A solid, well argued case against further central bank accommodation by Charles Wyplosz, professor of economics at the Graduate Institute of International Studies in Geneva, in the Financial Times. The centerpiece of his argument is that by providing ample liquidity and low interest rates, monetary authorities are delaying the very steps necessary for banks to regain confidence in one another, namely, writeoffs and capital raising.
While this article is cogent as far as it goes, it neglects the role of regulatory reform. In an op-ed piece today, Paul Krugman highlights the role of free-market ideology in the real estate bubble. It has become an article of faith that less regulation is better, despite the mounting evidence to the contrary. Alan Greenspan, a loyal disciple of Ayn Rand, was a staunch believer, as Krugman notes:
In a 1963 essay for Ms. Rand’s newsletter, Mr. Greenspan dismissed as a “collectivist” myth the idea that businessmen, left to their own devices, “would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings.” On the contrary, he declared, “it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product.”
Guess Greenspan never heard of Upton Sinclair’s The Jungle, which detailed the horrors of the turn of the 20th century meatpacking industry (sweatshop working conditions, adulterated meat, non-existent sanitation) and led, among other things, to the Meat Inspection and Pure Food and Drug Act of 1906.
From the Financial Times:
The combined central bank injection of liquidity last week was impressive. Still, more than five months after the interbank market froze, banks’ thirst for cash seems unquenchable. The central banks have done everything they can to keep financial markets orderly. They took the risk of feeding the moral hazard beast and what did they achieve? So far they have avoided the much-feared “Big Crunch”, but the end of the tunnel is not yet in sight. The time has come to ask the harder question: do commercial banks get it?
The big commercial banks hold mountains of cash, probably because they still have mountains of sickly off-balance-sheet liabilities that they are unwilling to acknowledge. Or it is because they fear that other banks are in that position and that this could trigger the Big Crunch. Or they just think that other banks think that way. Prudence is a much-needed virtue in banking, the more so because it has been forgotten in recent years.
But the further cash injection will not provide the permanent solution: the return of interbank lending. For that to happen, banks need to be reassured about each other. Recapitalisation is the only solution. Three big banks – Citibank, UBS and Morgan Stanley – have shown the way in recent days. They remind us that large losses must be financed by fresh share issuance. It matters little who provides the cash. We should not let concerns about sovereign wealth funds stand in the way of a permanent solution.
Obviously, shareholders do not like the dilution of their stakes, but this is what shareholding is all about. If a company has suffered, or is about to suffer, heavy losses, its shareholders will have to bear part of the trouble. Delaying tactics prolong the misery without solving the problem, which will not go away.
We now see that the willingness of central banks to provide liquidity at reasonably low cost is only allowing shareholders to delay the time of reckoning. There is no reason for allowing this to go on and on. Delaying tactics are, after all, what led to Japan’s lost decade, after some of the world biggest banks had suffered large losses and their shareholders rested on the authorities’ support to delay the inevitable. The inevitable eventually occurred, but meanwhile the cost to the Japanese economy was gigantic. This is a mistake that should not be repeated.
Much like in Japan then, today’s banks free-ride on the fear of a recession. They calculate that the central banks will not toughen up when credit is scarce and uncertainty huge. The central banks were right to provide banks with some breathing space, but they also have the right to ask what use has been made of this facility. With few exceptions, the answer is very little or nothing. The message must now go out: unless banks take up their losses and raise the required amount of capital, there will be no more liquidity.
It is currently far too cheap for banks to sit on cash, so the central banks must make it clear that, once the end-of-the-year settlements are passed, they will let the interbank market rates rise and rise, as high as needed to provide banks with the incentive to relinquish the vast amounts of liquidity amassed over the past few months. In short, they should call the banks’ bluff.
If you think back to what has happened, the picture becomes clear. Central banks have kept interest rates very low for many years. This has led many banks to seek juicy returns – to protect shareholder value, as they say – by taking unreasonable risks. This has also led to huge foreign exchange reserves accumulation all over the world. The great unwinding must now take place.
Risky behaviour eventually means that losses occur here and there. The losses merely make up for huge past returns. For the interbank market to be revived, these losses must now be accepted. Fortunately, the cash that found its way into excess foreign exchange reserves is now available in the form of sovereign wealth funds. The circle can be closed.
Financial protectionists will display outrage. It is never pleasant to see newcomers acquire significant shares of our biggest companies, but we must also accept that the era of easy money was a mistake. The fundamental basis of capitalism is that mistakes must be borne. Here we are. But please, bring this misery to its end.
Don’t know about other readers, but I’m completely sick to death of hearing about Alan Greenspan, and his sick devotion to….who, exactly? Who is she anyway? I was sick of his pump liquidity/bailout philosophy while still trying to pass himself off as “libertarian” as Chairman, and it’s driving me bananas listening to his endless litany of absolutions now. I mean, for goodness sake, someone stop reporting his narcissistic inanities…..prod me when he admits guilt.
Bush may well be a mental midget, but the state of financial markets now is not his fault, it’s entirely Greenspan’s. How the hell anyone can consistently bail out financial institutions (on the way up, obviously, and after assisting them make superprofits) while espousing libertarian beliefs, and refusing to get involved in moderating market behaviour (ie. support regulation) is beyond ridiculous.
With regard to the first of his comments above (taken from his 1963 tome “how to be a complete and utter tool” I believe) borders on complete lie. At best, it betrays either a lack of knowledge, or ideology-based blindness to the facts. In the best interests of companies to do the right thing? Puhlease! All the corporate scandals of the 2000s, the housing mess and so on is a testament to the fact that, even with regulation-lite in the US, reprehensible corporate behaviour not only exists, but thrives. I’m sure there are some businesses that act with a certain amount of morals, but when products sell themselves (and price and quality become increasingly irrelevant), companies can do what the hell they like. How can he not get this? Unless of course you believe real estate agents and car salesmen are not only your best friend, but honest and on your side. Sorry, too much experience with them for me to be pursuaded.
Bernanke, funnily enough, seems to get it. He can the see the liquidity trap reaching it’s craggy hand out of the grave looking to zombify the financial sector and hence, real economy. No wonder he’s getting so creative in his old age with discount rates and TAFs and so on. There have been mortgage failures, and there will likely be some broader financial (dare I say, bank) failures, and they should be allowed to happen, and the government simply has to protect innocent depositors, as opposed to lenders or equity-holders. The liquidity pump has been manned by Mr Atlas so faithfully for so long that he’s bequeathed inflation to his successor Bernanke. Thanks for that. And now it’s coming back in spades from China, the result of tying it’s policy via the exchange rate to the US. Double thanks. The financial sector has been seriously weakened now that the problems are finally, but inexorably and ultimately (obviously, as they all do) coming home to roost. There is a time (in fact, all the time) when blind ideology produces sub optimal outcomes, only the time period changes. Remedies that are actually designed to work are what is required, with broad-based buy-in invited. The government is now going to have to get involved and, in an election year, it’s a cinch to happen.
There are so many more things to say about this wingnut that I’ll never get off this chair if I try…….So pleeeeease, make this site a “froghead-free zone”…..and Happy Birthday by the way.
(A)greed about Greenspan.
He might well have been a disciple of Ayn Rand in his younger days. But those were his younger days.
You should see the formal oath of allegiance he swore when accepting a knighthood from Queen Elizabeth.
“Arise, Sir Alan…”
Excellent analysis of the central banks’ ‘surge’ in cash supposedly intended to give the big commercial banks temporary ‘breathing room’ in order to reach a ‘settlement’ and ‘stabilize’ this crisis.
It is beyond ironic that this description of the battle to stabilize the banking situation is exactly the same as the Bush ideological based lies about ‘stabilizing’ the situation in the supposedly temporary battle in Iraq.
“The ‘surge’ in military support is intended to provide temporary ‘breathing room’ so that the conditions of a political ‘settlement’ can be worked out by the Maliki government, and ‘stabilize’ Iraq.”
Same ideological BS —- just a different theater of war for the ruling Empire.
Japan continues to be used as a benchmark for what the Western banking system should be avoiding in order to limit the financial crisis. I have to wonder if it really is all that simple,we acquire new banking capital, admit or past investments were bad and all is well. Its one thing for Citi, MS to raise additional capital its another for J6P to admit that his/her home is really only worth .50 cents or less on the dollar and they should continue making payments, continue buying new cars and continue creating new CC debt.
That seems to be the prevailing wisdom. Admit loses rasise capital and continue flooding the world with bad debt, but as Japan as shown this much much easier said then done and this is a global problem not a country specific one. I am very discouraged that this financial crisis is much larger and global in scope than any previous ones and market participants seem to even more confident that everything is just going to perfect in a couple of months. The is survivorship bias at work.
Banks will continue to find new ways to transfer risk and thus add new layers of risk to the market; that is what they do best.
New methods and mechanisms will be engineered, arm-in-arm (no pun intended) alongside FASB accounting charades which enable bridges to be constructed which allow financial manipulation and non-accountability to jump from one offshore island to the next, all in the name of GAAP and SEC reporting (fraud).
The latest scams are already in the pipeline:
LDI strategies are starting to gaintraction in the United States. This interest is a response to increased volatilityin financial reporting and cash contribution requirements 4 caused by the Pension ProtectionAct of 2006 (the PPA) and financial accounting reform of how plan sponsors account forpension plans under new Financial Accounting Statement 158 (FAS 158). Included amongt he effects of the PPA and FAS 158 are faster funding requirements…
“It has become an article of faith that less regulation is better, despite mounting evidence to the contrary.”
The problem isn’t the ideal amount of regulation, IMHO it is mixing capitalism and socialism. Although they are each self consistent, a mixture of both is not. Mixing capitalism and socialism is like mixing coffee and beer. The end result doesn’t keep the best qualities of both, it is crap. Since financial institutions have a mix of explicit and implied govt guarantees, deregulation in their case amounts to a half capitalist half socialist system. For example, take Californias electic utility “deregulation”. Supporters of capitalism and socialism compromised and agreed to half of each (retail prices fixed by the govt, but market based wholesale prices with the kicker that long term contracts were not allowed, had to buy short term essentially spot prices). It failed spectacularly. Deregulation of a capitalist enterprise makes sense. But not a socialist system. Should we “deregulate” the FDIC?
the Reserve Bank of New Zealand under Don Brass actually floated the idea of dissolving itself-leaving depositors to ‘vote with their feet’ vis a vis healthy banks and where they put their money. Also, neither in NZ or here in Australia do we have FDIC deposit insurance.
Of course, we have spared ourselves the mayhem and carnage of the fragmentation of credit formation you have in the USA (mortgage repossessions here remain as the lowest on Earth)
The problem is not regulation but complexity.
No one, however crazy, denies that fractional-reserve banking depends on regulation. Bagehot described the regulator’s task in Lombard Street: distinguishing between liquidity and insolvency.
In other words, a classic Bagehotian lender of last resort needs to be able to distinguish administratively between good loans and bad loans.
We’ve seen how well the ratings agencies do at this. Do you really think that if you set Paul Krugman up with his own brand new Federal department, perhaps the Department of Debt, he would do a better job?
He probably would. For a while. Then his ratings would degenerate into little pieces of meaningless bureaucratic model-generated red tape, like everyone else’s ratings.
This is the regulatory cycle. Complexity creates loopholes, loopholes create bubbles, bubbles create crashes, crashes create calls for new regulation, new regulation creates more complexity. Lather, rinse, repeat. How many more times do we need to go through this?
The fundamental problem is that fractional-reserve banking depends on administrative pricing of securities, and administrative pricing doesn’t work.
Um, you are aware that The Jungle was a novel, n’est ce pas? I sure hope the bloggers of 2106 won’t have to resort to State of Fear when they try to explain what went into those cans labeled “IPCC.” Oh, wait, I forgot, Upton Sinclair good, Michael Crichton bad.
Oh, and have you ever noticed that not lending to bad credit risks is redlining, whereas lending to bad credit risks is predatory lending? Does the phrase Community Reinvestment Act mean anything to you? Dr. Krugman, like all great political intellectuals, takes his cut coming and going.
I request that when you mention Leading American Economists, you remind me which is which. Thus for one you might write “[too odious even for Harvard]”, for another “[stole from Russia]” and for a third “[worked for Enron]”. I’d find that helpful.
Sorry, not a fan of ayn rand, her novels are almost unreadable. Of course, I thought Finnegans wake was unreadable too, for different reasons. The overwhelming, oppressive , heavy stances she pushes are almost a reminder of what the worst ideologues of the 20th century were.
Sure, the article almosts misses the topic of reform but before reform can even be contemplated, the problems have to be solved, not temporarily but by biting the bullet.
The suffering caused by the crisis of the moment will impact not just the culture of consumerism but more importantly perhaps, highlight the income gap and that’s where the nascent impetus for socialism will reside.
“not lending to bad credit risks is redlining”
Is it? I thought it was using geographical zones to determine bad credit risks (rather than income, character, …).
“It is currently far too cheap for banks to sit on cash, so the central banks must make it clear that, once the end-of-the-year settlements are passed, they will let the interbank market rates rise and rise, as high as needed to provide banks with the incentive to relinquish the vast amounts of liquidity amassed over the past few months. In short, they should call the banks’ bluff.”
If this is the professor speaking, he has it quite backwards. Higher administered rates would only create more fear of credit risk amongst banks, discourage them away from even higher libor spreads, and encourage them to take even greater refuge in marginally higher treasury bills.