responsibility hazard”: while the financial system went into orbit, where were we? Were we asking our governments to discipline financial markets, or to abandon inflation targeting? Maybe we wanted to believe it was true: post-inflation, asset-owners feeling wealthier every week, the big economies of the global south soaring into advanced liberal capitalism … And if we did not do the responsible thing then, we cannot be confident in our condemnations of the financial sector today.
There is an ultimately impossible asymmetry in a system of government that will have governments fall on economic outcomes – ”it’s the economy, stupid” – and yet makes economic policy something operated by technocrats in a language that excludes most of the population. If the system of government infantilises the governed in this way, expect populist crowd-pleasers to come now in place of honest regulation.
“
Bernanke’s criticism of the 1930’s Fed was that 1) they were too focused on the dollar and therefore allowed the monetary base to contract; and 2) in their role as lender of last resort, they allowed too many banks to fail.
Bernanke’s actions since last August have emerged from the following chain of logic:
-blame for the Depression rests on the 1930’s Fed’s shoulders.
-the Depression was on of the worst single events in our history.
-therefore, the Fed should act to do practically anything it can to prevent another Depression.
I don’t think the criticism over moral hazard or inflation will change Bernanke’s mind. It is likely that if unemployment accelerates the Fed will continue to run the “Depression avoidance” drill.
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Interesting conversation, but I find it to be somewhat circular.
I think a better question would be ‘CAN the Fed be independent’? That is, can an institution created through the coercive powers of government be independent from its creator? I would argue a resounding no.
You must post the clip of Gasman mentioning you on CNBC – you have made the big time although he said you have two things working against5 you: the name and that you went to Harvard. Gashole obviously never heard the saying show me someone who makes personal attacks and I’ll show you someone who is losing the argument. He is so opathetic he is suggesting that you are a short on the stock. Perhaps if he actually read the posts he would get it right, as in that is outside your purview.
If a central bank knows that a bank is sound, of course it should ruch to rescue. But again, what does a central bank know?
Anyone who thinks that is going to happen with 76 million Boomer’s about ready to retire and all the money for SS and Medicare having already been spent is smoking crack.
Printing presses away.
“ie., if any of the $29 billion in liabilities assumed by the Fed in that rescue comes a cropper, the cost comes from the public purse”
The Fed released Flow of Fed Funds for the first quarter. In section F.108, assets and liabilities of Federal Reserve Banks and Treasury monetary accounts that supply or absorb bank reserves, bank loans n.e.c. were listed as assets of $159 billion, for the first time.
As far as I can tell “not elsewhere classified” (n.e.c.) does not mean that these loans are investment grade. The Fed has told us that the collateral they accept in exchange for treasury securities at the discount window, has to be investment grade.
I assume that Bear’s $29 billion and other collateral from commercial banks and broker dealers are part of the $159 billion. These loans could be highly illiquid collateral with no market dumped on the Fed’s balance sheet.
Is this something the taxpayer should be concerned about?
This Business Week article gives a good description of the Bear facility, which it not at all like its discount window or Term Auction Facility. For instance:
What the Fed is calling a $29 billion “loan” to help finance JPMorgan Chase’s (JPM) purchase of Bear Stearns (BSC) looks much more like a $29 billion investment in securities owned by Bear. Although the Fed insists that it isn’t technically buying any assets, in practical terms it’s doing exactly that.
Wow, quite a bunch of comments. Everything from pseudo academic posturing to a few rants. Here are my thoughts:
1. A great thought provoking article.
2. Bernanke and company stepped over the line but where were the other agencies (FDIC, Sec etc.), congress and the administration. It should have been a colaborative effort but they, in my opinion, used the Fed for cover.
3. The Fed is over run with academics who are itching to try out theory in the real world. Say what you will about Greenspan but at least he knew the business side of the economy. Volker was much the same. I guess the last time we had a professor running the Fed was the inimitable Arthur Burns and we know how he managed things.
I have advocated the repeal of the Federal Reserve Act since 1980. The republic survived without a central bank from 1837-1913 and could survive without one again. The Fed independent? Hahahahaha as the Mogambu Guru would say.
IA,
Will grant the Fed’s independence has been a joke of late, but Bernanke may be a one-term Fed chair and a lot of other seats are open too, so who knows what we will have in a year.
Regarding no central bank, a very good article in Palgrave’s Dictionary of Money & Finance (which since I am turning in I am afraid I will need to check later) argues that the US has had two central banking traditions, one of which had the central banking functions performed by the Treasury. I am fairly certain that was during the period you cited. That turned out not to work so well in the end, hence the Fed.
These arrangements are always in reaction to the last set of problems. They succeed for a while, then devolve. The nature of human affairs, I suppose.
This should be the proposal today:
The 1961 commission on Money & Credit recommended increased coordination of examining and supervisory authorities. At the federal level, it was recommended that there should be only one examining authority for commercial banks. The Comptroller of the Currency and his functions and the Federal Deposit Insurance Corporation should be TRANSFERRED TO the Federal Reserve System. The Commission on Money & Credit would leave the state supervisory agencies intact, but would coordinate their to a greater extent with the Federal Reserve in banks all federal regulation and supervision would be concentrated.
The Fed needs immunized from powerful special interest groups, i.e., the commercial bankers.