Yes, but isn’t that what it’s supposed to do? In order to meet the objectives of high, stable growth and low, stable inflation monetary policymakers must insulate the real economy from financial sector shocks. That is, central bankers strive to keep credit market disturbances problems from spreading to the economy at large. This, I submit, is the most important lesson we have learned from analyzing the monetary policy failures that led to the Great Depression of the 1930s.1
Analysis of the 2007 financial crisis has been filled with comments about “moral hazard” and the “Bernanke put.” The thrust of these criticisms is that recent monetary policy actions by the Federal Reserve provided ex post insurance to institutions that engaged in reckless behaviour. It is claimed that such policymaker-designed bailouts underwrite risk taking that leads, inevitably, to the next financial crisis.
In the first essay in this series, I explain why financial crises of the sort that we have been experiencing recently have been, and are likely to continue to be, a repeated consequence of the interaction of incentives and innovation.2 Here, I argue that a central bank that takes an appropriate risk management perspective is a stabilizing force, strengthening rather than weakening the financial system.
To understand this conclusion, it is useful to begin with a few definitions. Let’s start with moral hazard. To 19th century insurers, a moral hazard was a person who was unusually susceptible to the temptations created by insurance. That is, someone whose character made them predisposed to carelessness and fraud.3 Modern (neoclassical) economics steers clear of such normative connotations, defining moral hazard as the risk that a borrower, or someone who is insured, will behave in a way that is not in the interest of the lender, or the person selling the insurance.4
As a general rule, the existence of insurance is a good thing, both providing diversification for individuals who cannot obtain it otherwise, and allowing risk to go to those able to bear it. The fact that people can purchase fire insurance for their homes is what makes mortgages possible. This is just one example among many of how the modern financial system improves the efficient operation of the economy.
It is important to accept that insurance changes incentives. But that is an argument for careful design, not for elimination.5
Bernanke put or fire insurance?
The term Bernanke put is the descendant of “Greenspan put.” My favorite source for conventional wisdom, Wikipedia, defines the latter as the “perceived attempt of then-chairman of the Federal Reserve Board, Alan Greenspan, of ensuring liquidity in capital markets by lowering interest rates if necessary.” (I did not write this entry.)6 The term was coined in 1998 after the Fed lowered interest rates following the collapse of the investment firm Long-Term Capital Management. The effect of this rate reduction was that investors borrowed funds more cheaply to invest in the securities market, thereby averting a potential downswing in the markets.7
I believe that critical interpretations of these actions get it exactly wrong. As Chairman Bernanke said on 31 August 2007, “It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.”8 It is, however, the responsibility of the Federal Reserve, and all central banks, to make sure very bad things do not happen; protecting the public from adverse consequences of financial turmoil and reducing the volatility in the economy as a whole. That is, something exactly analogous to fire insurance.
Does it create moral hazard to make the worst possible economic outcomes extremely unlikely? The answer is surely no. We should not be forced to buy insurance against things that policymakers can keep from happening in the first place. What should happen, however, is that individuals who take more risk face the possibility of more pain.
Okay, returning to the current instance, we can now ask two questions:
- Have central bankers’ actions reduced the likelihood of the worst possible outcomes?
- Have individuals and institutions that took more risk paid a higher price?
It seems to me that the answer to both of these questions is unequivocally yes. The purpose of the Federal Reserve’s actions – reducing the federal funds rate target by a total of 75 basis points and the discount rate by 125 basis points – have been aimed at making sure very bad things do not happen.9 And, if my reading of the news is accurate, losses are being distributed based on how much risk people took.
In these four essays, I have explored some of the lessons we should take away from the turmoil that began in early August 2007. The first essay established that financial crises are intrinsic to the modern economy. Financial institutions borrow short to lend long and so they are always susceptible to crises when short-run borrowing dries up. And the regulatory mechanisms designed to mitigate these problems will perpetually fall behind financial innovations that are constantly seeking out the weakest point in the system. Innovators will always find flaws in the regulatory and supervisory apparatus, and manipulating the inherent limitations of the relationship between asset managers and their investor clients. In and of themselves, these innovations enhance the efficient operation of the economy, so it is important to encourage rather than stifle them. We do, however, have to constantly strive to improve regulation. But the best we can hope for is to reduce the frequency of financial crises and reduce their impact on the broader macroeconomy.
I have suggested we consider four concrete:
- Trust, but verify. Investors should insist that asset managers and underwriters start by disclosing both the detailed characteristics of what they are selling together with their costs and fees. This will allow us to know what we buy and understand our bankers’ incentives.
- Standardisation and trading. Governments could help clarify the relative riskiness of assets by fostering the standardization of securities and encouraging trading on organized exchanges.
- Deposit insurance. A well-designed, rules-based deposit insurance scheme is essential to protecting the banking system from future financial crises. Lender of last resort actions are no substitute for deposit insurance.
- Central banks should be financial regulators. Central banks should have a direct role in financial supervision. In times of financial crisis – as in times of war – good policy-making requires a single ‘general’ directing the operations.
My final conclusion is negative. Some observers worry that recent central bankers’ responses to the subprime crisis of 2007 will encourage asset managers to take on more risk than is in society’s interest. I believe that this is wrong. Punishment is being meted out to many of those whose risky behaviour led to the problems, while central banks’ actions have, so far, reduced the collateral damage that this crisis could have inflicted on the economy.
1 This is the essential insight of Chairman Bernanke’s path-breaking work collected in Essays on the Great Depression, Princeton, New Jersey: Princeton University Press, 2004.
2 See “Financial Crises Are Not Going Away.”
3 For a fascinating history of the term “moral hazard” see Tom Baker, “On the Genealogy of Moral Hazard,” Texas Law Review, vol 75, no 2, December 1996, pg. 237-292.
4 For a detailed discussion of the implications of moral hazard in finance see Chapter 11 of Stephen G. Cecchetti Money, Banking and Financial Markets, 2nd Edition, Boston, Mass.: McGraw-Hill Irwin, 2008.
5 For an excellent discussion of why traditional concepts of moral hazard are not applicable to the current circumstance see Lawrence Summers, “Moral Hazard Fundamentalists,” Financial Times, 23 September 2007.
6 A textbook definition of a put option goes something like this: “A contract that confers the right, but not the obligation, to sell a financial instrument at a predetermined price prior to the expiration date of the option.” For someone who plans to sell the asset in the future, a put option ensures that the price at which the asset can be sold will not go down.
7 The result of the Greenspan put was that equity investors experienced substantial losses as US stock market capitalization fell from $20 trillion at the 2001 peak to $11 trillion a mere two years later. A 45 percent loss hardly seems like iron-clad insurance.
8 “Housing, Housing Finance, and Monetary Policy,” speech presented at the Federal Reserve Bank of Kansas City’s Economic Symposium, Jackson Hole, Wyoming.
9 Some people characterized these interest rate reductions as a bailout. But since every debt instrument has both a buyers and a sellers, when interest rates changes create transfers; someone wins and someone loses. And, the winnings exactly cancel the losses. So, when the FOMC reduced the federal funds rate target, whether you won or lost depends on whether you had an existing fixed-rate loan (lenders win and borrowers lose) or either an existing adjustable-rate loan or a new loan (borrowers win and lenders lose). I can’t see how such transfers, which always exist whenever interest rates change, create a bailout.