August 19, 2007
Should Central Banks Intervene During This Financial Crisis?
Should Central Banks Intervene During This Financial Crisis? Becker
The Fed, the European Central Bank, and the Japanese Central bank have all been pumping liquidity into the global economic system through easing borrowing in overnight money markets in order to stem the lending crisis brought on by heavy default rates on sub prime loans. The Fed on Friday also lowered the rate they charge to banks, and encouraged them to use this rate to borrow for longer than overnight, especially with sub prime loans as collateral for their borrowing.
By contrast, the British Central Bank has not taken any special steps, and the head of that bank, Mervyn King, and some other economists have argued that trying to stem the crisis by making loans cheaper and more available is an unwarranted bailout of financial institutions. This could create a risk-called "moral hazard"- which means in this situation that hedge funds and other financial companies might lend recklessly in the future in the expectation that they would be helped again by Central Banks if they get into trouble. Others have argued that the financial system has to go through a crisis to eliminate all the reckless investments that have been made during the past few years.
I have been a strong opponent of bailouts of individual companies since I do not believe in the "too big to fail" justification when applied even to large manufacturers, financial intermediaries, or service companies. In particular, I was against the Fed's putting pressure on private investors to bail out Long Term Capital during the financial crisis of the late 1990's. It would be a further mistake for the Fed or other Central banks to come to the assistance of hedge funds or other lenders that may be in financial difficulties because they excessively invested in assets of dubious value. They should bear the consequences of their mistakes. In particular, no assistance should be given to home lenders or others who might go bankrupt because it made an excessive number of highly risky mortgage loans to borrowers with dubious credit.
To be sure, in the environment of the past several years of very low interest rates, sharply rising housing prices, and new instruments for managing and aggregating risk, it is easy to understand why loans to finance home ownership spread to borrowers who in the past would not have been considered sufficiently credit worthy. Many of these loans have turned sour because interest rates have begun to rise sharply, especially on low-grade mortgages, and because of the steep slowdown in the increase in housing prices. Yet f the discussion of this experience typically forgets that most homeowners who can no longer meet mortgage payments and may have to sell their homes will get back more than they paid because housing prices remain well above what they were when they bought their homes with cheap loans.
So is laissez faire the right option in this case, and the Fed and other central banks should not offer any special help? I would have absolutely no doubts that this is the right policy if the major risk of the present situation were that some hedge funds and other financial institutions would experience sharp rundowns in their assets and even bankruptcy. However, the Fed's recent intervention was driven by the fear that the weakness in financial markets will spread to the real economy, and will adversely affect employment, investments, and general welfare in the United States. The same justification would apply to Europe and Asia as well. The avowed goal of such interventions would not be to help individual companies or borrowers, but rather to stabilize the complicated and interconnected economic system.
Such an approach by the Fed and other central banks is not foolish, and may be right, but I believe they should continue to be guided by the criteria that have served them very well during the past couple of decades. That is, their policies should be determined by rules dependent on broad developments in the economy: unemployment, the growth in GDP, and the inflation rate. Central banks should intervene by lowering interest rates only when these broad economic indicators begin to slip badly. Since unemployment continues at low levels, and inflation is still modest, the U.S. GDP growth rate is the only major indicator that has worsened- output in Europe, Japan, and most of the rest of the world has continued to grow at a brisk pace.
I conclude that central banks should be especially vigilant for signs that the damage is spreading to fundamental economy indicators, but should refrain from any special actions until that time. Otherwise, central bank policy would get confused between rules that depend on broad developments in the economy, and discretion that is affected by development in the housing market, the market for credit, or other specific markets.
Against Bailouts--Posner's Comment
If a person's assets grow in value, he can borrow more against them, or expect a lower interest rate if he does not increase his borrowing (for then the lenders have more security). This is true of houses as of other assets. In a growing economy, with the amount of land available for housing more or less fixed, the value of residential property can be expected to increase--over the long run. But in the short run, asset prices may stagnate or even decline. In recent years, homebuyers have been willing to take on historically unprecedented risk in the form of 100 percent mortgages (on the subprime bubble, see my posting of June 24) and floating interest rates. As a result, if housing prices fall, a buyer can find himself with negative equity (that is, owing more than his house is worth) and paying a much higher interest rate than the rate prevailing when he bought the house.
Although a floating interest rate shifts risk from lenders to borrowers, lending without requiring a significant (or sometimes any) down payment imposes substantial risk on lender as well as borrower, since they have in effect a joint interest in the property that secures the loan. Moreover, the costs of foreclosure and resale are considerable and amplify the loss of value when housing prices fall and precipitate defaults.
Back in 2005, both the Economist magazine and the Federal Deposit Insurance Corporation, along with many others, warned that American housing prices were growing at unsustainable rates; the FDIC noted that in the five years ending in 2004, U.S. home prices had risen by 50 percent. There is a long history of housing busts following housing booms, and although generally in this country the booms and busts have been local rather than nationwide, Japan famously experienced an extremely severe nationwide drop in housing prices in 1990. One might have expected concerns with the possibility of a bust, given the housing bubble and risky lending, to drive up interest rates, but this did not happen, because lenders were willing to assume a very high level of risk. In part this was because the initial lenders could sell loan packages to hedge funds and other specialists in risk bearing.
The bubble burst, defaults ensured, interest rates rose--precipitating more defaults--and some lenders were wiped out. Finally the Federal Reserve Board stepped in and eased interest rates by providing additional capital to the banking industry.
The only justification for bailing out risk takers is to avoid a depression (or as it is politely called nowadays, a "recession", but, oddly, the worse the macroeconomic consequences of a speculative boom and bust, the stronger the argument for punishing the risk takers (which include both borrowers and lenders) by not bailing them out. The punishment should fit the crime (I use "crime" in a figurative sense); the worse the crime, the heavier the optimal punishment, setting aside issues of detectability. If the government relieves risk takers of the consequences of their risks, there is a divergence between social and private risk. An example is subsidized flood insurance, which leads to excessive building in floodplains.
There seems a particular perversity in making credit cheaper, since cheap credit fed the boom. Lower interest rates encourage borrowing and hence spending and also increase the price of imports by making the dollar worth less relative to other currencies. Moreover, government intervention to help lenders and borrowers invites further government regulation--for example limits on subprime lending. There is no more reason to discourage risk taking than to bail out the risk takers when the risks they have voluntarily assumed materialize.
The losses sustained by hedge funds in the bursting of the subprime bubble lend a note of irony to opponents of taxing them comparably to other investment companies. They argue that hedge funds play an essential role in bringing market values into phase with the underlying real economic values. It now seems that a number of hedge funds were caught up in a speculative frenzy, and that far from bringing about convergence between market and real values they enlarged the wedge between them.
Studies in cognitive and social psychology have identified deep causes for the overoptimism, wishful thinking, herd behavior, short memory, complacency, and naive extrapolation that generate speculative bubbles--and that require heavy doses of reality to hold in check. Any efforts to soften the blow will set the stage for future bubbles.