If there’s a credit crunch, leave the Fed Funds rate alone, raise the discount rate and use the discount window

There is a flood of articles, comments and editorials pointing to the risk of the current renormalisation of credit risk spreads becoming a true credit crunch/squeeze/crisis - choose your own adjective. Almost invariably the author then concludes that, should a credit crunch materialise, the relevant monetary authorities (mainly the Fed at this juncture) will and should lower interest rates. Why?

A credit crunch is a liquidity crisis that can, if things get badly out of hand, lead to disorderly markets – indeed to markets seizing up and ceasing to trade altogether – and to unnecessary and socially costly defaults. I assume everyone is agreed on that. Why would the right response to that be a cut in the short (default-) risk-free nominal interest rate? We don’t have a credit crunch because the short risk-free nominal interest rate is too high. We have a credit crunch because private agents have lost confidence in their counterparties ability to meet their obligations on the agreed terms. What is required, from the policy point of view is an injection of confidence, that is, of liquidity, not a reduction in the short nominal risk-free interest rate.

In a credit crunch, liquidity is everything. Liquidity is a property or characteristic of assets of claims. It is not a binary, all or nothing characteristic – you either have it or you don’t – but measured along a continuous scale. The (degree of) liquidity of an asset is measured by the speed and cost with which it can be realised, that is, turned into cash or cash equivalent instruments. Cost measures both transaction costs (bid-ask spreads and other fixed and variable costs associated with a secure transfer of title and exchange for cash) and the effect on the market price of a successful realisation of the asset. A perfectly liquid asset can be sold instantaneously, at no cost and without any effect on the prevailing market price.

For standardized financial instruments, like a fixed-rate mortgage, a ten-year fixed-coupon bond or an unsecured bank loan of a given maturity, the only determinant of liquidity that matters is the confidence of the potential buyers in the ability of the issuer of the instrument to meet the terms of the contract. If you can, with a reasonable degree of confidence, put a number both on the probability that the issuer of the bond will default and on the amount you will be able to recover should a default occur, the odds are that the market will be able to price the bond and that you will be able to sell it at that price. It’s when there is pervasive Knightian uncertainty, when the market doesn’t have a clue about the creditworthiness of the obligor, that fear and panic take over and trading stops.

The private sector is a lousy source of liquidity Since liquidity is ultimately a function of confidence, the market (whoever she is) and private institutions will never be able to create instruments with the same degree of liquidity as the serious sovereigns of this world. That is because, unlike private agents, the state has the monopoly of the legitimate use of force. It can tax those in its jurisdiction, and it can prescribe and proscribe behaviour. Specifically, it can force those in its jurisdiction to accept in payment and final settlement of debt and other financial obligations, anything it designates as legal tender. The central bank, as the liquid window of the state, tends to be the agent of the state that has some of its liabilities (currency) designated to be legal tender, but it could be any other agency designated by the state.

Private institutions, commercial banks, investment banks, hedge funds or what not only create fair weather liquidity: the instruments they issue or guarantee are liquid when you don’t need it, illiquid when you need them to be liquid. The private liquidity accordion looks mighty impressive when fully extended; it is puny when completely compressed.

The central bank (the Fed, as the central bank faced most directly with the mess of the sub-prime mortgage debacle – a mess to a large extent of the Fed’s making) therefore must respond to a credit crunch by guaranteeing the liquidity of a wide range of instruments held by private parties, instruments that without the Fed’s intervention would become illiquid. The Fed should do so by following Bagehot’s 150-year old advice. With one slight clarifying amendment, that advice is as follows: in times of financial stress and distress, lend freely, at a penalty rate, against collateral that would be good in normal times but may by heavily impaired in the extraordinary times prompting the Fed’s intervention.

A proposal The Fed should not lower the Federal Funds target rate by engaging in more aggressive open market purchases. That lowers the cost of funds even to those who are not financially distressed. In addition, even a 100 bps cut in the Fed Funds rate may not help much if irrational fear and despondency cause an escalation of the subjective assessment of counterparty default risk and a collapse of subjective recovery estimates. No, rather than inject liquidity broadly into the market through open market purchases, the Fed should lend directly to the distressed institutions, using its discount window(s) (there are three discount rates; the benchmark primary credit rate currently stands at 6.25%, 1.00% above the Federal Funds target rate; the secondary and seasonal credit rates exceed the primary rate). The Fed should charge a rate well in excess of the (unchanged) Federal Funds rate. The current 100bps spread seems puny and too low to be a proper penalty rate. After all, credit crunches and liquidity squeezes are a well-established feature of how financial markets operate. Private institutions that get into trouble because of inadequate liquidity should pay a price for this.

All borrowing at the discount window is collateralised, and it is key that this continue to be the case. The Fed should indeed insist on ample collateral; private liquidity constrained beggars cannot be choosers and the Fed should require that any loans be over-collateralised at ‘orderly market shadow prices’. The collateral may not be worth much when ‘marked to market’ under credit crunch conditions, but the Fed will have a pretty good idea of what it would be worth when orderly markets are restored.

This policy has a number of advantages.

First, by lending only at a penalty rate and by insisting on adequate collateral, the risk of moral hazard is minimized and private players are reminded where it matters of the importance of managing liquidity properly.

Second, by not cutting the Federal Funds rate, the Fed would avoid the over-liquification of the economy that it engineered and failed to reverse following the stock market crash of 1987, the Asian crisis of 1987 and the Russian crisis of 1988 and the stock market collapse of late 2001. The Fed has, with the help of the Bank of Japan and to a lesser extent of the ECB, created the chronically lax credit conditions that have resulted in the asset booms and financial market excesses of the past couple of decades. Under my proposal, there would be no ‘Bernanke put’ to follow the ‘Greenspan put’. It's always good not to solve the immediate crisis by laying the foundations for the next one. The Fed has done this too often in the past. It's time to get serious.