Exigent Circumstances

Posted by Jon Faust on 11 March 2009

From Robert J. Barbera and Jon Faust.
It is very difficult to have a coherent discussion about the proper policy response at this point in the financial crisis without first deciding where all parties stand on two questions. First, is current risk pricing ‘right’ in the sense we think pricing is ‘right’ in normal times, or might current pricing be reflective of some breakdown in the pricing mechanism? Paul Krugman has recently argued essentially that the current prices are ‘right,’ in which case the main policy goal is to begin mopping up the carnage implied by current values.
Many others think it is instead likely that the current price of risk in markets reflects some sort of market dysfunction. For this group--we might call them ‘the risk pricing is screwed up’ group—a second question becomes essential. Are the problems akin to mere liquidity problems or are they something deeper?
Some take the view, roughly, that if we just got the market for the toxic assets going again, the price at which the market would trade would be reflective of more normal risk pricing. This makes the problem sound like a simple liquidity problem. Many folks might have subscribed to this view in Sept. 2007, and perhaps in Sept. 2008. Today, we think we must consider another view.
One version of the alternative is that the economy is on the beginning slopes of a self-reinforcing downward spiral. Think of an economy-wide bank, run-style scenario where consumers, firms, and banks all simultaneously pull back spending. In this view, one could induce folks to trade toxic assets, but they might well trade on the price path implied by the downward spiral. In short, the market could very well price discover its way straight to depression
Can policymakers know how likely this downward spiral is? Probably not. Economists can formulate coherent accounts of the ‘prices are right’, the ‘liquidity,’ and the ‘downward spiral’ scenarios. Because the economy presents these events very infrequently, though, nobody can be very certain which is happening. We think, however, policymakers should be very concerned about the downward spiral. At the very least, we believe that the policy authorities must be prepared for this case.
From a policymaking perspective, the downward spiral possibility poses severe political challenges. Suppose the government takes extraordinary action and the crisis dissipates with only a deep recession—the best scenario we have left. We may have piled up a great deal of government debt in the process, and we will never know if the extraordinary actions were warranted. Similarly, if the Titanic had steamed slowly and safely across the north Atlantic, the Captain would never have known if he really needed to slow down and suffer the derisive ‘Titanic makes slow crossing’ headlines. If we do begin to slip into a downward spiral, extraordinary political courage and leadership will be required to respond quickly and aggressively before the spiral goes too far. In broad terms, the following steps are likely to be required.
1. Shift the emphasis from ‘getting price discovery going again.’ 
The ‘price discovery’ step seems to have been a roadblock to rapid, decisive action. Perhaps there is a view that if we just design the right mechanism, we can coax the market to reveal a more favorable price for the troubled assets. In the ‘downward spiral’ case, the search for the magic mechanism will be in vain. There may simply be no reliable way for market pricing to lead us off the downward spiral path.   Policy makers must contemplate forcing markets onto a different path, not following them on whatever path they choose.
2. Make it clear that the government will do whatever it takes to avert the downward spiral path. 
To put one element of this point very crudely, the government needs to make it clear that its policies will wipe out those who use financial markets to bet in favor of Armageddon. While both Treasury Secretary Geithner and Chairman Bernanke have made statements about doing whatever needs to be done, some actions appear to belie these statements. For example, it appears to be taking months to resolve details of the TALF, which currently appears to be limited only to new Aaa credits. Such struggle over TALF, which is itself not the heart of the matter, creates some doubt about concrete implications of the ‘do whatever it takes’ attitude.
2. Be prepared to act quickly. 
Speed is likely to be of the essence. One concern here is that, due to the timing of the presidential cycle, Treasury is drastically understaffed at the moment, which could hamper rapid action on complex issues. While the Fed does not face this problem, it seems that the authorities have determined that the Fed will take only minimal credit risk, and that it will be Treasury that takes on credit risk if policy demands it.    A re-balancing of assignments may be required if quick action is required.
4. If mark-to-market accounting is a barrier, suspend it at least temporarily.
Part of the difficulty in formulating plans, as we understand it, comes from concerns regarding the mark-to-market implications of policies that promote trade in the troubled assets.   Once we premise policy on the view that market prices are not ‘right’ at the current moment, though, it is only natural, and may become essential, to suspend (briefly at least) mark-to-market accounting.
5. When time is of the essence, move aggressively within existing mandates.
Revising mandates takes time, but both the Fed and Treasury have broad powers under existing mandates. For example, under section 13.3 of the Federal Reserve Act the Fed can, in ‘exigent’ circumstances, lend to private sector institutions subject to few restrictions.   The main requirement is that the loans ‘are endorsed or otherwise secured to the satisfaction of the Federal Reserve bank.’ We hope that the authorities will interpret ‘to the satisfaction of’ in light of the Fed’s overarching mandate to facilitate financial stability and maximum sustainable employment. That is, the Fed should be ‘satisfied’ that the loans are in the best interest of the American people. An alternative view is that the Fed must be satisfied that the collateral guarantees a high probability of repayment.   If the framers of 13.3 had intended ‘satisfaction’ to mean ‘fully collateralized’ they could easily have clarified. More generally, an emergency is not the time for either Treasury or the Fed to interpret their mandates with the abundance of caution warranted in normal times.

Aggressively following these suggestions would require a shift in the current policy orientation, in our view. We believe that the downward spiral is a real possibility right now, but reasonable people will differ on this point. Given the risks, the authorities should at least have in place plans consistent with the sort of principles described above.


Robert J. Barbera
Chief Economist ITG, 


Director, Center for Financial Economics, Johns Hopkins University