Tyler Cowen’s Misguided Morality Play

I’m late to this item, and I probably should let it go, but it is so disingenuous (I’m tempted to say intellectually dishonest) that I can’t let it go by.

On Sunday, the New York Times ran an “Economics View” article, “It’s Monetary Policy, Not a Morality Play,” by Tyler Cowen, well known libertarian and professor of Economics at George Mason. Dean Baker already had a go at it, but there are some elements that he didn’t address that need to be examined.

Cowen starts by painting a picture of a Fed beset by objections to interest rate cuts because they might bail out financial fat cats:

Wherever there are problems, people look for villains. The subprime mortgage crisis is a case in point. Hedge fund managers and speculators have been blamed for buying securitized loans heedlessly and spreading financial risk beyond the banking sector.

And since every villain must be punished, the Federal Reserve is being attacked as “bailing out the speculators.” Because it has injected additional liquidity into the economy, and kept short-term interest rates from rising, the Fed has been portrayed as a craven tool of the rich, in the pocket of Wall Street but neglecting the concerns of Main Street.

But financial markets rarely fit into simple moral narratives, and much as these stories may comfort many of us, they are not a good guide to understanding financial policy. Talk of a bailout is overstated. Some institutions have benefited from Fed policy, but the story is not a conspiratorial one: liquid markets are good for many investors, and if the Fed succeeds in keeping markets running, that helps hedge funds, too.

Notice the use of passive voice in the first two paragraphs. Not once does Cowen identify who might be calling for the Fed not to come to the aid, indirectly, of hedge funds and investment banks. Given the condescending tone of the third paragraph, you’d assume it was the unwashed populists, like Congressmen and the press, who are leading these calls (to the extent they exist, Cowen is overdramatizing) while by implication, the cool-headed pros are in favor of a rate cut.

If anything the reverse is true. The Financial Times and çentral banker Willem Buiter both commented disapprovingly on how Bernanke appeared to have been corralled by Henry Paulson and Senate Banking Committee chair Christopher Dodd into letting Dodd speak for Bernanke and say he was prepared to use “all available tools” to save the markets. Both saw this as a sign of a badly politicized Fed, and secondarily, of considerable pressure to cut rates. Even Congressman Barney Frank, chairman of the House Financial Services Committee and a card carrying friend of labor, has called for a “meaningful” rate cut.

The pols see the interests of homeowners, the battered real estate industry, and to a lesser degree, banks, as paramount. Democrats, the ones you’d expect to take a populist line, have been eager to see the Fed cut rates. The only article I have seen that fits Cowen’s stereotype is “Moral Hazard” by Robert Reich, in which he objects to Fed rate cuts and other government assistance to the rich without corresponding measures to the poor. If Cowen was addressing Reich’s piece, then say so, rather than making it sound as if he was the voice of a vast left-wing conspiracy.

No, the concern about bailing out the hedgies has come, for the most part, from professional economists and the Fed itself. Here are just a few examples.

The Financial Times’ Martin Wolf, in “Central Banks Should Not Rescue Fools“:

This then is a crisis in the market for financial lemons. So what should the authorities do about that? My answer is “nothing”. They should, of course, stand ready to provide liquidity to the market, at a penal rate (since insurance should never be free), and also to adjust interest rates to overall macroeconomic conditions. But they should not promote the survival of a market in lemons….

Burned children fear the fire. If some of the biggest and most powerful institutions in the world have been playing with fire, they need to feel the burns. It is not the central banks’ job to rescue them by creating a market in the incomprehensible. It is their job to preserve the banking system and the health of the economy. Neither seems now to be in grave danger.

Decisions made in panic are almost always bad ones. Stick to principles and let the masters of the financial system sort themselves out. They are paid enough to do so, after all.

An earlier Wolf comment:

Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust.

When William Poole, chairman of the St Louis Federal Reserve, said that “the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves”, I gave a cheer.

Not so Jim Cramer, hedge fund manager and television pundit, who declared last Friday that chairman of the Federal Reserve, Ben Bernanke, “is being an academic!…My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! . . . The Fed is asleep.”

So capitalism is for poor people and socialism is for capitalists. This view is not just offensive. It is catastrophic.

Here we have Raghuram Rajan, professor of finance at the University of Chicago:

Because of the self-fulfilling nature of liquidity, small interventions can sometimes revive moribund markets, seemingly at low cost. However, there are indeed costs, perhaps significant ones. First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious – much as a government-funded recapitalisation hurts the taxpayer. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it. As such strategies build on each other they will eventually overwhelm the abilities of even the most deep-pocketed interventionist central bank. Thus, even from the perspective of moral hazard, the distinction between liquidity infusions and recapitalisations is fuzzy indeed.

So what should a central bank do in a time of market turmoil? It should clearly lend freely against unimpeachable securities and also maintain a liquid market in such securities. Anything more is problematic. To intervene by making a market in illiquid securities as some have suggested, or in illiquid assets such as housing, may be to imbue those securities or assets with a liquidity they never should have had and thus distort their value.

And we have Avinash Persaud, chairman of Intelligence Capital Limited and an emeritus professor at Gresham College, London:

Can lower interest rates temper investor losses? Yes, if the problem is caused by a temporary lack of liquidity; no, if it is caused by a “de-rating” of asset quality, as is occurring today. Cutting interest rates for everyone does not encourage investors to take more care in the future. Each of the emergency rate cuts referred to above spawned an asset bubble.

And we also have Henry Kaufman:

At the heart of the long-term underlying challenges that face the U.S. financial system is the question of how to enforce discipline. One way is to let competitive forces discipline market participants: The manager who performs well prospers, while those who do not fail. This is the central precept of free market economies. But this approach is compromised by the fact that advanced societies typically do not allow the process to follow through when it comes to very large financial institutions. The fear is that the failure of behemoth financial institutions will pose systemic risks both here and abroad.

Therefore, market discipline falls more heavily on smaller institutions, which in turn motivates them to merge into larger entities protected by the too-big-to-fail umbrella. This dynamic has driven financial concentration and will continue to do so for years to come. As financial concentration increases, it will undermine marketability, trading activity and effective allocation of financial resources.

If competition is not allowed to enforce market discipline, the most viable alternative is increased supervision over financial institutions and markets.

None of the economists quoted above is considered to be radical; they are all mainstream. (we haven’t even gotten to the views of the camp that has been alarmed about speculation all along, such as Nouriel Roubini, Andy Xie, and James Grant.)

Further note that Martin Wolf cited St. Louis Fed chairman William Poole as being opposed to intervention beyond that needed to stem damage to the real economy or to keep the markets functioning. In the same spirit, Philadelphia Fed President Charles Plosser remarked this weekend:

Thus, the Fed does not seek to remove volatility from the financial markets or to determine the price of any particular asset; our goal is to help the financial markets function in an orderly manner. I agree with Chairman Bernanke that we should not seek to protect financial market participants, either individuals or firms, from the consequences of their financial choices.

So here we have at least three high ranking Fed officials, including Bernanke himself, reluctant to bail out market participants who have created their own problems. Yet Cowen presents them as pressed by unnamed forces to adopt this view, when it appears to be widely held among members of the Fed itself, and among well respected economists.

What is dishonest about Cowen’s presentation is that he appears to be deliberately confusing the notion of “moral hazard” with morality. Now economists will admit that the term of art “moral hazard” is inapt, since it does carry unintended ethical connotations (the more technically minded might invoke “hidden actions” and contract theory). But the underlying concern is legitimate.

Moral hazard refers to the adverse effects that insurance can have on the behavior of the insurance. Cheap water damage insurance might make homebuilders too cavalier about building on flood plains. Similarly, fire insurance policies can encourage arson.

The groundbreaking work by Kenneth Arrow in this area suggests that it is difficult to organize the complete set of markets needed to achieve first level efficiency in contracting. The layperson’s translation is that moral hazard is a persistent problem.

Moral hazard, despite its name, is not an issue of equity but efficiency. Arson, for example, both destroys houses and rips off the insurance company, increasing insurance policy prices for everyone else. Similarly, reckless financial risk taking diverts capital and other resources from more productive uses (for example, hedge funds and Wall Street trading desks have drained the mathematical talent of many elite schools away from careers in science).

But Cowen turns the argument on its head. It’s the defenders of capitalism who would like to see the profligate risk takers suffer (to the extent that can be done without creating too much collateral damage), but Cowen would have us believe that anyone who criticizes the operation of market, even ones with flawed incentives that generate bad outcomes, is either economically illiterate or a socialist.

Update 9/10, 3:30 PM: The folks at Overcoming Bias noticed that “Tyler Finds Overcoming Bias Is important, For Others“:

On Aug. 15, Tyler Cowen didn’t think much of overcoming bias, at least in himself….

On Sept. 9, Tyler thinks others should try hard to overcome bias in policy stories….

Yup, other people sure need to overcome their biases :) Seems Tyler did fall for the confident proposer bias, by assuming we place a huge priority on overcoming bias. But he (and Arnold) never responded to my request for clarification, so I can’t really tell.