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November 30, 2008

Economist's View - 2 new articles

Bigger is Better

Joe Stiglitz:

A $1 Trillion Answer, by Joseph E. Stiglitz, Commentary, NY Times: What President-elect Barack Obama will need to do is horribly complicated but also very clear.

First, he must stop the economy from going deeper into recession. Then he needs to bring about a robust recovery, preferably in ways that support the long-term needs of the United States: by repairing our neglected public works, invigorating our technological leadership, making our society greener, fixing our health care problems, healing our social and economic divide, and restoring our social compact.

It will not be easy. President Bush's legacy of debt and the opposition of those who benefit from the status quo present major obstacles.

There is an emerging consensus among economists that a big — very big — stimulus is needed, at least $600 billion to $1 trillion over two years. Mr. Obama's announced goal of 2.5 million new jobs by 2011 is too modest. In the next two years, almost four million workers will enter the labor force — or would if there were jobs. Combined with the loss of employment this year, that means we should be striving to create more than five million jobs.

A large stimulus package can always be trimmed later if it's not needed... Faint measures would be foolhardy. A weaker economy will suffer lower tax revenues, more foreclosures and more bankruptcies. Once a firm is bankrupt, you can't unbankrupt it by providing a stronger stimulus later on. ...

But what you do with the money counts... The money needs to be spent carefully to ensure that every dollar provides as much stimulus now as possible while also contributing to long-term growth. ...

Americans are rightly afraid of losing their jobs, and with that, their health insurance and their homes. We need to provide health insurance to the unemployed and to the uninsured, and we need to do it quickly, possibly through an expanded and more efficient Medicare.

We also need to stem the flood of foreclosures. If we help poorer homeowners, banks will benefit, too... And we need to change the bankruptcy laws to help homeowners. ...

Deregulation and the failure to adopt regulations to cover risky new financial products have contributed much to the current mess. So far, we have merely given banks more money to spend recklessly. We have done little to change the banks' incentives or constraints. ...

If the asset program is not changed and if regulations are not imposed to change the behavior of those who got us into this situation — who enriched themselves at the expense of their shareholders — then confidence will not return. Those who got us into this crisis cannot have undue influence in shaping the response.

America has great assets, including a productive labor force and the best universities in the world. None of these assets so far has been impaired by Wall Street's follies. These strengths, coupled with a sensible and fair economic stimulus package and judicious regulation, will help our economy recover.

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November 29, 2008

Economist's View - 3 new articles

The Need for Reliable Information

There has been much debate about whether the financial crisis is driven by lack of liquidity or from fears about lack of adequate capital and solvency, but I'm starting to think a third component is important as well, the complete breakdown of traditional information flows, and a loss of confidence in the models used to evaluate that information. Markets need information to work properly, and the information financial markets need is not available.

For example, investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers? And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery? Investors no longer trust analysts and the models they use. They watched the business channel dutifully and all they heard was about the gold mine in housing. Sure, there were a few voices on the other side, but they were in the minority and mostly marginalized. All that bullish advice about housing turned out to be wrong. And there's no reason investors should trust the models used to process information either. The models used for risk assessment turned out to be far wide of the mark - a costly deviation - and if you go back and look at the Fed's forecasts of coming economic conditions (or the forecasts coming from the regional banks), it's very clear the models were underestimating the severity and length of the downturn, enough so to be relatively useless. At a more individual, face to face level, I suspect their are many homeowners who believed what their real estate or mortgage broker told them are now wondering how they could have been so foolish. They won't believe them next time. They won't know what to believe.

As I think through each stage of the mortgage process and what has gone wrong, it seems to me that the traditional information flows that are needed for people to make economic decisions, especially risky ones, are no longer present, or if they are present, simply not believed. And without the information people need to make decisions, the markets freeze up.

It's the feeling you have when you suddenly discover that everything you thought you knew about something, something you believed and relied upon for years, is wrong (like when you find out something your parents told you just isn't so). Those are moments that can stop you in your tracks while you reevaluate and figure out what it all means, while you take time to figure out how you should respond in the future.

We have recognized that liquidity and solvency are problems, and we have directed policy to try to address those problems, but I am not sure we are devoting enough attention to repairing the collapsed information structure. You can get around the problem through government guarantees or other types of insurance, but those create other problems, so it's best to avoid this if possible. However, it's going to be difficult to convince people they can trust this information again, people won't easily believe a ratings agency, real estate agent, risk assessment model, etc. just because someone announces that the problems are all fixed now, models can't be repaired overnight, so on some fronts time may be the only real solution. But on other fronts, perhaps we can do better. This is not my area, so maybe what we can do is limited here too, but is there more that the government could do, for example, with accounting standards or required disclosures that would help people evaluate the stability of a particular institution? Are there changes that could be made to give buyers and sellers more confidence that the people acting as their agents in the transaction have the right incentives? Is there some way to immediately change the regulation and structure of the ratings agencies that can help to restore confidence in their assessments of risk? The point is that we need to move now to start repairing the problems that are limiting the availability of information needed for these markets to function.

Perhaps the most important thing the government could provide is confidence in bank balance sheets. There are lots of ways to do this, e.g. the government could purchase toxic assets through auctions, and the auctions would serve as value discovery mechanisms, the government could flood the banks with capital so that there was no doubt about their solvency, or it could simply put a price floor under some of the assets on the books, i.e. say that they stand ready to buy any and all of a particular class of asset at a pre-set price (heavily discounted). People could then put a lower bound on the value of the asset side of the balance sheet, and they wouldn't have to worry that the banks own actions or events outside the institutions control - an unanticipated failure of another bank that undermines a class of assets in its portfolio - won't suddenly change it's balance sheet position beyond a known amount. Somehow people need to be able to evaluate the bounds of the risks they are taking.

Big shocks don't necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets. I don't think the crash, for example, caused us to question the reliability of the information we receive the way this episode has. After the crash, we still thought we understood how to use models to process reliable information. But this crisis has destroyed confidence in the information and the models we use, and it won't be easy to bring this back.

As noted above, while there may be some steps the government can take to help, solving this problem won't be easy, it will take time to repair the models and the information flows. That will eventually happen, but in the short-run the government must find some way around the problem. One way, the best way I can think of, is through insurance (e.g. the price floor above) and I hope we will see more movement along these lines. The deal with Citibank can be viewed as a step in this direction (there is a 29 billion dollar deductible and a 10% copay in the insurance they were provided - see the update at the end of this post), but more can be done - more must be done - to overcome the lack of reliable information in these markets.

"The Road to Depression"

Brad DeLong says two big mistakes made the crisis worse:

The Road to Depression, by Brad DeLong, Project Syndicate: For 15 months, the United States Federal Reserve, assisted by the financial regulators of the US Treasury, have been trying..., above all, to avoid a deep depression.

They have also had three subsidiary objectives:

  • Keep as much economic activity as possible under private-sector control, in order to ensure that what is produced is what consumers really want.
  • Prevent the princes of Wall Street ... from profiting from the systemic risk that they created.
  • Ensure that homeowners and small investors do not absorb too much loss, for their only "crime" was to accept bad risks, which they would not have done in a world of properly diversified portfolios.

Now it is clear that the Fed and the Treasury have lost the game. If a depression is to be avoided, it will have to be the work of other arms of the government, with other tools and powers.

The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. Had the Fed and the Treasury given those two objectives their proper - subsidiary - weight, I suspect that we would not now be in this mess...

The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse... The logic behind that decision was that, previously in the crisis, equity shareholders had been severely punished...

But this was not true of bondholders and counterparties, who were paid in full. The Fed and Treasury feared that the lesson being taught in the last half of 2007 and the first half of 2008 was that the US government guaranteed all the debt and transactions of every bank and bank-like entity that was regarded as too big to fail. That, the Fed and the Treasury believed, could not be healthy.

Lenders to very large overleveraged institutions had to have some incentive to calculate the risks. But that required, at some point, allowing some bank to fail...

In retrospect, this was a major mistake. ... With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion..., but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Yes, this is what might be called "lemon socialism," creating grave dangers for corporate control, posing a threat of large-scale corruption, and establishing a precedent for intervention that could be very dangerous down the road.

But would that have been worse than what we face now? The failure to sacrifice the subsidiary objective of keeping the private sector private meant that the Fed and the Treasury lost their opportunity to attain the principal objective of avoiding depression.

Of course, hindsight is always easy. But if depression is to be avoided, it will be through old-fashioned Keynesian fiscal policy: the government must take a direct hand in boosting spending and deciding what goods and services will be in demand.

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November 28, 2008

Economist's View - 4 new articles

Krugman: What to Do

More from Paul Krugman. This is from the New York Review of Books (there's much more in the original):

What to Do, by Paul Krugman, NY Review of Books: What the world needs right now is a rescue operation. The global credit system is in a state of paralysis, and a global slump is building momentum as I write this. Reform of the weaknesses that made this crisis possible is essential, but it can wait a little while. First, we need to deal with the clear and present danger. To do this, policymakers around the world need to do two things: get credit flowing again and prop up spending.

The first task is the harder of the two, but it must be done, and soon. Hardly a day goes by without news of some further disaster wreaked by the freezing up of credit. ...

Even if the rescue of the financial system starts to bring credit markets back to life, we'll still face a global slump that's gathering momentum. What should be done about that? The answer, almost surely, is good old Keynesian fiscal stimulus. ...

I believe not only that we're living in a new era of depression economics, but also that John Maynard Keynes—the economist who made sense of the Great Depression—is now more relevant than ever. Keynes concluded his masterwork, The General Theory of Employment, Interest and Money, with a famous disquisition on the importance of economic ideas: "Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

We can argue about whether that's always true, but in times like these, it definitely is. The quintessential economic sentence is supposed to be "There is no free lunch"; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes's world—and ours—was therefore not of resources, or even of virtue, but of understanding.

We will not achieve the understanding we need, however, unless we are willing to think clearly about our problems and to follow those thoughts wherever they lead. Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

Paul Krugman: Lest We Forget

Financial reform and regulation of the shadow banking system cannot wait:

Lest We Forget, by Paul Krugman, Commentary, NY Times: A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, "Why didn't we see this coming?"

There was, of course, only one thing to say...: "What do you mean 'we,' white man?"

Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but ... there were plenty of precedents... Yet these precedents were ignored. And the story of how "we" failed to see this coming has a clear policy implication — namely, that financial market reform ... shouldn't wait until the crisis is resolved. ...

Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was "resilient," as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer ... is that nobody likes a party pooper. While the housing bubble was still inflating, lenders[, investment banks, and money managers] were making lots of money... Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

There's also another reason the economic policy establishment failed to see the current crisis coming. ... [T]he crisis of 1997-98... showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers "The Committee to Save the World"... who "prevented a global meltdown." In effect, everyone declared ... victory..., while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears,... investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed ... prudential regulation of the financial system.

Now we're in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. ...

And because we're all so worried about the current crisis, it's hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be ... regulating the "shadow banking system" at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn't, and the urgency of action will be lost.

So here's my plea: even though the incoming administration's agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.

The Need for a Lender of Last Resort

How important is the lender of last resort role played by central banks?:

Financial markets and a lender of last resort, by Eric Hughson and Marc Weidenmier, The recent subprime mortgage crisis raises serious questions about the role of a lender of last resort and the appropriate role of monetary policy. Academics, policymakers, and the financial press have debated the extent to which central banks should intervene in the marketplace, provide liquidity, and even purchase the non-performing assets of troubled financial institutions. Although economists, Washington insiders, and the media may debate the extent to which the lender of last resort function should be intensified in wake of the current financial market meltdown, proponents and opponents of monetary policy generally agree that it is very difficult to identify the effect of the lender of last resort function on financial markets.

Fortunately, history provides some insight into the importance of a lender of last resort in dealing with a financial crisis, especially the provision of liquidity by financial institutions to help cash-strapped firms in the short run. Following the Panic of 1907, which was accompanied by one of the shortest but most severe financial crises in American history, the US Congress passed two important pieces of legislation that established a lender of last resort: (1) the Aldrich Vreeland Act of 1908 which allowed banks to temporarily increase the money supply during a financial crisis, and (2) the Federal Reserve Act of 1913 which replaced Aldrich-Vreeland and established a public central bank in the US (Moen and Tallman, 2000).

The two acts were designed to increase the elasticity of the money supply, which was largely fixed by the supply of gold and the requirement that banks could only issue notes if they were sufficiently backed by US government bonds. The money supply was especially inelastic during the fall harvest seasons when the financial markets tended to be illiquid as cash moved from the money centre banks to the interior to finance the harvesting of crops. The financial stringency made New York financial market vulnerable to banking and financial crises in the fall as financial institutions were often forced to call in stock market loans in response to large unexpected withdrawals of cash in response to a greater than expected harvest season. Indeed, several of the largest financial crises of the National Banking Period (1870-1913) occurred during the fall harvest season including 1870, 1890, 1893, and 1907 (Kemmerer, 1910; Miron, 1986; Sprague, 1910).

A lender of last resort reduces financial volatility

In work with Asaf Bernstein, we use the seasonal nature of financial crises during the National Banking Period as an identification strategy to isolate the impact of the introduction of a lender of last resort on financial markets (Bernstein, Hughson, and Weidenmier 2008). We compare the standard deviation of stock returns in September and October over time before and after the introduction of a lender of last resort. The identification strategy should isolate the effects of the lender of last resort function on interest-rates and stock returns from other macroeconomic shocks. Wohar and Fishe (1990), for example, argue that World War I and the closure of the New York financial markets played an important role in the change in the stochastic behaviour of interest rates, in addition to the founding of the Federal Reserve. Given that these events all occurred around the same time, they argue that it is difficult to separate out the effects of these different events on interest rates. Our strategy enables us to identify the effect of the introduction of the lender of last resort because if the lender of last resort is responsible for what we find – lower volatility in financial markets - the effect should be largest in September and October.

We investigate stock volatility for two reasons: (1) stock volatility typically rises prior to the onset of a recession (i.e., the current financial crisis) and (2) given the poor quality of high frequency macroeconomic data from the National Banking Period, we can use stock volatility as a metric to provide some insight into the chicken and egg problem: do financial crises have real effects or do real shocks cause financial crises? If the former is true, then the introduction of a lender of last resort should reduce financial market volatility. As shown in Figure 1, stock volatility was more than 40% lower in the pre-lender of last resort period (1870-1908) versus the period 1908-1925. Although we find that stock volatility in September and October was larger than the other ten months of the year prior to the monetary regime change, this was no longer true after the introduction of a lender of last resort. We find similar results using the call loan interest rate, the interest rate financial institutions charged investors to buy stocks on margin. Figure 2 shows that interest rate volatility declined more than 70% in the months of September and October after the establishment of a lender of last resort. These volatility reductions are statistically significant at conventional levels.



The dramatic decline in volatility during the months of September and October has several implications for today's policymakers and the current global financial crisis. First, financial crises can have large economic effects. Second, the provision of liquidity by a lender of last resort can be very important for containing the spread of a financial crisis that can have significant macroeconomic economic effects. Third, the reduction in uncertainty associated with a lender of last resort is likely to increase investment and shorten the duration of recessions. Fourth, while our analysis provides some insight into the importance of containing a liquidity crisis, it has less to say about the role of a lender of last resort when the solvency of financial institutions is uncertain.


Bernstein, Asaf, Hughson, Eric, and Marc D. Weidenmier. (2008). "Can a Lender of Last Resort Stabilize Financial Markets? Lessons from the Founding of the Fed." NBER Working Paper.
Kemmerer, E.W. (1910). "Seasonal Variations in the New York Money Market." American Economic Review 1(1):33-49.
Miron, Jeff (1986). "The Nominal Interest Rate, Seasonality, and the Founding of the Fed." American Economic Review.
Moen, Jon and Ellis Tallman. (2000). "Clearinghouse Membership and Deposit Contraction during the Panic of 1907." Journal of Economic History 60(1):145-63.
Sprague, O.M. (1910). "A History of Financial Crises under the National Banking Period." Washington: U.S. Government Printing Office.
Fishe, R. P. H. and M Wohar (1990). "The Adjustment of Expectations to a Change in Regime: Comment." American Economic Review 80(4): 531-555.

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November 27, 2008

Economist's View - 4 new articles

Giving Thanks for Economists. Or Not.

Martin Wolf says " one of the big lessons of this experience is that economics is too compartmentalized":

A time for humility, Speech by Martin Wolf, FT: Last year I enjoyed telling a number of entirely unfair jokes about economists. This year, I looked at the same source and found only one joke about the profession's involvement in depressions. Here it is:

Such a severe depression and banking crisis could not have been achieved by normal civil servants and politicians, it required economists' involvement.

This, in short, is a time for humility. Why did we mostly get "it" so sensationally wrong? ... It is a pretty good question. It is a pretty embarrassing one, too. It is one everybody I meet now asks. ...

Perhaps this was more than could reasonably be expected. But I do think we need to ask ourselves whether we could have done a better job of understanding the processes at work.

The difficulty was that we all tend to look at just one bit of the clich├ęd elephant in the room. Monetary economists looked at monetary policy. Financial economists looked at risk management. International macroeconomists looked at global imbalances. Central bankers focused on inflation. Regulators looked at Basel capital ratios and even then only inside the banking system. Politicians enjoyed the good times and did not ask too many questions. And what of commentators? Well, they tended to indulge in the fantasy that the above knew what they were talking about. I am embarrassed to admit this.

I am not seeking to deny that a few people saw important pieces of the emerging puzzle and some saw more than a few pieces. ... But I would insist that one of the big lessons of this experience is that economics is too compartmentalised and so, too, are official institutions. To get a full sense of the risks being run, we needed to combine the worst scenarios of each sets of experts. Only then would we have had some sense of how the global imbalances, inflation targeting, the impact of China, asset price bubbles, financial innovation, deregulation and risk management systems might interact.

Alternatively, we could have spent more time studying the work of Hyman Minsky. We could also have considered the possibility that, just as Keynes's ideas were tested to destruction in the 1950s, 1960s and 1970s, Milton Friedman's ideas might suffer a similar fate in the 1980s, 1990s and 2000s. All gods fail, if one believes too much. Keynes said, of course, that "practical men … are usually the slaves of some defunct economist". So, of course, are economists, even if the defunct economists are sometimes still alive.

These might seem idle thoughts: these errors are now bygones. But what if we are now making new and even bigger errors in rushing back to Keynes? The thought worries me. What if now that households in the US and UK are no longer able, or willing, to borrow any more, we are set on breaking the back of taxpayers, instead? Is the end of this crisis the destruction of the credit of some of the world's most creditworthy governments? It is a thought I would like to suppress. But it haunts me. It should haunt you, too. ...

One might not expect much from economists, but one would surely expect them to warn us of a crisis on this scale. Some humility is in order. That is going to hurt. A humble economist? Surely not.

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"The Moral Stage of Wall Street"

George Packer wants Wall Street executives to grow up and apologize for their behavior:

The Moral Stage of Wall Street, by George Packer: Swiss bankers are not known as paragons of transparency and moral accountability, so it's a nice surprise to read that the top officials of UBS, the foundering financial institution recently bailed out by the Swiss government, will forgo twenty-seven million dollars in compensation and bonuses. It appears that these Swiss bankers have a faint pulse of shame.

It has not gone remarked upon enough that their American counterparts apparently have none. Having brought the American and global economy to its knees through their reckless, short-sighted, downright stupid investments, and then looked to the government for a very expensive lifeline, the leaders of Citigroup, A.I.G., Goldman Sachs, Morgan Stanley, Lehman, and other financial giants are maintaining a carefully nonchalant public posture. Andrew Cuomo, New York's Attorney General, had to hold a threatening press conference on Wall Street in order to frighten A.I.G. into announcing that raises, bonuses, and lavish retreats will be suspended. But fear is not the same thing as shame. Morally speaking, it's inferior.

The moral code of these Wall Street executives corresponds to stage one of Lawrence Kohlberg's famous stages of morality: "The concern is with what authorities permit and punish." Morally, they are very young children. The Swiss bankers are closer to stage four, most common among late teens, where a concern for maintaining the good functioning of society takes hold. Stage six, an elaboration of universal moral principles based on an idea of the good society, is a distant dream for the titans of global finance.

In private life, extreme indebtedness, bankruptcy, the ruin of those close to you, and dependence on the government dole are generally thought to be causes for anguish, self-denial, and a degree of shame. But if you're a financial executive with an exalted title, a big enough salary, a deep enough debt, and a vast enough handout, these same disasters entitle you to go on living and feeling about yourself much as you did before. You even have a right to think that the taxpayers owe it to you—that it's for their own good, not yours. You don't have to explain yourself; you certainly don't have to apologize.

I would like to see these malefactors of great wealth apologize to the country. I would like to see them organize their own press conference in a lineup on Wall Street and, in the manner of disgraced Japanese officials, bow low to the pavement, express contrition, and beg their countrymen's forgiveness. Such a scene would go some way toward cleansing the smell of the financial crisis.

Of course, nothing like this is going to happen. So instead, like the parents of two-year-olds, the next Congress should summon them to Washington and publicly punish these executives who, in Kohlberg's terms, "see morality as something external to themselves, as that which the big people say they must do."

Update: Arnold Kling comments:

I tend to agree with Tyler Cowen that individual moral propensities are less important than overall social context. To borrow from a different branch of social psychology, I would say that Packer is committing the Fundamental Attribution Error.

In my view, the problem comes from trying to use what I call letter-of-the-law regulation in finance. Call it L regulation. With L regulation, the regulator lays down specific, quantitative boundaries (think of risk-based capital requirements, with fixed numerical weights for various types of assets). The managers of financial institutions are told to stay within those boundaries.

In contrast, think of something I might call S regulation, for spirit of the law. With S regulation, the manager of a financial institution that enjoys some government protection would take an oath to maintain the safety and soundness of the institution. With S regulation, it is wrong to just tiptoe along the edge of the quantitative boundaries, without considering the potential risk to the firm.

Suppose we take it as given that government is going to protect some of the liabilities of some institutions, because of deposit insurance, implicit guarantees, "too big to fail," or other reasons. I would like to see such institutions be covered by S regulation even more than by L regulation.

I would like to see managers of government-protected institutions take an oath to safeguard the soundness of their companies. I would like to see them subjected to prison terms for violating that oath. The oath is a general promise, not satisfied simply by staying within the boundaries of L regulation.

I believe that S regulation would change the motives of bank managers. They would be looking for ways to avoid failure, rather than for ways to stay within the letter of the law.

There can be plenty of risk-taking institutions in our society. But they should not at the same time be institutions that enjoy government protection when they fail.

"The Rebirth of Keynes, and the Debate to Come"

Robert Reich on the question of tax cuts versus government spending as a stimulus measure:

The Rebirth of Keynes, and the Debate to Come, by Robert Reich: The economy has just about come to a standstill... Consumer spending has fallen off a cliff. Investment is drying up. And exports are dropping because the recession has now spread around the world.

So are we about to return to Keynesianism? Hopefully. Government is the spender of last resort, which means the new Obama administration should probably be considering a stimulus package in the range of $600 billion, roughly 4 percent of national product -- focused on building and repairing the nation's crumbling infrastructure, providing help to states to maintain services, and investing in new green technologies in order to wean the nation off oil.

But between now and late January, when the stimulus package will be voted on, we're likely to be treated to a great debate over the wisdom of Keynesianism. ...

Conservative supply-siders ... will call for income-tax cuts rather than government spending, claiming that people with more money in their pockets will get the economy moving again more readily than can government. They're wrong, too. Income-tax cuts go mainly to upper-income people, and they tend to save rather than spend.

Even if a rebate could be fashioned for the middle class, it wouldn't do much good because, as we saw from the last set of rebate checks, people tend to use extra cash to pay off debts rather than buy goods and services. Besides, individual purchases wouldn't generate nearly as many American jobs as government spending on infrastructure, social services, and green technologies, because so much of we as individuals buy comes from abroad.

So the government has to spend big time. The real challenge will be for government to spend it wisely -- avoiding special-interest pleadings and pork projects such as bridges to nowhere. We'll need a true capital budget that lays out the nation's priorities rather than the priorities of powerful Washington lobbies. How exactly to achieve this? That's the debate we should be having between now and January 20 or 21st.


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November 26, 2008

Economist's View - 5 new articles

Fed Intervention: Managing Moral Hazard in Financial Crises

"Moral hazard has its costs, but it also has its benefits":

Fed Intervention: Managing Moral Hazard in Financial Crises, by Harvey Rosenblum, Danielle DiMartino, Jessica J. Renier and Richard Alm, Economic Letter, FRB Dallas: Editor's note: Federal agencies and regulators have taken decisive steps to combat the financial crisis that began in the summer of 2007 and continued into the fall of this year. This Economic Letter focuses on key Federal Reserve actions through early October.

At the end of September 2008, U.S. policymakers had been working for more than a year to contain the shock waves from plunging home prices and the subsequent financial market turmoil. For the Federal Reserve, the crisis has given new meaning to the adage that extraordinary times call for extraordinary measures. The central bank has dusted off Depression-era powers and rewritten old rules to address serious risks to the global financial system.

The spreading financial crisis has led the Fed to pump liquidity into the economy and expand its lending beyond the commercial banking sector. In March, it assisted with J.P. Morgan Chase's buyout of Bear Stearns, a cash-strapped investment bank and brokerage. Six months later, the Fed took direct action again, with an $85 billion bridge loan to prevent the disorderly failure of American International Group (AIG), a giant global company heavily involved in insuring against debt defaults.[1]

These Fed actions—part of a broader U.S. government effort to contain the financial crisis—call to mind two earlier financial interventions: in the case of Long-Term Capital Management (LTCM) in 1998 and in the aftermath of the Sept. 11, 2001, terrorist attacks.

In both episodes, the Fed felt compelled to protect the financial system from severe shocks and the overall economy from spillovers that might produce serious downturns. Inherent in the Fed's moves was a natural by-product of intervention—moral hazard and the controversy that flows from it.

Concern about moral hazard helps explain why the Fed has traditionally intervened only rarely and reluctantly, trying to do what's necessary, but as little as necessary, to achieve financial stability. Markets generally should and do self-correct. When potential financial problems arise, the Fed's default reaction has usually been to do nothing and let the markets work their way through the difficulties.

On rare occasions, however, the markets themselves are at risk of failure. In such cases, the Fed can't fulfill its obligation to promote financial stability without direct action. Two factors have strengthened the case for central bank intervention in the past decade—the financial system's increased globalization and the untested nature of the new and complex financial instruments that have come under stress.

The escalation of what's now recognized as a global financial crisis has changed the modus operandi of Fed interventions. The guiding principle of do what is necessary, but as little as necessary, has been replaced by the recognition—reinforced by actions—of the importance of doing whatever it takes to break the downward spiral in the financial and credit markets that has contaminated the overall economy. With a broad understanding of the consequences of inaction, the Fed has taken a hard turn toward intervention in an atmosphere in which fear of moral hazard has been displaced by the reality of systemic risk's unacceptable consequences.

Fed intervention helped defuse threats to the financial system from LTCM's failure and the 9/11 terrorist attacks. The central bank accepted the moral hazard from intervention as the price for avoiding larger financial breakdowns. In the current crisis, the Fed's actions have no doubt mitigated damage to the financial system and economy. Doing so, however, required developing new tactics to address the crisis, going far beyond the traditional instruments of monetary policy.

Intervention's By-Product
Moral hazard, a term first used by the insurance industry, captures the unfortunate paradox of efforts to mitigate the adverse consequences of risk: They may encourage the very behaviors they're intended to prevent. For example, individuals insured against automobile theft may be less vigilant about locking their cars because losses due to carelessness are partly borne by the insurance company.

Moral hazard occurs whenever an institution like the Fed cushions the adverse impact of events. More to the point, lessening the consequences of risky financial behavior encourages greater carelessness about risk down the road as investors come to count on benign intervention. Moral hazard must be weighed carefully in responding to financial crises.

In the cases of Bear Stearns and AIG, some argue that the greater good would have been served had the Fed stood back and allowed the firms to fail, immediately taking all management, shareholders and creditors down with them. This course would avoid moral hazard entirely—and satisfy the general public's desire for seeing Wall Street highfliers brought low.

The Fed, however, must be ever vigilant in its mission. The Federal Reserve Act explicitly and implicitly sets out several mandates to guide Fed actions. The most important are

  • Full employment and sustainable economic growth;
  • Price stability;
  • Banking and financial system stability.

By intervening in a financial crisis, the Fed doesn't allow markets to play their natural role of judge, jury and executioner. This raises the specter of setting a dangerous precedent that could prompt private-sector entities to take additional risk, assuming the Fed will cushion the impact of reckless decisionmaking. So when intervention is the only option, the Fed has the duty to minimize micro moral hazard—that is, the benefit to any specific firm or industry.

Minimizing micro moral hazard starts with imposing tough terms—generally the orderly closure of the troubled firms that benefit from intervention. The Fed didn't just shovel money at Bear Stearns' and AIG's problems. It demanded collateral for the loans and charged interest—in AIG's case, at high rates.

Minimizing micro moral hazard means keeping information about the targets, timing and terms of any potential intervention as vague as possible, a tactic sometimes called "constructive ambiguity."

Minimizing micro moral hazard also means aiding selected firms only as a last resort. Federal authorities found alternative solutions short of direct intervention for some financial giants. The Fed expedited the reclassification of investment banks Goldman Sachs and Morgan Stanley to bank holding companies. Private-sector buyers acquired Merrill Lynch, Washington Mutual and Wachovia.

When direct intervention does take place, the Fed's duty goes beyond minimizing micro moral hazard. The central bank has the equally important responsibility to maximize macro moral hazard—a somewhat counterintuitive term that captures the greater good of preventing unnecessary damage to financial markets and the economy.[2]

Maximizing macro moral hazard recognizes the Fed's obligation to reduce the risks of recession and price instability and the risks stemming from an unstable banking and financial system. By fostering a more stable macroeconomic environment, the Fed's policy actions reduce the private sector's pain from bad decisionmaking.

The outright, uncontrolled collapse of Bear Stearns or AIG could have harmed millions of households and companies as financial market troubles brutalized retirement accounts, paralyzed the flow of capital, and ultimately led to layoffs, stunted consumption and a severe recession. The goal of Fed intervention is to prevent, or at least forestall, such macroeconomic spillovers.[3] (See "Minimizing Micro Moral Hazard: The Fed Rarely Intervenes.")

Hedge Fund on the Edge
Long-Term Capital Management provides an apt starting point for a discussion of Fed intervention because it involved the first financial disruption after the rapid expansion of the shadow banking system, a shorthand term for the financial services segment that includes big brokerage firms, hedge funds and innovative financial products like structured investment vehicles.[4] These entities aren't subject to the same supervision as banks, so they don't hold as much capital to cushion themselves against losses.

A high-profile hedge fund founded in 1993, LTCM brought together the best minds of academia and Wall Street. John W. Meriwether, former manager of one of Salomon Brothers' most profitable bond divisions, recruited renowned Ph.D.'s such as Myron Scholes and Robert Merton, soon-to-be winners of the 1997 Nobel Prize in economics, and former Fed Vice Chairman David Mullins. The partners' aim was to profit from market-price anomalies using complex mathematical models.

At its peak, the fund earned stunning returns of more than 40 percent. In 1997, as increased competition began squeezing margins, LTCM reached for high returns by leveraging its capital through risky securities repurchase contracts and derivatives transactions. By some accounts, the fund used capital of $2.3 billion to support investments of $125 billion.

The first sign that LTCM might be in trouble came when the fund lost 10 percent on its investments in June 1998. The situation worsened in mid-August, when a deep decline in oil prices left the economies of Russia and other oil-exporting countries in a precarious state. Russia's debt default and devaluation of the ruble prompted a massive flight of investors from risky securities to U.S. Treasuries and a dramatic widening in interest rate spreads.

Global bond markets plunged, and in August alone, LTCM lost $1.8 billion—44 percent of its capital. Losses piled upon losses and reached $4.8 billion. As LTCM faced increasing margin calls, default was imminent.

The speed with which LTCM spiraled out of control recalls an old saying in financial circles: If I owe a bank a million dollars and I can't pay, I'm in trouble. If I owe a bank a billion dollars and I can't pay, the bank's in trouble. If I owe a dozen banks billions of dollars each and I can't pay, the banking system could be in trouble.

The threat of systemic risk led the Fed to help arrange a managed unwinding of LTCM's affairs, which would let the fund fail and avoid a fire sale of its assets. On Sept. 23, the New York Fed facilitated a meeting with top executives from 14 Wall Street and international banking firms. With the exception of Bear Stearns, which declined to participate, the financial institutions agreed to back a capital infusion of $3.5 billion. The deal transferred oversight and veto power and a 90 percent equity stake to the consortium, leaving a 10 percent stake for the LTCM partners as an incentive to close down operations in an orderly fashion.[5]

In his Oct. 1, 1998, congressional testimony, Fed Chairman Alan Greenspan explained why the Fed decided to intervene: "Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own."

The Fed's action helped contain possible spillovers, but it didn't preserve LTCM. The hedge fund failed, but in a way that minimized the impact on financial markets and the economy—at the cost of both micro and macro moral hazard.

Financial Crisis Averted
On Sept. 11, 2001, terrorists hijacked four planes, crashed two into New York's World Trade Center, a third into the Pentagon and a fourth in a field in Pennsylvania. The nation watched in horror as both WTC towers collapsed. The financial system wasn't the target per se, but it was thrown into disarray. The most direct impact was the closure of U.S. financial markets for four days—only the seventh time they'd shut down for such a long stretch. A secondary impact came from the closure of U.S. airspace, which stopped the movement of mail and checks around the country.

Exacerbating the situation was the backdrop against which the events occurred. The U.S. economy was in the sixth month of a recession, although this wasn't widely recognized at the time, not even within the Fed. And financial markets were skittish, mired in the biggest bear market since the Great Depression. By early September, the Standard & Poor's 500 Index was down 29 percent from its March 2000 peak and the Nasdaq had lost 67 percent of its value.

Immediately after the attacks, the S&P 500 futures declined precipitously, and chaos reigned on the streets near the New York Fed, the New York Stock Exchange and elsewhere in the financial district—all within blocks of the fallen towers. It became apparent that U.S. financial markets couldn't open. At 10 a.m., 74 minutes after the first plane hit the World Trade Center and 30 minutes after the stock market's scheduled opening, the Fed released a statement: "The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs."

Though the financial markets would remain closed for the rest of the week, the Fed did indeed remain open. In the days after the terrorists struck:[6]

  • The discount window lent $45.5 billion on Sept. 12, compared with the Wednesday average of $59 million the previous two months.
  • Check float jumped to $22.9 billion that day, well above the two-month average of $720 million.
  • The New York Fed used open market operations to inject $61 billion in liquidity into the economy on Sept. 12, then added another $38 billion on Sept. 19.
  • The Fed arranged foreign exchange swap lines with the European Central Bank, the Bank of England and the Bank of Canada to provide dollar liquidity to global markets.

When the markets reopened Sept. 17, the Federal Open Market Committee (FOMC) held an emergency conference call and cut the fed funds rate, which applies to banks' short-term borrowing from one another, from 3.5 percent to 3 percent. As other short-term rates fell in response to the Fed's move, many businesses and individuals saw their borrowing costs decline. The statement the Fed released in announcing its action reiterated the central bank's commitment to providing liquidity and keeping the fed funds rate below target, as needed.

Although the Dow Jones industrials suffered what was, until the current crisis, its worst one-day point loss on Sept. 17, panic was averted.[7] The payments system returned to normal within days, and the recession ended two months later.

In the wake of 9/11, the Fed cast a wide and deep safety net to prevent the systemic risk that could have resulted from a meltdown of the financial system spreading to the U.S. and other economies around the globe. Despite the obvious need for intervention, the Fed's actions entailed some degree of moral hazard.

The Current Crisis
Signs of trouble began surfacing in February 2007, when a handful of financial companies took losses on assets related to U.S. subprime mortgages. What would become the worst financial crisis since the Depression wasn't widely acknowledged for six more months—not by financial markets, not by policymakers.[8]

Since then, banks, brokerages, investment houses and hedge funds worldwide have revealed a seemingly endless succession of losses, write-downs and outright failures. Behind the crisis is the collapse of a five-year boom in housing prices that had been fueled by risky and exotic mortgage financing backed by unprecedented levels of leverage.

Some subprime loans offered low initial interest rates; others only required interest payments, needed no down payment or were made with no proof of income. The mortgages were bundled into multilayered securities graded by risk, then sold to hedge funds, investment banks, insurance companies and other investors, many of which sought to reduce risks associated with the mortgages by purchasing credit default swaps (CDS).

A relatively new entry in the financial derivatives market, these instruments committed one party to cover its counterparty's losses should an investment go sour. In 2000, the CDS market was $1 trillion; by 2008, it was $62 trillion, roughly 4.5 times U.S. gross domestic product. These derivatives helped fuel the surge in mortgage-backed securities by reducing perceived default risk.

When the housing bubble burst, default risk far exceeded what investors had anticipated, and the market for mortgage-backed securities cratered. Financial institutions found themselves holding large portfolios of hard-to-value assets that could only be sold at fire-sale prices.

As assets deteriorated, we began to hear a lot about counterparty risk. What if CDS sellers couldn't fulfill their obligation to insure assets against losses? If a major player in the vast, tangled credit derivatives market were to collapse, it could start a chain reaction in which one counterparty's default undermines the ability of other firms to fulfill their obligations. Markets would begin doubting the counterparties, and investors would flee these companies, leaving them to face the grim task of attracting new capital in skeptical markets. If they can't, they sink into trouble. A significant number of troubled firms would trigger systemic risk.

Credit default swaps and other financial innovations hadn't been tested under adverse conditions. What's more, they took off at a time when markets and the economy had become more globalized and technology-driven, factors that both made the financial universe more complex and increased uncertainty about how to respond to potentially widespread failures of these new instruments.

The Fed didn't sit idly by as tremors shook the financial markets. As with the 9/11 threat, its initial response focused on injecting liquidity into the financial system. On Aug. 17, 2007, the Federal Reserve Board cut a half percentage point off the discount rate, making it cheaper for commercial banks to borrow short-term funds from the Fed. On Sept. 18, the FOMC surprised financial markets by reducing the fed funds rate to 4.75 percent. The Board also cut the discount rate a half point. Over the next year, the FOMC cut the fed funds rate eight more times, dropping it to 1 percent at the end of October.[9] The Board gradually reduced the discount rate from 5.75 percent on Sept. 18, 2007, to 1.25 percent on Oct. 29, 2008.

Unlike the Long-Term Capital Management and 9/11 episodes, which resolved themselves quickly, the latest financial turmoil continued to bubble throughout 2008, leading the Fed to take unorthodox steps to make money available to the financial system. The central bank opened its lending operations to different kinds of financial institutions, granted longer-term loans and accepted a broader range of collateral.

In December 2007, the Fed introduced the first of several new lending mechanisms—the term auction facility, which lends to banks for longer periods and usually at a lower rate than they could secure via the discount window. Part of the reasoning behind the new facility was to avoid the perception that discount window borrowing is a sign of financial weakness.

A stickier issue was capital constraints at primary dealers, a class of lenders not regulated by the Fed and without access to its credit facilities. (See box titled "Primary Dealers' Critical Role.") The term securities lending facility, established in March 2008, provides extra liquidity through a 28-day program that allows, for a fee, primary dealers to acquire Treasury-grade assets by using riskier assets as collateral.

The primary dealer credit facility, also created in March, extends the Fed's safety net by opening discount window loans to primary dealers. As the financial crisis deepened, the Fed created lending programs to add liquidity to other segments of the financial markets. In September, for example, the central bank made money available to foreign central banks, commercial paper investors and money market funds.

No lending facility could effectively address the kind of crisis of confidence that befell Bear Stearns, an investment bank and brokerage that had been a Wall Street fixture since 1923, surviving even the stock market crash of 1929 without laying off employees.

On Monday, March 10, 2008, rumors hit European trading floors that Bear Stearns might be unable to fulfill commitments for its trades. The company's management was quick to address the reports but couldn't quash the mounting speculation. The rumors became self-reinforcing, compelling some trading partners to pull back from doing business with Bear Stearns. A de facto run had begun.

On Thursday, Bear Stearns' CEO reached out to the New York Fed and the Treasury Department, setting into motion a whirlwind that would bring an end to an institution that had accumulated $1.6 billion in losses and write-downs. Two days later, a firm that had a peak market value of $25 billion in January 2007 was offered to J.P. Morgan Chase for $236 million, a mere 3 cents on the dollar.

When Bear Stearns sought help, the New York Fed could have done what the Fed usually does when a ship is at risk of sinking on its watch: nothing. Bear Stearns would have been allowed to fail, and the Fed would have stood witness to a company reaping what its missteps had sown. The tale would have been tragic in the same vein as the fates suffered by Drexel Burnham Lambert, the Wall Street brokerage that fell victim to the junk bond bust of the 1980s, and Enron, the energy giant that toppled in 2001.

The Fed did nothing for Drexel or Enron. However, it supported the J.P. Morgan deal with an unprecedented $29 billion loan to an entity created to purchase largely mortgage-related Bear Stearns assets. The agreement calls for the loan, made at the discount rate for up to 10 years, to be repaid as the assets are sold. If they appreciate by more than operating expenses, the Fed stands to make a profit. It will bear any losses beyond the $1.15 billion contributed to the entity by J.P. Morgan.

The Fed decided to facilitate the Bear Stearns sale because it feared dire consequences for the financial system. Bear Stearns had open trades with no fewer than 5,000 other firms. On a much grander scale, the firm was one of the world's largest counterparties, reporting in a Nov. 30, 2007, Securities and Exchange Commission filing that its derivative holdings had total leverage of $13.4 billion. The company was involved in 750,000 contracts in March 2008, according to the New York Fed. Allowing the company to default would have triggered the first stress test of the fast-growing, interwoven derivatives market, an event that would undermine the Fed's ability to meet its legal mandates for growth, price stability and financial stability.

The Fed actions were aimed at reducing risks to the financial system, not helping Bear Stearns' owners. The company's stock price peaked above $171 a share in January 2007, representing a market capitalization of some $25 billion. Despite the financial turmoil of early 2008, it was at $70 a share just before the ill-fated week of March 10–17. It's difficult to fathom how much more the Fed could have adhered to its commitment to minimize micro moral hazard, considering the $2 a share price reached during the negotiations. To keep Bear Stearns out of bankruptcy court, J.P. Morgan Chase eventually raised its offer to $10 a share, or $1.4 billion, still a faint shadow of where the market had valued Bear a year earlier.

The authority to intervene in Bear Stearns can be found in a 1932 amendment to the Federal Reserve Act, allowing the central bank to make direct loans outside the banking system "in unusual and exigent circumstances." The power was last used in the Great Depression.[10]

The Fed used this authority again when AIG appeared on the brink. The company's sound businesses were being threatened by the excessive CDS risks taken by its London-based AIG Financial Products unit. After a year in which AIG took $18 billion in losses, the company faced a cash crunch after mid-September downgrades to its credit rating. It needed a $13 billion capital infusion in a week in which investors showed their lack of confidence in the company by driving down its stock price 80 percent.

When AIG couldn't raise money in the private sector, it turned to the Fed and the Treasury. The central bank provided a two-year, $85 billion line of credit, secured by warrants, to purchase nearly 80 percent of the company if AIG fails to raise enough money through asset sales or other means to repay the loan. The Sept. 16 agreement's interest rate was steep—indeed, punitive—at 8.5 percent above the London interbank offered rate (Libor), an industry benchmark.[11]

Like Bear Stearns, AIG had invested heavily in CDS markets. At the end of September 2007, its Financial Products unit had $505 billion in exposure, stretching into many parts of the world. A year later, AIG had written down a fifth of its exposure but still stood on the precipice. In announcing its decision on Sept. 16, the Fed said it saw enough risk to conclude that "a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance."

Many critics contend that Bear Stearns and AIG were "bailed out." Former Treasury Secretary Paul O'Neill refuted this notion in a New York Times exchange on Bear Stearns:[12]

Times: Do you think it was appropriate for the Federal Reserve to lend a helping hand to Bear Stearns and save a private investment company from its own bad decisions?

O'Neill: I would say they didn't save Bear Stearns. They saved the financial system from a panic collapse. I reject the notion they helped Bear Stearns. Bear Stearns was destroyed. [Emphasis added]

Times: No it wasn't. It was purchased by J.P. Morgan, which will keep it alive.

O'Neill: They're going to keep the book alive. But the institution of Bear Stearns has been destroyed. They've gone from $158 to $2 of equity. It's wallpaper. It's not even good wallpaper. It's butcher paper.

The Lehman Decision
Roughly six months after the Bear Stearns intervention and amid AIG's unraveling, another Wall Street investment bank and primary dealer found itself on the brink. Round-the-clock efforts by the Fed and Treasury to find a buyer for Lehman Brothers Holdings over the weekend of Sept. 13–14 fell apart. On Monday, Lehman became the largest bankruptcy in U.S. history, listing liabilities of $613 billion in its filing.

The impact—both predictable and unpredictable—of Lehman's failure reverberated immediately through global financial markets. The fallout spread to individuals and businesses with seemingly no connection to Lehman.

In the LTCM and Bear Stearns interventions, the Fed contended its actions were necessary to keep financial markets from seizing up and to minimize the negative spillovers on the broad economy. The Fed feared that the quick and disorderly failures of some financial enterprises would have systemic effects on the nation and likely, around the globe.

In April 3, 2008, testimony to Congress about the Fed's intervention in Bear Stearns, New York Fed President Timothy Geithner described the adverse consequence the Fed sought to avoid: "Asset price declines … led to a reduction in the willingness to bear risk and to margin calls … [resulting in] a self-reinforcing downward spiral of … forced sales, lower prices, higher volatility and still lower prices."

Geithner cataloged the possible spillover effects from Bear Stearns' collapse—protracted damage to the financial system, widespread insolvencies and ultimately higher unemployment and borrowing costs, and a lower standard of living because of losses to retirement savings.

Why didn't similar arguments persuade the Fed to prevent the collapse of Lehman, an investment bank and primary dealer comparable to Bear Stearns in size and importance? The answer, according to Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson, came down to untenable taxpayer losses and doubts about the legal authority to intervene in this particular case.

A few weeks after Lehman's bankruptcy, Bernanke addressed the issue: "Facilitating the sale of Lehman … would have required a very sizeable injection of public funds … and would have involved the assumption by taxpayers of billions of dollars of expected losses…. Neither the Treasury nor the Federal Reserve had the authority to commit public money in that way; in particular, the Federal Reserve's loans must be sufficiently secured to provide reasonable assurance that the loan will be fully repaid. Such collateral was not available in this case."[13]

Lehman had months to find private buyers for all or parts of its enterprise. None could be found, not even with the help of the Fed and the Treasury. And the firm's condition had deteriorated to the point where the Fed couldn't find sufficient collateral for a primary dealer credit facility loan.

Within hours of Lehman's bankruptcy filing, the negative consequences contemplated by Geithner in Bear Stearns' case began to unfold. Losses tied to holdings of Lehman debt forced one of the oldest money market funds to sink below the purchase price of $1 a share, financial markets seized up, stock markets around the world plunged, and governments were eventually forced to inject capital directly into their banking systems and extend deposit insurance safety nets.

In some ways, the Lehman episode was as close as possible to a controlled experiment in the realm of economics. By not intervening, the Fed created no moral hazard. Interestingly, some critics who chastised the Fed for creating moral hazard with Bear Stearns declared that moral hazard should have been disregarded in the case of Lehman.

Little will be gained by debating the what-ifs surrounding Lehman. By the time Lehman filed for bankruptcy, the cost to insure the debt of other investment banks had also skyrocketed. A prohibitively expensive Lehman rescue would have merely forestalled one failure, but many other at-risk investment banks would have remained as the financial system buckled under intense leverage. What Lehman revealed was the need to give authorities better tools to manage the threats to firms considered key to the nation's and the world's financial infrastructure.[14]

What are the lessons of Lehman's demise? In particular, should moral hazard be categorically and systematically avoided? With the interconnectedness of the global economic and financial systems, it's clear that fire sales can spread to distant places and impact economic entities far removed from the initial calamity. It took the collateral damage from Lehman's bankruptcy for this to be widely appreciated by those who have invoked moral hazard to argue against Fed interventions. Moral hazard has its costs, but it also has its benefits.

The Fed's Hippocratic Oath
A basic precept taught in medical schools is first, do no harm. All interventions—whether they involve medicine or finance—have potential costs, benefits and unintended consequences. These are often difficult to anticipate, especially in the financial realm, where crises occur infrequently and each differs from its predecessors in important ways.

In keeping with the principle of doing no harm, it is ideal to leave markets to work their magic. When the Fed does intervene, it tries to do what's necessary—but as little as necessary—to achieve financial stability.

This is as it should be. Unfortunately, defining "as little as necessary" is rarely easy. In turbulent times, the challenge regulators face is that maps charted during past crises are all but irrelevant. Each crisis requires judgment calls that must be executed in real time, often using incomplete and partly accurate information.

In the current financial crisis' first year, the Fed's response has been measured, reflecting the commitment to doing only what's necessary. The central bank began with the hope that the routine tools of monetary policy would be sufficient to lessen the danger to the markets and the economy. The Fed turned to unorthodox solutions—the new lending facilities and direct intervention—only when faced with a deepening crisis. Direct intervention has been rare, taken only when stakes were high and other options were exhausted.

Intervention in the financial markets in general, or in the affairs of a single financial institution, remains a red-button option, reserved solely for tangible threats to the Fed's primary goals. The Fed prefers to rely on the self-correcting mechanisms of market forces. This discipline flows from a guiding principle: No one entity is too big to fail; only the financial system is too big to fail. Some entities may be so caught in the intricate weave of the financial system that their problems can't be resolved quickly. Using this metaphor, Bear Stearns and AIG were single threads that, if pulled, could have unraveled the entire financial system.

As ideal as it would be to eliminate moral hazard, the Fed—the central bank for the world's largest economy—can't do that and fulfill its legal mandates. Like it or not, central bankers face the reality that managing moral hazard is an inescapable part of their job description. Seeking to minimize micro moral hazard during tumultuous times is as far as they can go.

Minimizing Micro Moral Hazard: The Fed Rarely Intervenes

This decision tree summarizes how the Fed responds to potential financial crises. After getting a reading on the economy's vital signs, the Fed determines whether the threat at hand might compromise the central bank's three primary goals.

If the Fed sees little risk, no action is taken, avoiding moral hazard and leaving the markets to sort out the difficulties. The Fed reacts this way to nearly all potential troubles in the financial sector.

A pervasive threat to the overall economy or the financial system can justify direct action. The Fed rarely makes these interventions; when it does, it strives to manage the resulting moral hazard in the least costly way.

The first choice entails the Fed's acting as an outside coordinator to bring together private institutions to defuse the threat. It's a strategy that minimizes public-sector risk, and the central bank used it with the Long-Term Capital Management hedge fund in 1998.

When this option isn't feasible, the Federal Reserve Act provides the authority to deal directly with pressing threats. The preferred strategy involves forging partnerships with private institutions, a course the Fed took in March 2008 with Bear Stearns, a troubled investment bank and brokerage with sufficient remaining collateral to support the intervention.

When private partners aren't willing to step up, the Fed can act alone if troubled firms still have sufficient collateral. In September 2008, the Fed arranged a purely public intervention for AIG, a huge financial services company.

If remaining collateral is insufficient to support taxpayer-financed actions, the Fed under current law is obliged to let the markets decide a troubled firm's fate. The Fed accepted this outcome with Lehman Brothers in 2008.

Primary Dealers' Critical Role

Primary dealers are banks and securities broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. They're vital to monetary policy because the New York Fed's Open Market Desk trades on behalf of the Federal Reserve System. Purchasing government securities in the secondary market adds reserves to the banking system; selling securities drains them.

The New York Fed established the system in 1960 with 18 primary dealers. The number peaked at 46 in 1988 before starting to decline in the mid-1990s. By 2007, it was down to 20. The main reason for the dwindling number of dealers has been consolidation, as firms have merged or refocused their core lines of business. (A list of primary dealers can be found on the New York Fed's website at

In addition to their role in monetary policy, primary dealers are important in keeping the nation's fiscal house in order. The federal government tends to spend more each year than it takes in from tax revenue. To keep Washington open and operating, and the government functioning around the world, the Treasury raises money by selling bills, notes and bonds to investors. In recent years, more than half the money raised has come from foreigners.

Primary dealers handle the bulk of the underwriting—that is, the buying, handling and distribution of the U.S. debt. In addition to distributing new Treasury securities, the dealer network makes a deep, broad and liquid secondary market for previously issued Treasury securities.

A liquid secondary market enhances the marketability of Treasury debt and lessens the burden of financing government operations for taxpayers. Without this network of dealers, the Treasury would be hard-pressed to reliably finance essential government services.

An efficient primary dealer network is important for other reasons. Nearly all debt is priced off of interest rates on similar maturity Treasury securities. The Treasury rate is the so-called risk-free rate in the economy. Private-sector borrowers pay the risk-free rate, plus a premium to compensate for potential default risk.

The U.S. and global financial systems, not to mention the U.S. economy and its millions of businesses and households, are absolutely dependent upon a smoothly functioning and reliable Treasury market for financing their credit needs. If the Treasury market is closed or not working properly because of problems with the primary dealer network, credit can't be priced and can't flow, leaving the private sector starved for credit.

With the primary dealers' pivotal role in mind, on March 16 the Federal Reserve Board invoked the emergency provisions of the Federal Reserve Act, authorizing the New York Fed to extend the discount window's safety net to primary dealers. In its announcement, the Fed said it created the primary dealer credit facility to "bolster market liquidity and promote orderly market functioning." The action left no doubt about primary dealers' important role: "Liquid, well-functioning markets are essential for the promotion of economic growth."

About the Authors

Rosenblum is executive vice president and director of research, DiMartino is a financial analyst, Renier is a research analyst and Alm is senior economics writer in the Research Department at the Federal Reserve Bank of Dallas.


  1. The Fed has worked closely with the Treasury Department to mitigate the financial crisis. In early September, for example, Treasury took control of the Federal National Mortgage Association and Federal Home Mortgage Corp., two federally sponsored investors in the housing sector.
  2. For more on this subject, see "Fed Policy and Moral Hazard," by Harvey Rosenblum, Wall Street Journal, Oct. 18, 2007.
  3. Timothy Geithner, testimony before the Senate Committee on Banking, Housing and Urban Affairs, April 3, 2008.
  4. See Geithner's remarks in "Brokers Threatened by Run on Shadow Bank System," MarketWatch, June 20, 2008. The term shadow banking system was coined by Paul McCulley, who used it for the "whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures." See "Teton Reflections," Global Central Bank Focus, August/September 2007.
  5. Alan Greenspan, testimony before the House Committee on Banking and Financial Services, Oct. 1, 1998. One solution to the problem of socalled too-big-to-fail banks would be forced recapitalization by competitors. See "What Reforms Are Needed to Improve the Safety and Soundness of the Banking System?" by Harvey Rosenblum, Federal Reserve Bank of Atlanta Economic Review, First and Second Quarters, 2007.
  6. "Taking Stock in America: Resiliency, Redundancy and Recovery in the U.S. Economy," by W. Michael Cox and Richard Alm, Federal Reserve Bank of Dallas 2001 Annual Report.
  7. The Dow suffered its worst one-day point loss on Sept. 29, 2008, when it lost 777.68 points.
  8. For more on this, see "From Complacency to Crisis: Financial Risk Taking in the Early 21st Century," by Danielle DiMartino, John V. Duca and Harvey Rosenblum, Federal Reserve Bank of Dallas Economic Letter, December 2007.
  9. One of these cuts, made at the depth of the crisis on Oct. 8, was unprecedented in that the FOMC acted in coordination with five other central banks. The FOMC cut the fed funds rate by a half point—from 2.25 percent to 1.75 percent.
  10. "The History of a Powerful Paragraph," by David Fettig, Federal Reserve Bank of Minneapolis The Region, June 2008.
  11. The Fed and U.S. Treasury later modified the terms of the government's financial support for AIG. The new terms included a lower interest rate at 3 percent over Libor and reduced fees on undrawn funds. They also included a lengthening of the lending facility from two to five years.
  12. "Market Leader," New York Times Magazine, March 30, 2008.
  13. "Current Economic and Financial Conditions," Ben Bernanke speech to the National Association for Business Economics 50th Annual Meeting, Washington, D.C., Oct. 7, 2008.
  14. "Reducing Systemic Risk," Ben Bernanke speech at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyo., Aug. 22, 2008.

Why Did Forecasters Missed the Crisis?

Dean Baker will wonder why he was left off this list:

The vision thing, by Chris Giles, Commentary, Financial Times: It has been a bad year for economic forecasters. So bad that royalty wants to know what went wrong. "Why did no one see it coming?" Britain's Queen Elizabeth asked during a visit to the London School of Economics this month. ...

Though there is great entertainment in looking back at the silly things economists have said, more is to be gained by examining the particular failings that contributed to forecasters' general inability to warn of the current mess.

First is the unforeseen, but now evident, fragility of the global economy in the face of a systemic banking collapse. ... Second, as Stephen King, chief economist of HSBC, says: "Almost all economic models assume that the financial system 'works'." ...

Third was the deep squeeze on household and corporate incomes from the commodity boom of the first half of 2008, which almost no one predicted. This weakened the non-financial sector before banks had any chance to repair the damage from the subprime crisis...

Fourth, most economic models suggest the demand for money will be stable, but banks and households have now begun to hoard cash. This threatens to make monetary policy ineffective..., something that is not generally factored into forecasting models.

Fifth is an over-reliance on the output gap – the difference between the level of output and an estimate of what is sustainable – in forecasting. That allowed policymakers to believe everything was fine ... because inflation was under control and growth was not excessive.

Sixth is the natural tendency to seek rationales for events as they unfold, rather than question whether they are sustainable. ...

Mention must ... be given to the notable voices of doom, who got important bits of the puzzle correct even if the timing or other details eluded them. Prof Roubini ... wrote a paper with Brad Setser in August 2004 predicting that the world's trade imbalances were unsustainable and likely to "crack the system in the next three to four years". He has been prescient in understanding the links between financial markets and the real economy.

William White, the former chief economist of the Bank for International Settlements, the central bankers' bank in Basel, Switzerland, was a persistent critic of lax monetary policy and the failure to stem credit expansion. Prof Rogoff also spotted the dangers of unsustainable global economic expansion in a 2004 paper with Maurice Obstfeld. In more recent work with Carmen Reinhart he has highlighted how policymakers fell into the "this time it's different" trap that dates back to England's 14th-century default.

Prof Persaud has made an honest living for many years warning about the fallibility of value-at-risk models and the tendency for them to encourage herd behaviour. And in the FT's new year survey of economists for 2008, Wynne Godley of Cambridge university, also a permanent bear, said: "I think the seizing up of financial markets may well result in a collapse in lending in the US to the non-financial sector so large that it causes a recession deeper and more stubborn than any other for decades – and deeper than anyone else is expecting." Quite.

Policymakers, too, have been far from consistently wrong. Mr Trichet dines out on stories of how he predicted the crisis and cites a Financial Times article as evidence... Mr King warned for years about the risks evident in the global economy and the IMF repeatedly warned about the unsustainable level of house prices.

Willem Buiter ... warns not to be too impressed by some forecasts that have turned out to be true, because they were lucky, not wise. "Hindsight is useless," Prof Buiter insists. ...

Predictive Models: Blown Off Course by Butterflies

In the 1980s, it seemed that computers held the key to economic forecasting, writes John Kay. With large models and sufficient processing power, predictions would become more and more accurate.

This dream did not last long. We now understand that economies are complex, dynamic, non-linear systems...

So economic crystal ball-gazing remains unscientific. The trend is the forecaster's friend. Extrapolation assumes that the future will be like the past, only more so. We project current preoccupations ... with exaggerated speed and to an exaggerated degree. ...

If extrapolation is the forecaster's friend, mean reversion is the forecaster's crutch. Much of the time, you can predict that next year's figure will be somewhere between this year's level and the long-run average. But mean reversion never anticipates anything out of the ordinary. Every few years, out-of-the-ordinary things happen. They just have.

Still, you might think there would be large rewards for those who succeed in anticipating these events. You would be wrong. People who worried before 2000 that the "new economy" was a bubble, or warned of the terrorist threat before September 11 2001, or saw that credit expansion was out of control in 2006, were not popular. They were killjoys.

Nor were they popular after these events. If these people had been right, then others had been blind or negligent, and the latter preferred to represent themselves as victims of unforeseeable events. As John Maynard Keynes observed, it is usually better to be conventionally wrong than unconventionally right.

"Woodward and Hall Analyze the Financial Crisis and the Recession"

I've been arguing that government spending is preferable to tax cuts as a means of stimulating the economy. Via an email from Bob Hall, an argument against that position from a paper described below:

General Stimulus

Current forecasts have real GDP reach its lowest value in the second quarter of 2009,... the total shortfall [is] $855 billion. This figure provides a way to think about the magnitude of a stimulus. Trying to push spending and output up to its trend level in a short time, would probably be unwise, for fear of overshooting. Eventually, the corrective forces of the economy would bring spending and output back to its long-run growth path. Policy fits in somewhere between, hastening the return to normal.

The case for stimulus is particularly strong with deflation hanging over the economy. But the Fed has a small amount of room left to stimulate through reductions in the fed funds rate—its target is currently one percent.

Fiscal stimulus will provide most of the needed boost. Fiscal actions take two forms, tax cuts and spending increases. Tax cuts raise consumer spending and business investment and thereby raise output and employment. When we speak of tax cuts, we include rebates paid to families who pay no income tax and we also include increase in social benefits, such as unemployment compensation. Spending increases go directly into higher output. Rebuilding a bridge produces output included in GDP and raises employment. The spending we are talking about here involves the government buying goods and services, not paying subsidies or benefits to families or businesses. Those go in the tax cut bucket. 25

Commentators apart from economists often compare the two types of policies in terms of bang for the buck. Bang is the amount added to GDP and thus to employment and buck is the amount of government money involved, or, equivalently, the addition to the government deficit. By this measure, spending stimulus comes out ahead of tax-cut stimulus. The spending automatically enters GDP and may have some second-round effects as well. Some part of a tax cut goes into saving, so the immediate increase in GDP is probably smaller. (John Taylor's evidence) Earlier this year, the federal government used a tax-cut stimulus that helped delay the recession. Now advocates of spending stimulus are using the bang-for-the-buck criterion to argue that it is time to crank up spending.

Bang for the buck is not the right way to score stimulus measures. The nation is not limited to any particular level of government outlay or deficit level. The U.S. federal government has the best credit rating in the world because its current debt is small in relation to its ability to tax in the future. If consumers save half of a tax cut, the cut can be made twice as large as the desired increase in immediate spending.

Instead, the choice between tax cuts and spending increases should depend on the tradeoff between the value of the increased spending, which favors tax cuts, and precision of timing, which favors spending increases. Consumers respond to improved resources, from a tax cut or any other source, by adding the most valuable spending that they were unable to afford prior to the improvement. They are bound to spend a tax cut on something they want. By contrast, the government is not notably successful in picking good spending projects. Way too much money goes to inefficient operations like Amtrak and to build multilane interstates in Montana. Unlike the consumer, the government does not reliably spend extra resources on valuable purchases.

On the other hand, the government can, in principle, concentrate a spending stimulus in the time when it is most desirable, namely in the next few months. The government cannot concentrate the spending that consumers choose to make from a tax cut—part of that spending may occur way too late. Unfortunately, it is hard for the government to crank up spending quickly. Even if the government hires contractors quickly to fix creaky bridges, the stimulus only takes effect when the contractor hires the workers and puts them to work, a process that takes up to a year.

The government could concentrate the spending from a tax cut into a brief period with a novel kind of fiscal stimulus, a general consumption subsidy. Here consumers would receive, say, four percent back from the government, for consumption purchases in the first three months of 2009. The credit would be refundable to low-income families and phased out, as the current income tax does for deductions, for high-income families. The stimulus from this policy would be concentrated at the time when stimulus is most needed, sooner than any practical government spending increase. One way to generate the subsidy is to eliminate state sales taxes for a period. (Kotlikoff-Leamer proposal)

A second way to concentrate the stimulus is to cut the payroll tax for a period of a year or two. Half of the immediate benefit would go to employers and would encourage hiring and retaining workers while the other half would increase the take-home pay of workers. The employer effect would be in place only during the tax cut, so it is highly concentrated. The worker half would be more like a standard tax cut, subject to the problem of consumption deferral. Cutting only the employer part of the tax would be most effective at targeting the stimulus when most needed.

The text quoted above is from a website maintained by Susan Woodward and Bob Hall. The goal is to provide analysis of the financial crisis and to recommend policy responses, i.e. to "update this description of what has happened in the U.S. economy since the crisis began in 2007 and to give a commentary on the events and on actual and recommended policies to deal with financial stress and recession":

Woodward and Hall analyze the financial crisis and the recession: Susan Woodward is a financial economist with a specialty in the mortgage market. She served as the Chief Economist of the Department of Housing and Urban Development. Recently, she prepared a study of mortgage closing costs for HUD. Robert Hall is a macroeconomist at Stanford: his website. We are maintaining a 30-page document on the crisis and recession, with a good deal of data and many source references. Some of the ideas we promote in the document are:

  • Low interest rates in the early part of the decade were responsible monetary policy to head off deflation, not an irresponsible contribution to a housing price bubble
  • The most important fact about the economy today is the collapse of spending on home building and the resulting recession
  • The aggressive response of financial policy seems to have contained the effects of the financial crisis on some key elements of spending, especially plant and equipment investment, through the third quarter this year
  • The government is wasting money by not stating a formal guarantee of Fannie Mae's and Freddie Mac's debt
  • Proposed and active programs for helping beleaguered homeowners reach only a small fraction of those in trouble and focus on the wrong goals
  • The top policy priority is a large stimulus to the overall economy rather than actions aimed just at housing

Click here for the pdf containing the analysis with graphs, sources, and bibliography. Click here for the Excel file containing the relevant data.

Back to the fiscal policy versus tax cuts question, according to the argument above, one reason government spending dominates tax cuts is that the private sector will allocate the money more efficiently than government. Government "is not notably successful in picking good spending projects," while the private sector recipients of tax cuts devote the money to "the most valuable spending."

Like purchasing stocks and houses in a bubble, things like that? The private sector isn't perfect either, some businesses will fail miserably, the resources are wasted, not every private sector employee is the model of efficiency, and some consumers will come home with magic beans (you can find roads to nowhere in the private sector too - they go to housing developments where the streets are in place, but there's little or nothing built there). So we mean relative efficiency. I'm not saying the government is just as efficient as the private sector, only that the relative levels of wasted resources may not be quite as stark as we sometimes think.

But here's the main question. Suppose we ask, "should we tax consumers and build a bridge, or should we let consumers keep the money?" If every time we ask that question the answer is "consumers should keep the money because they are more efficient," how does infrastructure ever get built? There must be times when there are public goods - goods the private sector will not build on its own - that have a net positive value to society. If that's the case, then there is a role for government to step in and provide those goods. So why not build what we need now? Tax cuts cannot be aggregated into large sums - the large amounts of money needed to build major infrastructure projects - but government can act as an intermediary by pooling the money into sums large enough to get the job done. This is a time when such pools of money will be available, so we should take advantage of the opportunity.

To be fair, the question in the previous paragraph is not quite the question Woodward and Hall are asking since it is also desirable to time the policy so as to optimally offset swings in GDP and employment. But I think that objection can be overcome with a combination policy that uses tax cuts to provide an immediate boost with infrastructure spending that maintains the boost over a longer time period.

A combination policy can also help with another problem. It is no easy task to find $700 billion dollars worth of infrastructure projects that clearly fit into the category of having net positive value to society. Spending the money just to spend it is wasteful, and it is detrimental to policymakers in the future who will have to live with precedent set by actions taken now. So we should invest the money where we get the most value, and also where it has the best chance of lifting us out of the recession.

Because of that, I would break up the stimulus into pieces, with part of it going to provide an immediate boost through targeted tax cuts of some sort, another part would be devoted to providing an ongoing stimulus through infrastructure spending - those projects with clear positive societal value - and the remainder would go to backfill shortages at the state and local level, enhance food stamp programs, extend unemployment insurance, fill lapses in health care coverage due to layoffs, and other such needs.

Knightian Uncertainty and the TARP

Ricardo Caballero and Arvind Krishnamurthy argue that the presence of Knightian uncertainty in financial markets means that recapitalization of financial institutions must be massive in order to work, larger than is likely to be practical. However, another solution - government insurance - can reduce the size of the required capital injection:

Knightian uncertainty and its implications for the TARP, by Ricardo Caballero and Arvind Krishnamurthy, FT Economist's Forum: ...To paraphrase a recent Secretary of Defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction ... has significant implications for economic behaviour and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. ...

The main implication of rampant uncertainty for the TARP and its relatives, is that capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, probably much-much more than the current TARP. The reason is that Knightian uncertainty generates a sort of double- (or more) counting problem, where scarce capital is wasted insuring against impossible events.

A simple example makes the point: Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays $1 to agent A, and the opposite happens in state Y. Thus, only $1 is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only $1 is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than $1. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.

Of course, real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.

But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.

The Knightian uncertainty perspective also sheds light on some of the virtues of the now defunct asset-purchases programme of the original TARP. ... In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital, more effectively than directly injecting equity capital.

Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons. Our point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude...

links for 2008-11-27


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