Support markets, not banks

An earlier version of this blog appeared as a comment on Larry Summers' contribution to Martin Wolf's Economists’ Forum, "Beware the moral hazard fundamentalists",

Larry Summers' contribution contains a nugget of sense about liquidity, but this is buried deep under several layers of dross about moral hazard – a term I consider unhelpful. Its use encourages getting sidetracked into a didactic, essentialist argument about whether the bail-outs and other official financial support operations under discussion are indeed creating moral hazard in the strict insurance-technical sense of the word. What we should be talking about is bad incentives producing bad - inefficient and inequitable - outcomes.

Providing liquidity to support markets

Liquidity is a key property of assets. It refers to the ability to sell the asset at short notice and at low transaction cost at a price close to its fundamental or fair value (fundamental or fair value is what you would pay for the asset if it could be bought and sold instantaneously and at zero transaction cost, that is, if ownership could be transferred costlessly and instantaneously). Liquidity is distinct from maturity or duration. Securities can have long remaining maturities or duration, yet be highly liquid because of the existence of deep, well-functioning secondary markets. Market liquidity is about trust and confidence. When normally liquid markets dry up, only the central bank can provide the public good of trust that restores liquidity swiftly and at little or no private or social cost. So it should be done.

More formally, correcting or mitigating market failure need not distort private incentives; injecting liquidity into a market that has become illiquid need not create moral hazard by distort private incentives for appropriate risk management in the future. Markets, that is, mechanisms for matching willing buyers and sellers at a price acceptable to both, are, in the case of assets like securities (or any store of value that can be resold in the future), subject to an inherent network externality: the likelihood of my being willing to buy a security at a price close to its fundamental or fair value is a an increasing function of the likelihood I attach to my being able to find a willing buyer for that security in the future at a price close to its future fundamental or fair value. When I believe that (1) I may have to sell the security in the future (possibly unexpectedly) and that (2) the future probability of finding a buyer is high, I am likely to buy now. If there are a lot of market participants with similar beliefs, the market today will be liquid. If there are a lot of market participants today with pessimistic beliefs about finding a future buyer at a price close to future fair value, the market today will be illiquid. Such a market will have at least two kinds of equilibria. One has self-fulfilling optimistic beliefs about future liquidity. Such a market will be liquid today. The other has self-fulfilling pessimistic ideas about future liquidity. Such a market will be illiquid today.

When the bad (illiquid) equilibrium prevails, one way to move to the good (liquid) equilibrium is for an agency whose liabilities have unquestioned perfect liquidity to inject liquidity into that market. In doing so it supports the market for the illiquid security. It does not bail out individual private businesses, that is, it does not act as a Lender of Last Resort (LOLR). The action will help the private businesses that hold the illiquid securities, but this assistance efficient: it corrects a distortion. The intervention renders liquid those securities that, because of fundamentally arbitrary albeit self-fulfilling beliefs, have become illiquid. The agency acts as a Market Maker of Last Resort (MMLR). The central bank is the natural agency to ‘liquidify’ (or should that be ‘liquefy’?) normally liquid markets that have become illiquid. That is because it is the source of ultimate, unquestioned, costless and instantaneous liquidity – the monetary liabilities of the central bank: commercial bank reserves with the central bank and currency.

Unlike the Fed and the ECB, the Bank of England does not appear to understand the nature of market liquidity and what could cause it to disappear and reappear. Instead of thinking of liquidity as a public good, it thinks of it as a private good that should be managed by individual financial institutions the same way they manage default risk or price risk.

Indeed, liquidity can be managed privately. Commercial banks could hold as assets only things that are highly liquid, like reserves with the central bank and government securities for which the secondary markets are normally deep and orderly (Treasury bills, gilts etc.). This would eliminate liquidity risk. However, such highly liquid asset portfolios would be socially inefficient (as well as unprofitable). We want our intermediaries to intermediate in support of long-term commitments by households and non-financial corporations. Some of the most productive assets are inherently illiquid. Someone has to hold them. If it can only be the originator of the illiquid asset (say a private entrepreneur investing in plant and equipment) the productive efficiency of the economy would be gravely impaired. Confidence that when some key financial market becomes illiquid, the central bank will support that market, by acting as MMLR (or buyer of last resort), is essential if our economy is to optimise its ability to generate productive but illiquid assets.

The Bank of England, until it changed its mind last week and decided to intervene in the 3-month repo market against illiquid collateral (mortgages), appeared to believe that any market operations by the Bank at longer than zero maturity (overnight), represented a bail-out of all potential or would-be sellers of the illiquid collateral. That is a nonsense. It may be that some banks and other financial institutions indeed had too few liquid assets on their books, even for orderly market conditions. In that case, charging a premium over the Bank’s marginal cost of funds (Bank Rate) on the Bank’s lending in the 3-month repo market makes sense. The Bank has decided to do so, setting the rate it charges for access to the Standing Lending Facility (the Bank’s discount window, 100 basis points above Bank Rate) as the floor for the rate it will charge on its 3-month repos. It should also value the illiquid collateral according to its fair value rather than its face value, and impose other constraints to safeguard the interests of the tax payer. Finally, it should impose an appropriate haircut (discount) on the (conservatively estimated) fair value of the collateral. If all that is done, market liquidity support (overnight or at a 1, 3, 6, 12 or 24 month horizon) is not a reward for past reckless lending or borrowing. It is correcting a distortion - mitigating market failure.

Bailing out undeserving private financial businesses

Larry’s rather blanket support for bailing out distressed financial businesses (as distinct from supporting markets) is quite unconvincing. Arguments by analogy are cute but prove nothing. No, smoking in bed is not an argument against have a fire department. It is, however, an argument for having a clause in the homeowners’ insurance contract stating that no valid claim exists if the house burns down because one of the occupants was smoking in bed.

Contagion (in the sense of irrational herd behaviour) is as frequently mentioned (and modelled in neat academic papers) as it is uncommon in practice. When many private institutions or many countries are being dragged down by a common tidal wave, it tends to be because they have the same flawed fundamentals, not because of contagion. Contagion is an argument for deposit insurance, if the contagion takes the form of panicky depositors. It takes the form of market support (MMLR) action rather than support for individual financial businesses (LOLR) action if the contagion affects the liquidity of the markets for other financial instruments. State entities, including the central bank, the deposit insurance agency and the Treasury should support markets and other social mechanisms with clear public good properties, like the payment, settlement and clearing systems. Individual private businesses should be directly supported only if this is necessary for the safeguarding of some socially valuable ‘institution’ (in the proper sense of the word institution, as opposed to its use in financial ‘institution’, where it simply means ‘business’).

I cannot think of a single financial institution that is too big to fail, in the sense that it would damage some systemically important social institution. If deposit insurance is deemed important, whether because deposits are deemed an important part of the payment mechanism or because of distributional, social or political concerns, let’s guarantee deposits, but allow the institutions issuing them to fail. In the UK, Northern Rock was both granted an uncapped and open-ended Liquidity Support Facility (credit line) with the Bank of England and an unlimited guarantee for its existing depositors (and most other unsecured creditors, except for the holders of subordinated debt!). You might be able to make a case for either one of these support interventions, but not for both.

To hold out the disgraceful bail-out of LTCM as an example of how to act in a crisis is extraordinary. Indeed no public money was involved. But the Fed (through the Federal Reserve of New York) put is reputation at risk, and in my view damaged it severely, by enabling and facilitating this shoddy arrangement - offering its ‘good offices’.

As a result of the bail-out of LTCM, there was never any serious effort to address the potential conflicts of interest arising from simultaneously financing hedge funds, investing in them, and making money executing trades for them, as many investment banks did with Long-Term Capital. The results are there today for all to see. Things were even worse because apart from the inherent potential conflict of interest that is present whenever a party is both a shareholder in and a creditor to a business, the bail-out created a serious corporate governance problem because executives of one of the financial institutions that funded the bail out had themselves invested $22 mln in LTCM on their personal accounts. Using shareholder resources for a bail-out of a company to which you have personal exposure is unethical, even where it is legal.

To crown it all, the founders of LTCM were allowed to retain some equity in the firm, supposedly because only they could comprehend, work out and unwind the immensely complex structures on its balance sheet. These were the same people whose ignorance and hubris got LTCM into trouble in the first place. Any handful of ABD graduate students from a top business school or financial economics programme could have unravelled the mysteries of the LTCM balance sheet in a couple of afternoons. This was the market establishment looking after its own. The bail-out of LTCM smacks of crony capitalism of the worst kind. The involvement of the Fed smacks of regulatory capture.

It is clear from Larry’s record at the World Bank (1991-1993) and at the US Treasury (from 1993 till 1995 as Under Secretary of the Treasury for International Affairs, from 1995 till 1999 as Deputy Secretary of the Treasury and from 1999 till 2001 as Secretary of the Treasury), that he has never seen a potential bail out he did not like: the United States support program for Mexico in the wake of its 1994-1995 financial crisis, the international response to the Asian financial crisis of 1997 and the 1998 Russian crisis and the Fed’s response to the 1998 LTCM crisis. I recognise the upside of bail-outs for those who arrange them: they look like movers and shakers, making and shaping events. It’s heroic, in an industry where heroism can be rarely displayed. But in all of the examples mentioned above, the bail-out did more harm than good.

Finally, Larry needs to add at least two other questions to his list of three ((1) Are there substantial contagion effects?; (2) is there a liquidity or a solvency problem?; (3) will there be costs to the tax payer?) central banks ought to ask themselves during financial crises. These are:

(4) Will this action (Lender of Last Resort bail-out of individual private financial businesses, Market Maker of Last Resort liquidity injections into the markets) have a material impact on the likelihood and severity of future financial crises?”

(5) Will this action produce any net social benefit?

Basel II: back to the drawing board?

Two crucial inputs into Pillar 1 (Minimum Capital Requirements) of the proposed Basel II Framework for the International Convergence of Capital Measurement and Capital Standards have, if not gone belly-up, at least been severely compromised by the recent financial markets turmoil. They are the reliance on credit ratings provided by the internationally recognised rating agencies (currently Moody’s, Standard & Poor’s and Fitch) and the crucial role assigned to internal models in everything from stress-testing to marking-to-model illiquid assets.

It is clear that, as regard rating complex structured products, the three internationally recognised rating agencies have done a terrible job. That is in part because rating complex structured products is very difficult. There is more to the ratings performance however. There appears to be a systematic bias in the ratings. If rating were merely difficult, you would expect as many over-ratings as under-ratings. What we see instead, is a persistent bias: ratings seem to systematically over-estimate the creditworthiness of the rated instrument or structure. The reason for this must be the distorted incentive structure faced by the rating agencies. They are inherently and deeply conflicted.

• First, almost unique in any appraisal process, the appraiser in the rating process is paid by the seller rather than the buyer.

• Second, the rating agencies provide (remunerated) technical assistance/advice on how to design structures that will attract the best possible rating to the very issuers whose structures they will subsequently rate.

• Third, rating agencies increasingly provide other financial services and products than ratings (or ratings advice). As with auditors, there is the risk that the rating (audit) service may be subverted in the pursuit of remunerative sales of these other products.

I am not asserting that the rating process of complex financial instrument is unavoidably utterly corrupt and useless, although some of it probably is. Clearly, reputational considerations mitigate the conflict of interest faced by the rating agencies. The rating agencies have, for a long time, done a passable job of rating sovereign debt instruments and corporate entities. However, the principal-agent chain linking an individual or team working for some rating agency to the buyer of the security they rate is lengthy and opaque. The bottom line is that no-one any longer trusts the rating agencies’ judgement of the creditworthiness of complex structured instruments. That puts a huge hole in Pillar 1.

The recent financial turmoil has led to a demystification of quants and other high-tech builders and maintainers of mathematical-statistical models and algorithms. We have had a powerful reminder of the ‘garbage in – garbage out’ theorem. On many occasions marking to model has turned out to be marking-to-make belief or marking-to-myth. Wishful thinking dressed up in advanced mathematics remains wishful thinking. The incentives faced by the designers, maintainers and users of these models, and of those who calibrate their inputs have not been taken into account. Again conflict of interest is pervasive and inescapable.

With so many illiquid, non-traded instruments on their books (and in off-balance-sheet vehicles that may have to be brought on balance sheet again soon), many banks are confronted with the fact that ‘fair value’, when it cannot be measured objectively by a market price, is unlikely to be calculated fairly by techie employees of the bank whose activities are not understood by the bank’s risk managers or top management, and whose pay and prospects depend in a pretty obvious way on the numbers their models crank out. Again reputational considerations will mitigate the incentive to distort, but will not eliminate it. Turnover of quants, risk-managers and even top managers is so high that the restraining influence of reputational concerns is often weak at best.

What is Pillar 1 of Basel II without reliable and trusted rating agencies and without reliable and trusted methods for marking to model the illiquid assets of the banks? Not something I would use as a rule book for capital measurement and capital standards for banks. So whither now with Basel II?

Forcing the rating agencies to clean up their act is one necessary condition for Basel II to get back on track. This would require rating agencies to forsake all activities other than providing ratings. It also requires the end of the payment for the rating by the issuer of the security being rated. The only workable model would be payment out of a fund raised by a levy on the entire universe of securities-issuing and investing industries that rely on ratings.

As regards internal models and marking-to-model, I can see no way the cripling conflict of interest can ever be resolved for anything other than the simplest structured products - those for which even the CEO can understand the principles underlying the model and the numbers going in and coming out. This would mean that banks would not be allowed to hold on their balance sheets, or to be exposed to through off-balance sheet connections, complex structures whose valuation cannot be verified easily by third parties. This is tough and will be unpopular with the industry, but necessary for financial stability.

In any case, if a financial product is too complex for its valuation to be understood by the average Joe, it probably contributes negative marginal social value. Such complex products tend to be motivated by regulatory avoidance and tax avoidance considerations, and should be discouraged by regulatory design. True risk trading and risk sharing require simple, transparent instruments, designed for specific contingencies (states of nature), rather like elementary Arrow-Debreu securities. They don’t require convoluted bundles of heterogeneous opaque contingent claims.

Feldstein's Jackson Hole Policy Prescription for the Fed

This post is almost identical to one that appeared on 13 September 2007, in the Financial Times, Martin Wolf’s Economists’ Forum.

There are times when I am quite pleased that Marty Feldstein, whom I admire as a professional economist and consider a friend, is not Chairman of the Federal Reserve Board. This is because his policy recommendations at the end of his Jackson Hole presentation amount to the proposal that the Fed forget about price stability and instead focus solely on cutting interest rates to minimize the likelihood and depth of a serious slowdown/recession in the US. That advice is dangerous. It is also rather surprising for Marty to express so much concern about a significant fall in US consumption demand, when he has called, for decades, for a significant increase in US private and public saving. When, at last, it looks as though he may get at least half of what he has asked for - lower US private consumption – it makes no sense to immediately ask for measures to boost private consumption.

Marty’s analysis of the origins and likely future course of the current financial turmoil in the US, and of its likely implications for the real economy and inflation, is quite convincing, although marred somewhat by the usual parochialism of US-based economists.

Extremely low credit risk spreads (as well as low long-term real interest rates) were a feature of the global economy, not just of the US. The fact that there was a willing demand for extremely large quantities of US sovereign debt from foreign official holders at very low yields no doubt contributed to the low level of US long-term interest rates and to the US housing boom. The willingness of European and Asian financial institutions to invest in securities that, directly or indirectly, exposed them to the US subprime and alt-A mortgage sectors must have been instrumental in the rapid expansion of this form of lending. The failures of regulation and supervision in residential mortgage lending markets and the unbridled growth of off-balance sheet vehicles that had neither capital nor supervision or regulation can be in part accounted for by regulatory arbitrage and by the restraining impact on national regulators and supervisors of competition for business between national financial centres. These pressures no doubt induced national regulators and supervisors in the US and elsewhere to take a hands-off approach and to rely on self-regulation (aka no regulation).

Home building in the US may have fallen by 20 percent over a year, but exports have grown by about 11 percent. Homebuilding is less than 5 percent of GDP while exports are now over 11 percent of GDP (imports are over 16 percent of GDP). Any recent and future decline in US housing construction is likely to be more than offset by the change in the trade balance. That leaves, of course, the wealth effects and liquidity/collateral effects on private consumption of a decline in US house prices.

But is a significant decline in US consumption not exactly what is required (and long overdue) for both internal and external balance reasons? Marty is always telling us that both the US private sector and the US public sector are saving too little. How will the private sector’s contribution to national saving be boosted without a significant fall in private consumption demand?

Given the prevailing nominal rigidities in US wage and price setting, any significant decline in household consumption and aggregate demand will depress economic activity. If liquidity constraints are empirically significant in the US, as they appear to be, the short-run Keynesian multiplier will deepen the economic downturn. One can easily envisage a quite deep recession.

The only mechanism to mitigate this, other than a fiscal expansion which would further weaken the external balance and also not do much for the national saving rate, would be a significant reduction in the US external trade deficit, brought about through an already weak and further weakening US dollar. This scenario would indeed become more likely were the Fed to cut its policy rates.

Marty, however, wants to use lower interest rates to stimulate every component of aggregate demand, with the possible exception of public spending on goods and services: “…lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to increase net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages”

Except for the increase in next exports, this sounds like a recipe for restoring the unsustainable status quo ante. And it is not at all obvious that, given the boost Marty wants to give to private consumption and investment demand, there would be any reduction in the US net external deficit at all.

In my view, given that increasing the US national saving rate is (a) necessary and (b) practically inconceivable without an economic slowdown and a possible recession in the US, it is better to have the slowdown now, while the world economy is still booming, than to wait until the world economy too slows down significantly. It makes no sense to call for higher private saving and then, when you are at last likely to get what you want, to ask for measures to boost private consumption.

Finally, from my perspective, risk-based “decision theory” would lead to the opposite conclusion from the one reached by Marty. He believes that the risk that the economy could suffer a very serious downturn should dominate the risk of higher inflation. I disagree. The Fed’s triple mandate (maximum employment, stable prices and moderate long-term interest rates) does not support any asymmetric treatment of risk to the real economy and risk to inflation (in the UK and in the eurozone, the central bank mandates are lexicographic, with price stability taking precedence over real economy objectives). So the question is: what would be a worse outcome - a deep recession or a loss of inflationary credibility? I would argue that the risks to price stability and to the anti-inflationary credibility of the Fed should take precedence over the risk of a deep recession. Recessions tend to be short. Restoring anti-inflationary credibility is a long-drawn out and costly process.

Clearly, if the current state of the economy is such that interest rate cuts would support the real economy without raising the risk of boosting inflation above the (implicit or explicit target rate), there is no short-run trade-off, no dilemma and no need for risk-based “decision theory”. Unfortunately, I don’t think were are in such a welcoming environment. Gauging the risk to price stability not from the Fed’s will ‘o the wisp indicator of core inflation but rather from the underlying behaviour of headline inflation, US inflation has been above the Fed’s comfort zone for five years. Unit labour cost growth is rising, quite likely a reflection of a decline in productivity growth that is not just cyclical.

To play fast and loose with inflation at this point risks undermining all that has been achieved since Volcker took over as Chairman of the Fed. This is even more pertinent because the Fed has a new Chairman whose first real test this is. Should he choose to act in a way that undermines the credibility of the Fed’s commitment to price stability, and should this lack of credibility get embodied in inflation expectations and long-term contracts, the cost of regaining virtue would be much higher than the cost of having a slowdown or even a recession now.

When in doubt, let it all hang out

From the dark days when I tried to grasp non-cooperative game theory, I know that there are circumstances that may make randomised (or mixed) strategies individually rational. Even at an abstract level, I have always considered randomised strategies to be bogus, unless there is a natural randomisation mechanism present in the fundamental structure/specification of the non-cooperative game. A coin toss simply won’t do, because there is no reason why, if heads are called but tails materialise, the coin tosser would be able to impose the action dictated by the outcome of the coin toss on the player. In other words, you cannot add randomisation of strategies as a deus-ex-machina to a game where the natural strategies are ‘pure’, that is, non-stochastic functions of (possibly random) state variables (Who tosses the coin? Isn't he also a player in the game? What are his objectives? What instruments does he have to compel the other players to abide by the outcome of the coin toss etc.?)[1]

Even if I disregard my deep conviction that randomised strategies are bogus - mathematical tricks without behavioural content - unless the randomisation device is itself part of the deep structure of the game, I have never, in the field of monetary policy, come across a configuration of circumstances that would make the deliberate creation of noise, uncertainty and ambiguity sensible, let alone optimal.

Central bankers have, however, often argued differently. I have been confronted many times with central bankers singing the praises of the pernicious doctrine of ‘constructive ambiguity’. This means that the central bank deliberately keeps the private sector in the dark about its true intentions or its true reaction function.

One example of alleged beneficial results from constructive ambiguity, is the central bank acting all coy about the circumstances that would induce it to bail out a private financial institution. This is supposed to be an efficient policy for minimising moral hazard. It's wrong. Policy can be stated clearly and conducted transparently without creating moral hazard. For liquidity problems, there is the discount window. For this to function well, the central bank should accept as collateral a much wider range of assets, including non-investment grade and impaired assets, than it currently does. That may involve the central bank acting as Market Maker of Last Resort in order to price the illiquid collateral. In the case of insolvency of a systemically important institution, it has to be made clear that all equity of the insolvent entity is extinguished if any public money goes in and that all creditors of the insolvent institution may take a hit (including, in the case of commercial banks, depositors to the extent that they are not insured). Finally, the entire top management goes without golden handshakes. That ought to take care of most of the moral hazard.

The threat of unexpected and unannounced foreign exchange market intervention intended to inflict pain on exposed private speculators is supposed to be an effective way of discouraging speculation against the currency, is another example of alleged beneficial use of constructive ambiguity. Even the deliberate creation of unnecessary uncertainty about future central bank interest rate decisions has been justified as a way to prevent the private sector from making one-way bets on some asset price or other.

I don’t buy this cloak-and-dagger-stuff. In my view the central bank’s policy objectives are best served by maximal openness and transparency. From this perspective, the Bank of England is making a mistake, if recent reports are accurate, by instructing the banks and building societies that borrow at its discount window (its ‘standing (collateralised) lending facility') not to comment on their use of that facility. The Bank refuses to comment on the identity of the discount window users, on the amount they borrow, and on the collateral they offer.

If secrecy is indeed what the Bank of England has imposed on its standing lending facility counterparties, it is bad policy. It is bad policy, first, because it won’t work. The £1.6bn collateralised (overnight) loan to Barclays Bank transacted on August 30, 2007, was known to everyone within e-mail distance of the Bank of England within an hour of the transaction taking place. It is bad, second, because it makes it look as though recourse to the discount window is a sign that there is something fundamentally fishy about the financial health of the discount window borrower. In fact, the mainstream press (not just the red-tops) often refers to the standing lending facility of the Bank of England as its ‘emergency’ credit facility. A major (re-) education effort by the Bank of England and its potential discount window counterparties is clearly overdue.

The only information conveyed by borrowing at the discount window ought be (1) that the loan was made at an interest rate 100bps above the Bank of England’s policy rate (which currently stands at 5.75%) and (2) that the borrower could offer appropriate (eligible) collateral. How punitive 100bps over the Bank of England’s policy rate is, depends on what the market rate is in the overnight money markets (or interbank market). During August, that rate has risen as high as 6.53%, which is only 12bps below the 6.75% rate charged at the Bank of England’s standing collateralised lending facility.

The best way to de-mystify discount window operations is for the Bank of England to report, for each transaction at the standing lending facility, the identity of the borrower, the spread charged over and above the policy rate, the amount borrowed, the nature of the collateral offered, the valuation of the collateral and the ‘haircut’ applied to it.

Secrecy about who borrows at the discount window, how much is borrowed and against what collateral, is an own goal in the struggle to restore orderly markets, as rumours, gossip, suspicion, leaks and strategic misinformation take the place of transparency and accountability – of the Bank of England to Parliament and of the borrower to its shareholders and other stakeholders. Even more dangerously, it reinforces the perception of the central bank in times of crisis as a manipulator of financial markets rather than a transparent strategic operator in the markets. The sooner this secrecy nonsense is ended, the better.

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[1] In Prescottian real business cycle theory, there is, in a competitive setting, a similar triumph of mathematical convenience over behavioural plausibility. When fixed costs create non-convexities which may well preclude the existence of a competitive equilibrium, some deus-ex-machina organises lotteries to convexify the economic environment. Employment lotteries are a favourite example in models with indivisible labour supply. This is an economic nonsense because there is no plausible story as to how any worker could credibly commit himself to accept the outcome of the lottery, as the winners would be, ex-post, better off than the losers (at least which mixed strategies, the utility levels attached to the pure strategies that are subject to randomisation are the same). There is a second major conceptual embarrassment with these deus-ex-machina lotteries. Typically the models in question are complete contingent market models. However, it is not possible, by assumption, to create contracts contingent on the outcome of the convexifying lottery. Permitting such contracts would re-introduce the non-convexities the lotteries are supposed to cure. This is truly bad, tool-driven economics.

© Willem H. Buiter 2007

A Fed Chairman's lot is not a happy one (happy one)

Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee (and also a candidate for the Democratic nomination for the US Presidency) and by Hank Paulson, US Treasury Secretary, Fed Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Chairman Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures from the Executive or from Parliament. Also, what operational independence the Fed has, is of relative recent origin. From 1942 until the Treasury-Federal Reserve Accord of 1951 released the Federal Reserve from the obligation to support the market for U.S. government debt at pegged prices and made possible the independent conduct of monetary policy, US monetary policy was made in the Treasury. For those 9 years, the Taylor rule was: i = 2%.

Even after the Accord, the fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. The strong populist, anti-banking currents in American politics in general, and in the Congress in particular, mean that the threat that what limited operational independence there is could be taken away is not perceived as an idle one by any Fed governor.

To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the three goals of monetary policy. The other two are maximum employment and moderate long-term interest rates. There is no quantitative or numerical definition of any of the three targets in the Act. Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out.

Both the Congress and the Executive branch of government lobby mightily for Fed actions aimed at preventing or at least limiting the losses on highly leveraged bets taken by hedge funds, private equity funds and a large number and variety of other financial institutions and special purpose vehicles - ‘conduits’, ‘structured investment vehicles’; the names vary but the economic essence of highly leveraged open positions is the same. Appeals to safeguard systemic financial stability often obscure the obvious truth. The special interests that would benefit most directly from such actions as a cut in the Federal Funds rate - highly leveraged Wall Street firms and tycoons caught on the wrong end of the increase in credit risk spreads and the disappearance of liquid markets for structured products and other contingent claims –claims that had often been touted as the ‘techfin’ solution to the illiquidity of traditional forms of credit such as secured (mortgages) and unsecured (credit card debt) – rarely play a systemically indispensable role in the intermediation of saving into investment or in the efficient management of financial wealth. Were they to go bust and disappear, they would be missed only by their shareholders and other stakeholders, and those who had lent money to them. If these shareholders and creditors are systemically significant, one assumes that the prudential regulatory regimes they are subject to would have ensured sufficient portfolio diversification for them to be able to absorb the losses caused by the insolvency of a number of highly leveraged funds/institutions.

The response to financial turmoil, disorderly credit markets and the sudden illiquidity of assets previously deemed liquid, should not be a cut in the monetary policy rate – the short-term risk-free nominal rate of interest. It should not even be to provide liquidity in large amounts at the policy rate (in the US, to keep the Federal Funds rate close to the Federal Funds target, currently 5.25%; in Euroland, to keep the overnight interbank market rate near the ECB’s Main refinancing operations Minimum bid rate (currently at 4.00%); in the UK to keep the overnight interbank sterling rate near Bank Rate (the repo rate currently at 5.75%). Market participants should pay a penalty for being caught with their liquidity pants down.

In a credit crunch/liquidity crisis, the central bank should make funds available freely, but at a penalty rate and against collateral that would be good under normal circumstances, but may have become severely depreciated as a result of the liquidity crisis.

Bagehot in the 21^st Century Both the Fed and the ECB failed to deliver the second part of Bagehot’s package: to lend at a penalty rate. One obvious way to provide liquidity at a penalty rate is to require banks and other eligible counterparties to access collateralised loans not at the policy rate, but at the discount rate. For the Fed, the primary discount rate used to be (until August 17, 2007), 1.00% above the Federal Funds target rate. Then, in response to the credit and liquidity crunch, the Fed, on 17 August 2007 lost its nerve and cut the primary discount rate from 6.25 percent to 5.75 percent. This reduction in the penalty for providing liquidity was the exact opposite of what Bagehot would have recommended. What is more, it is a recipe for increasing moral hazard without any appreciable gain as regards the provision of liquidity. The ECB kept its discount rate (the rate charged on its Marginal Lending Facility) at 100bps above its policy rate. It provided so much liquidity at the policy rate, however, that hardly any spontaneous takers turned up to rediscount eligible collateral at the Marginal Lending Facility. Only the Bank of England followed Bagehot’s nostrum,. Not only did it keep its discount rate (the rate on its Credit Facility) at an unchanged 100bps above its policy rate, it was quite willing to see the overnight interbank market rate rise towards the policy rate. It is not surprising that the least operationally independent of these three central banks, the Fed, bent furthest in response to financial market pressures for rate relief. It is surprising that the most operationally independent of the three, the ECB, was, in different ways, almost as accommodating as the Fed. The reason for this is probably lack of self-confidence by the ECB; they are the youngest and most untested of the three institutions. It looks as if they panicked and kicked the ball into touch by providing a massive (and excessive) injection of liquidity against high-grade collateral.

The central bank as Market Maker of Last Resort However, charging eligible counterparties during a credit crunch/liquidity crisis a penalty rate of 100bps over the policy rate is unlikely to be a sufficient deterrent to reckless and irresponsible risk-taking by these counterparties. There is a way in which the monetary authority can simultaneously address the core of the liquidity problem and provide the right incentives to encourage private financial institutions to manage their portfolios with greater regard to liquidity risk. That is for the monetary authority to act as Market Maker of Last Resort (MMLR) by expanding the range of assets eligible for rediscounting (or more generally acceptable as collateral in liquidity-providing open market purchases) to include illiquid assets, both investment grade and non-investment grade, but at a punitive price. This means that the net price received by the seller of the asset to the monetary authority represents a significant ‘haircut’ over what its fair or fundamental value would be under orderly market conditions. Operationally, this could, just to provide one example of a practical mechanism, be done through a Dutch Auction.

The monetary authority would first have to make it clear what kinds of assets (including possibly rather complex structured investment products) it is in principle willing to purchase in its auction. It would also have to specify the population of eligible counterparties. I would propose this be restricted to institutions accepting the appropriate degree of prudential regulation from the point of view of the Monetary Authority. Finally, given the eligible instruments and counterparties, the Dutch Auction could start. The central bank would announce that it would be willing to buy up to, say, $10bn (at notional or face value) worth of CDOs backed by impaired subprime mortgages. It would start the auction offering a buying price of, say, one cent on the dollar. CDOs offered at that price would be accepted, up to the total amount of the auction ($10bn face value). If the total amount offered at 1 cent on the dollar were to exceed $10bn face value, there would be pro-rata sharing among those making offers to sell. If less that $10bn face value were offered at one cent on the dollar, $ 2bn, say, the central bank would offer to buy up to $8bn at, say, 2 cents on the dollar, all the way up to 100 cents on the dollar. A further haircut could then be applied to the sequence of auction prices established through this mechanism.

Such a Dutch Auction is a price discovery mechanism. The central bank does not need to know the true value, it simply needs to have a mechanism for discovering the reservation prices of the private holders of the illiquid securities. The central bank has all it needs to conduct such an auction: deep pockets and the absence of a profit motive. It does not need superior information about the fair or fundamental value of what it buys.

Those who note that the central bank acting as Market Maker of Last Resort is effectively performing the role of a publicly-owned 'vulture fund', buying up distressed, illiquid assets from sellers keen/desperate to realise some value somewhere, are substantially correct. Those who then question why this job cannot be left to regular private vulture funds miss the key point about a liquidity crisis/credit crunch. If private vulture funds can do the job, so much the better: there would be no need for a market maker of last resort. Private vulture funds can do their job when there are orderly markets, generally good liquidity for most normally tradable assets, and selective, issuer-specific, solvency issues. There are times however, that waiting for private vulture funds to step forward and to what they are supposed to do risks creating an avalanche of illiquidity that creates unnecessary and socially costly defaults and bankruptcies, and in the limit risks undermining key payment, clearing and settlement mechanisms for which the banking system continues to be important. In such circumstances, only the central bank has the deep pockets at the right time - now - to act and make a market.

Policy rate cuts Policy rate cuts are justified if and only if the legally mandated objectives of the monetary authority require it. For the Fed these objectives are the triple mandate of maximum employment, stable prices and moderate long-term interest rates set out in Federal Reserve Act as amended in 1977. Credit crunches and liquidity crises therefore matter only to the extent that they affect these three goals, now or in the future. Fortunately, instruments exist with which credit squeezes and liquidity crises can be addressed effectively, and without creating moral hazard (such as the MMLR at punitive prices described above) that do not involve changing the monetary policy rate.

I hope and expect that if and when the Fed perceives that real economic activity is likely to weaken materially going forward and/or that inflation is likely to undershoot its comfort zone (wherever that may be), rates will be cut decisively and without delay.

I also fear and expect that, because of the relentless pressure being brought to bear on the Fed by all branches of the Federal Government (with the exception, as far as I know, of the Supreme Court), the Fed will be convinced to cut the Federal Funds target rate, probably as soon as the September meeting. I fear this could be not because this is the best way to guarantee the optimal trade-off between its three macroeconomic goals, but because this is the only way to salvage some measure of future independence for the Fed, in the face of irresistible pressure for a cut now from a lobby for a lower Federal Funds rate that includes special interests ranging from low income households unable to service their wildly inappropriate mortgages to extremely high net worth hedge fund managers facing massive losses and early retirement.

I hope I’m wrong on the last point.

© Willem H. Buiter 2007

RIP free and undistorted competition in the proposed Revision Treaty for the EU?

The Neanderthals have won. For the first time since the Treaty of Rome was signed in 1957, free and undistorted competition will no longer be among the guiding principles of the European Union.[1] This concession to the dark side was unnecessary and is unforgivable. If the EU is not about a single, free market with undistorted competition, then what is it about?

The proposed ‘Constitreaty’ represents a significant redistribution of voting power among Member States. There is also a material transfer of national sovereignty to Brussels involved in the following: granting the EU single legal personality; the creation of a full-time Council President; the creation of a single EU foreign minister – I believe the formal title is Lord High Executioner of the European Union for Foreign Affairs and Security Policy; the creation of a unified EU diplomatic service; and the extension of qualified majority voting in a large number of areas. There are further important constitutional changes such as the reduction in the number of Commissioners and the increased budgetary powers of the European Parliament.

Our leaders should not lie to us by insisting that this Treaty is just a minor tidying-up exercise. It is an amending Treaty only in the sense that death is an amendment to life. The British people must have the opportunity to vote in a referendum on this Constitution in Treaty’s clothing.

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[1] From the Treaty of Rome (1957) to the Treaty of Nice (signed in 2001) the Treaties have contained, in the section on the Principles of the European Community, references to free movement of goods, persons, services and capital and undistorted competition. For instance the currently effective Consolidated Version of the Treaty Establishing the European Community, Part One –Principles, Article 3. 1 states: “For the purposes set out in Article 2, the activities of the Community shall include, as provided in this Treaty and in accordance with the timetable set out therein: … (c) an internal market characterised by the abolition, as between Member States, of obstacles to the free movement of goods, persons, services and capital; … (g):a system ensuring that competition in the internal market is not distorted; “.