Martin Wolf Takes Bernanke to the Woodshed

Oh, I do so enjoy it when the Financial Times’ chief economics editor, the normally measured and thoughtful Martin Wolf, works himself into a lather.

Wolf blasts what he reads as the Fed’s vow of last week, uttered by Senate banking committee chairman Christopher Dodd, to keep the markets afloat (Dodd’s exact words were that Bernanke would “use all the tools at his disposal”). Traders took that as a promise that the Fed would cut rates at its regularly scheduled September meeting, although Fed officials had tried to dampen that notion. However, yesterday the Fed indicated that worsening conditions might warrant a policy response even sooner.

I admit I may have gotten this wrong. I saw having Dodd speak as a brilliant bit of stagecraft, since it might calm the markets (which were irrationally spooked) yet give the Fed chair plausible deniabilty. Note that the Japanese yen had spiked up sharply overnight and in European trading, which could have led to a massive unwinding of the carry trade and in turn, large scale selling into an already deteriorating market.

But the fact that Bernanke even met with Dodd (and Paulson) was troubling (meeting Dodd without Paulson would have been more appropriate. The only reason for Bernanke and Dodd to talk would be about regulations, not the state of the financial markets).

Nevertheless, I hadn’t realized that Bernanke was present when Dodd made his remarks. That puts an entirely different coloration on things.

Wolf’s article, “Central banks should not rescue fools,” (subscription required) is a bill of indictment. The Fed should not become politicized, which is what giving Dodd such a visible role suggested. It needs to more clearly parse out the actions it takes to promote its two, not always consistent goals of economic stability and soundness of the financial system.

Martin bluntly characterizes the current game as one of finding a new sucker (the latest candidate being the taxpayer) and calls our current situation a “lemon crisis.” His solution is not to bail out lemon vendors, but to force them to turn lemons into something better than mere lemonade or let bottom fishers set a market clearing price.

From Wolf:

Sometimes a picture is worth a thousand words. The one last Wednesday showing Christopher Dodd, chairman of the US senate’s banking committee, flanked by Hank Paulson, Treasury secretary, and Ben Bernanke, governor of the Federal Reserve, was such a picture. This showed Mr Bernanke as a performer in a political circus….The Fed has its orders: save Main Street and rescue Wall Street….

Policymakers must distinguish two objectives: the first is macroeconomic stability; the second is a sound financial system. These are not the same thing. Policymakers must not only distinguish these objectives, but be seen to do so. The Federal Reserve failed to do this when it issued statements, on prospects for the economy and on emergency lending, on August 17. This unavoidably – and undesirably – confused the two goals.

The statement on the economy was also premature. Everybody knows that the Fed’s job is to stabilise the economy and prevent deflation. Everybody knows, too, that the Fed will investigate the economic implications of the crisis in the credit markets at the next meeting of the open market committee. If prospects seem significantly worse, the Fed will, presumably, cut rates. But now a cut looks pre-announced. Monetary policy should not be made “on the hoof” in this way, except in the direst of circumstances.

This brings one to the second objective: ensuring the functioning of the financial system. The question is how to help the system without encouraging even more bad behaviour. This is such an important question because the system has been so crisis-prone, as Larry Summers points out (“This is where Fannie and Freddie step in”, August 27). I think of the underlying game as “seek the sucker”: sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer who rescues the players who became rich from lending to sucker number one and selling to sucker number two.

The most recent game is a particularly creative one. This time the geniuses seem to have created a “lemons crisis”, after the celebrated paper by the Nobel laureate George Akerloff*. Consider the market in used cars. Suppose buyers cannot tell the difference between good cars and bad ones (lemons). They will then offer only an average price for cars. Sellers will withdraw any good cars from the market. This may continue until the market disappears entirely.

What is driving this is “asymmetric information”: buyers believe sellers know more about the quality of what they are selling than they themselves do. This seems to be precisely what has now happened to trading in certain classes of security. The crisis is focused in markets in structured credits and associated derivatives. The cause seems to be rampant uncertainty. Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties. This, in turn, has led to the panic purchases of US Treasury bills shown in the chart.

Yet the difficulty is not a lack of general liquidity. Central banks have provided it freely. Some would argue that, in the case of the Fed, with its half a percentage point cut in the discount rate, provision has been too cheap and, in the case of the European Central Bank, provision has been too free. Nor is this a general crisis in lending. Credit spreads have not exploded for corporate or emerging market debt. They have merely become less unreasonable. Market volatility has increased, but not to extraordinary levels.

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

This is why I disagree with the suggestion by Willem Buiter and Anne Sibert, in the FT’s economists’ forum, that central banks should now become market-makers of last resort. Central banks could do this only if someone regulated not just the soundness of financial institutions (as now) but also the properties of all the products these institutions invent. Otherwise, the central banks might be forced to buy what they do not understand. They would, instead, be offering a commitment to be buyers of last resort in a market for lemons, thereby subsidising the creation of a market in junk. If central banks were to regulate products, however, they would be running the financial institutions. Ours would become a quasi-nationalised financial system.

Now suppose central banks did, instead, refuse to intervene in the afflicted markets. What would happen? Sellers must turn lemons into apples, pears, strawberries and all the rest. In other words, they must demonstrate the precise properties of what they are trying to offload. Where they cannot do this, they may have to hold securities to maturity. Meanwhile, vulture funds would invest in obtaining requisite knowledge. Losses will also have to be written off. How much of the market in securitised lending would survive this shake-out, I have no idea. But I do not care either. That is for the players to decide, after they realise the consequences of getting it wrong.

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

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

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  1. EEngineer

    Yeah! There’s still some grown ups out there. Unfortunately, “there” is a long way away from the problem and few here are curious enough to read the FT since it’s “foreign” press.

  2. Anonymous

    Beautifully put! This crisis is the test that will show us all whether the Fed is in fact an independent central bank or beholden to political and/or financial interests.

  3. Anonymous

    A thought for people trying to solve the credit crisis. (Really for the ones who get to actually read the contracts). But hey, maybe they read your blog too.

    Model the unwinding on the used car market in the US — it’s definitely got lemons but it works pretty well: The first owner takes a huge hit for the simple reason that he wants to sell which sends a really bad signal to the market. (i.e. new cars depreciate by up to 50% in the first three years of ownership.) After that hit, the market actually works pretty well. If there’s some product line with a lot of supply at two years old, you can pretty sure it had a lot of lemons and a low price. If there’s a line with little supply, it’ll probably have a higher price.

    In other words the CDO market can probably recover after this and work just fine. Whether it will get set right in the next few months is an entirely different question. It looks to me like the issuers were counting on Uncle Ben to bail them out and didn’t bother to plan for the worst case scenario.

  4. Anonymous

    The little piggies gonna have to learn to build their house from bricks! Blow wolfie blow!!

  5. Lune

    That’s neat to view this through the prism of theories on asymmetric information. It adds another way to understand what’s happening. But I wonder whether it’s asymmetric information or just plain lack of information. It seems there are a few possibilities:

    1) The seller knows he’s selling junk and the buyers have now become suspicious (asymmetric info)
    2) Neither the seller nor the buyer really knows the true value of these products (note how many sellers are out there claiming essentially their models are “broken”)
    3) Both the seller and the buyer know exactly what the value is, but the seller doesn’t want to accept vulture offers of $0.10 on the dollar for fear of what having to mark-to-market would do for the rest of their portfolio.

    We’ve seen evidence for all 3 possible scenarios. Are there specific outcomes/predictions that could be made using asymmetric information theory that would allow us to test if we’re indeed in market type 1?

  6. Yves Smith


    That’s an astute observation. I don’t have a ready answer, but I think your #2 will produce behavior much like #1. The seller once claimed he knew what the paper was worth. Now he says he has no idea.

    There’s an old expression in negotiating, “Never bid against yourself.” In this case, buyers, who already have plenty of reason to distrust sellers (first they said they were experts, now they say they are idiots), could view this ‘I don’t know what this is worth” as a ploy to make the buyer make the first offer, hoping the buyer will offer more than what it is really worth.

    In other words, buyers may suspect the seller claims of lack of a basis for pricing to be a ruse to extract a better bid.

    But other thoughts very much appreciated.

  7. Anonymous

    Sellers can “sell” to themselves at a price they like by refinancing in maturities that match the asset and then holding to maturity.

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