Cutting through the nonsense about the ‘Bernanke Put’

The Central Bank is supposed to target inflation – and providing price stability is vouchsafed help if it can to keep growth ticking along. There’s a lot of loose talk about how central bank action ‘underwrites’ risky moves by financial operatives. But creating more liquidity when a liquidity crunch threatens economic growth (and is not necessary to keep inflation in check) is core business.

And it doesn’t underwrite bad behaviour. Those people who bought bonds full of lousy sub-prime loans are still losing their shirt. But all those good businesses that might have gone broke because the economy was sinking are saved by sensible macro-economic management.

Below, Larry Summers (writing exclusively for the Financial Times and Club Troppo) sets out the issues better than I could for those interested.

Beware moral hazard fundamentalists, by Larry Summers, Commentary, Financial Times (free): Central to every policy discussion in response to a financial crisis … is the concept of moral hazard. Unfortunately, there is great confusion … about … when moral hazard is, and is not, a problem. …

The term moral hazard originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire…

In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future bail-outs. …

Moral hazard fundamentalists misunderstand the insurance analogy… As a consequence, their proposed policies, if followed, would reduce the efficiency of the financial sector in normal times, exacerbate financial crises and increase economic instability. They are wrong in three crucial respects.

First, … the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is contagion as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened. In the presence of contagion there is every reason to expect that individual institutions will under-insure because they will not feel obliged to take account of the benefits their insurance will have for others.

Second, the insurance analogy fails to take account of … a key aspect of the financial context moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent… But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion.

More subtly, but no less important, the knowledge that efforts will be made to stand behind solvent institutions facing runs reduces the capital institutions have to hold, encourages investment in productive but illiquid projects and reduces the risk of contagion.

Third, in the insurance template used in thinking about moral hazard, the insurer pays more out because of the behavioural changes induced by insurance… Something parallel happens when the government guarantees a financial institutions liabilities.

But much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. In the much criticised LTCM case no taxpayer money … was spent. A competent lender of last resort … actually turns a profit, as the IMF did in its response to the financial crises of the 1990s. Monetary policies that prevent deflation of the kind that cost Japan a decade of growth in the 1990s are another example of how a policy can respond to stress without imposing costs on taxpayers or the economy.

Where does all of this leave policy? …1hese considerations suggest that prudent central banks will make judgments during financial crises not on the basis of avoiding moral hazard but rather by asking themselves three questions.

First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.

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16 years ago

He’s right, to a certain extent. But there is a serious issue that has accumulated as a result of past actions/ distortions with the money supply and a low interest rate policy that went for too long.

In other words they’re in this soup because of prior policy mistakes.

The problem now is that the fed is creating another bubble somewhere else and the whole thing will happen again. Only thing is that next one could be the tsunami no one will be able to control. They seem to be getting bigger and bigger.

The old barbarous relic is now trading at $730 and will go higher as the Fed continues to lower interest rates.

In other words the gold price is essentially telling us that the Fed is on the way towards monetizing the problem.

There’s no free lunch here though. The effect of monetizing will be felt as downward slide in the US standard of living compared to the rest of the world. In other words the dollar will buy less.

What’s really interesting is just how low volatility is to make the Fed act compared to early times like the 70’s.

Uncle Al left Ben a really ugly job.

16 years ago

I think though larry is missing a big point here. There will be a cost taken not by the taxpayer in the strict sense of the word although we don’t know that yet seeing the Fed is “repoing” mortgage securities. The real cost will be felt through the socialization of a lower standard of living for all Americans in comparative terms as a result of a cheap dollar and large infusion of high powered money from the fed.

Fred Argy
Fred Argy
16 years ago

Nicholas, I fully agree with Summers on ‘moral hazard’: the risk of encouraging bad behaviour is small beer compared with the risk of general financial market instability.

But Summers does not address the risk of raising inflation expectations, which has the potential to generate instability in long term bond markets. Obviously Bernanke kept this risk in mind when he reduced by 0.5% but resisted the temptation to reduce rates by 1% (as some were advocating).

The other issue is this. As any large financial institutions, especially commercial banks, have an ‘implicit guarantee from the central bank that their depositors will not be left high and dry because of liquidity mismanagement, why not force these institutions to take out deposit insurance? The Campbell Commitee serious considered this option but in the end decided against it. I forget why.

Tom Noonan
Tom Noonan
16 years ago

Do you wonder why Ben Bernanke dropped the Fed rate 0.5% rather than the expected 0.25%? Well in August 1929, Benjamin Strong dropped the Fed rate 0.5% (J.K. Galbraith, “The Great Crash”. 1954/1975). Then the market recovered straight away, like now, but the Fed walked away and the market crashed in October.

By now the fall in the USD is manifest; and really the USA can’t just become the play money of the region, to prop up mad speculators, but it is a window for the really smart money to slip out the door – like Goldman Sachs then.

I’m not a futurist, but talk of moral hazard is so much horseism and distraction. These guys play for real like around a canasta table playing with heaps per point, and giving the public nonsense as judged by its internal inconsistencies.
In passing, classical theory: central banks should raise interest rates while lending freely on good security – if there is any left.

Look foreward to future fire-works.