Lender of Last Resort Policy - The Risks Involved
What will be the impact of the recent liquidity operations? What are the problems of central banks acting as lender of last resort?
Essentially, there are two key problems:
1) Potential trade-offs with other central bank objectives
2) The moral hazard effect
Note: A thorough, detailed account of the problems involved can be found in the book "Financial Crises, Contagion, and the Lender of Last Resort". A Reader, edited by Charles Goodhart and myself.
1) The Risk of Inflation
First of all, there can be a conflict between financial stability and price stability. To see that, it is helpful to look at episodes in the past. Stephan Sauer, one of my PhD students, analysed three liquidity crises during the Greenspan era in his paper "Three Liquidity Crises in Retrospective: Implications for Central Banking Today."
Stephan presents evidence that emergency liquidity assistance implies risks to price stability when it is not focused on the inter bank market and quickly sterilised. He shows that the rescue operations after September 11th, 2001 have been quickly sterilised (taken back) and so had no impact on inflation. In contrast, the aggressive cuts in interest rates after the stock market crash in 1987 and the LTCM crisis in 1998 causes inflation to rise. At these events, US interest rates had been set lower than what the Taylor rule suggests.
Now we could say the heck with a little bit more of inflation. We enjoyed enough price stability during the last 15 years, and there are definitely worse things than 2 percent more inflation. From time to time we have to face them. That is a good point. For the US, it may indeed be the individually rational strategy to inflate away part of its nominal debt, as a substantial part is now owned by foreigners. But if inflationary expectations rise and the dollar is falling, the US (or the world economy) may fall into a vicious circle - as has been pointed out by Calculated Risk.
For the US, this may not be so disastrous. A falling dollar increases the Dollar value of those assets owned by US firms and citizens abroad, as long as these are denominated in foreign currency. If Uncle Sam has bought some Eurobonds, he can enjoy capital gains from a rising Euro. Not bad for the US Net Investment Position. There is a famous quote by John Connally, Secretary of the US Treasury under Richard Nixon, who once (1971) told a couple of Bundesbankers worried about exchange rate fluctuations: “The dollar is our currency, but your problem." People have been surprisingly honest at that time – a year before Watergate.
2) The Moral Hazard Issue
The moral hazard involved is the second serious problem. Frequently, the lender of last resort activity of central banks is seen as a free lunch: In a systemic crisis, so the argument, injecting liquidity to support illiquid yet solvent banks works as a public good, providing insurance against otherwise uninsurable exogenous risks. This improves the efficiency of financial markets: trusting that they will be rescued in times of a systemic crisis, financial institutions are encouraged to undertake more risky, but profitable investment. Thus, society is allowed to enjoy higher real rates of return on average.
But this argument ignores that there is an economic need for liquid investments. Systemic risk is not exogenous. In a joint paper with Jin Cao (PDF 442 KB) at the University of Munich, I have shown that providing a put option against systemic events dampens the incentives for prudent behaviour. Instead, free riding on the liquidity supplied by other, more prudent institutions is encouraged. The price for liquidity provision will be distorted. This will result in insufficient supply of real liquidity, raising the likelihood of a systemic crisis.
Concern about that issue has indeed been the main reason why many central banks have been so reluctant to act more aggressively. Central banks should not rescue fools. I recommend reading Martin Wolf in the FT and Raghu Rajan, again in the FT.
Providing central bank insurance to those institutions that have engaged in reckless lending poses enormous hazards. Mervyn King, Bank of England governor, just hit the nail by pointing out ( FT, Sept. 12 2007): “The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises.”
It is amazing that the moral hazard issue has not been taken more seriously by leading US economists. The story about Harvard Economists Divided Over Fed's Next Move before the recent Fed meeting is quite telling. Usually, people on the right side are very much concerned about the risks involved in bailing out the poor. Now, when it comes to bailing out the poor finance industry, sides change quickly. Economics is indeed all about incentives.
The tragic is that during a crisis, there is no way to escape. Central banks are trapped in a dilemma of the proportions of a Greek tragedy. If they try to abstain, they risk triggering a crisis. If they give in (as they eventually have to anyway), they will increase the intensity of future crises. It may well be that Mervyn King’s letter (PDF 84 KB) to the chancellor reconfirming his brave statements was the trigger for the run on the mortgage bank Northern Rock the next day. The reckless lender Northern Rock (what an apposite name) smashed the credibility of the Bank of England.
Obviously, there is a serious dynamic consistency problem. Ex ante, you might want to commit not to intervene. Ex post, there are strong incentives to renege on such a commitment. Of course, clever financial market participants notice that commitment problem right from the start. Reliance on central banks coming to rescue as lender of last resort is bound to encourage higher risk taking. As shown in my joint paper with Jin Cao, surprisingly, even for the case of pure illiquidity risk, central bank intervention increases the incentive of financial intermediaries to free ride on liquidity provision. The commitment not to intervene, however, is not credible.
What should be done? According to the "Austrian hangover theory," creating a recession is the only way to purge the excesses of previous booms, leaving the economy in a healthier state. The “winds of creative destruction” would cause healthy pain. I don’t think this is a sensible solution. As Paul Krugman puts it: “Bad investments in the past should not require the unemployment of good workers in the present.”
It is no surprise that Wall Street Journal now supports my view - despite its old obsession about moral hazard created by the IMF in bailing out emerging market countries – see Has Fed Risked Creating Moral Hazard?
It is no surprise, but pretty funny that Jim O'Neill, Goldman Sachs Global Head of Research, "comments" discovered his compassion with millions of people in the US who are going to suffer from large negative equity from their houses losing value – this indeed was the best way to justify his call for a rate cut. Similarly, it was pretty clever from Jan Hatzius, again Goldman Sachs New York, to argue that the damage to financial markets is likely to be contained since the Fed will lower interest rates when necessary. Why not base my investment strategy on that insight?
Read next section: What should be done?