naked capitalism

This post first appeared on June 6, 2008

An article in today’s Wall Street Journal, “Insider Joins Critics of the Fed, Faulting Credit-Crisis Programs,” discusses at some length a recent speech by Richmond Fed president Jeffrey Lacker in which he took issue with some of the Fed’s recent financial services industry rescue efforts. The article itself failed to do justice to his speech, which was more nuanced than the usual “bailing out banks creates moral hazard” argument.

In fact, as we’ll discuss, the expanded charter of the Fed calls into question the appropriateness of its independence. It is increasingly making resource allocation decisions which are political in nature and should arguably be debated and determined in that realm.

In his London speech, Lacker defined two types of bank runs: non-fundamental, when the institution is sound but hit by a liquidity crisis, versus a fundamental run, where depositors and creditors wanted out because they know someone would wind up holding the bag. In the latter case, speed of exit is a virtue, since the laggards are the ones who run the risk of not recovering their assets.

The problem with central bank intervention is two-fold. It may not always be possible to parse out whether a crisis is fundamental or non-fundamental in nature. However, when a crisis is fundamental (or as we like to say here, a solvency rather than a liquidity crisis), Fed assistance distorts relative asset prices and delays the relevant markets finding clearing prices. As Lacker stated:

The ideal central bank lending policy would require making clear distinctions between different possible sources of bank or financial distress. If an episode of financial disruption is a true liquidity crisis, like a non-fundamental run on the banking system, then aggressive central bank lending can, in theory, stem the crisis and prevent unnecessary insolvencies that impose real losses on the economy. Lending when in fact the financial sector is just coping with deteriorating fundamentals, however, distorts economic allocations by artificially supporting the prices of some assets and the liabilities of some market participants. Moreover, it is likely to affect the perceptions of market participants regarding future intervention, and thus alter their incentives and future choices.

But Lacker made a second set of observations, which the Journal breezed by: the existence of a central bank safety net leads banks to neglect cheap risk reduction measures they could take on their own.

For instance, the big reason that bank runs happen is that depositors go to yank all their funds out at once, when those institutions are set up to handle only a comparatively small proportion of those holdings being withdrawn on any day. But most customers don’t need that much liquidity on a daily basis and can be given incentives to sacrifice such quick trigger access. As Lacker points out:

The intuition behind the classic bank run story is that banks are susceptible to runs because depositors are free, at any time, to claim all of their money on demand. This is a contractual choice, and one that makes some sense given depositors’ demand for short duration, liquid savings instruments. But if a bank can restrict its depositors’ ability to demand their funds on the spot in certain circumstances – in the event of heavy demands for withdrawals, for example – then the bank will be less susceptible to a run. And there is ample precedent for deposit contracts with such characteristics. In 19th century U.S. banking panics, banks preserved their liquidity, individually, by suspending the convertibility of their deposits into currency. They also had recourse to collective actions through the issuance of loan certificates by clearinghouses in the major cities, which allowed the clearinghouse members to meet their interbank obligations and customers to make interbank transfers without drawing on banks’ scarce supplies of currency.

While Lacker’s candor is refreshing, he has not teased out the full implications of his observations. Supporting the prices of some assets has the effect of enriching certain interests at the expense of others. Similarly, shifting risk from individual banks onto the central bank is believed to be worthwhile because any collective costs are assumed to be lower than that of a financial crisis. But the degree of risk transfer we’ve seen in the last year, which seems close to a “heads I win, tails you lose” game for the financiers, again raises question of fairness and resource allocation.

Axel Leijonhufvud, in a Centre for Economic Policy Research paper “Keynes and the Crisis,” (hat tip Richard Alford) does a first-rate job of analyzing what the credit market upheaval has revealed about the limitations of various economic models and institutional arrangement. In particular, he found that it called into question the central premise of modern central banking, including central bank independence (emphasis his):

There are two aspects of the wreckage from the current crisis that have not attracted much attention so far. One is the wreck of what was until a year ago the widely accepted central banking doctrine. The other is the damage to the macroeconomic theory that underpinned that doctrine.

Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level.5 Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measure by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is ‘right’. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

A second tenet of the doctrine was central bank independence. Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.

Transparency of central banking was a minor lemma of the doctrine. If monetary policy is a purely technical matter, it does not hurt to have the public listen in on what the technicians are talking about doing. On the contrary, it will be a benefit all around since it allows the private sector to form more accurate expectations and to plan ahead more efficiently. But if the decisions to be taken are inherently political in the sense of having inescapable redistributive consequences, having the public listen in on all deliberations may make it all but impossible to make decisions in a timely manner.

When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.

Consider as examples two columns that have appeared in the Wall Street Journal in recent weeks. One, by John Makin (April 14), argued that leaving house prices to find their own level in the present situation would lead to a disastrous depression. Policy, therefore, should be to inflate so as to stabilise them somewhere near present levels. If the Fed were to succeed in this, it might not find it easy to regain control of the inflation once it had gotten underway, particularly since some of the support of the dollar by other countries would surely be withdrawn. But in any case, the distributive consequences of Makin’s proposal are obvious to all who (like myself) are on more or less fixed pensions. The other column, by Martin Feldstein (April 15), argues that the Fed had already gone too far in lowering interest rates and is courting inflation. He wasin favour of the Fed’s attempts to unfreeze the blocked markets and restore liquidity by the unorthodox means that Volcker had mentioned.

The likely prospect for the United States in any case is a period of stagflation. The issue is going to be how much inflation and how much unemployment and stagnation are we going to have. To the extent that this can be determined or at least influenced by policy the choices that will have to be made are obviously not of the sort to be left to unelected technicians.

There has been a great deal of hostility towards the Fed, as witness by comments here and on other blogs, and by the existence of sites such as “Bernanke Panky News.” A lot of that is Greenspan backlash. Having become too willing to take credit for general economic prosperity (and having taken too much interest in the performance of the stock market, something no previous Fed chair gave a fig about), he became the focus of anger over the credit crisis. While the Fed bears significant responsibility, messes this big have many parents.

But there has been another thread mixed in with this: resentment at the Fed salvaging the banking industry, with contingent and real costs, in the form of higher inflation, per Alford’s and Leijonhufvud’s analysis. Now that many of those actions may indeed have been the best among a set of bad choices (although I suspect economic historians will conclude the Fed cut rates too far too fast). However, the big issue is that they involved consequences of such magnitude that they should not have been left to the Fed. I was amazed, and was not alone, when Congress did not dress down the Fed in its hearings on the Bear rescue for the central bank’s unauthorized encroachment into fiscal action (ie., if any of the $29 billion in liabilities assumed by the Fed in that rescue comes a cropper, the cost comes from the public purse). So the frustration isn’t merely about outcomes, it’s about process, about the sense of disenfranchisement. And that will only get worse as this crisis grinds along.