By Martin Wolf

"I regret to say that the Federal Reserve independence is not set in stone. FOMC discretion is granted by statute and can be withdrawn by statute." Alan Greenspan, The Age of Turbulence.

To critics it is now the "Bernanke put" – the belief that, as under Alan Greenspan, the US Federal Reserve will always ride to the rescue of Wall Street. The jubilant response of traders to the Fed’s 50 basis point cut in the short-term interest rate might justify this suspicion. But saving Wall Street from its follies is not the Fed’s objective. It is an (unfortunate) by-product of the attempt to do its job.

It would be wonderful if those responsible for this most absurd of financial crises could be punished without damaging millions of innocent bystanders. But it is impossible. If the Fed does its job, it helps the financial sector. The latter will, no doubt, recover and then find some new, imaginative and currently unforeseen way to generate a possibly bigger crisis several years hence. Whereupon, it will expect the Fed to do its job, as Wall Street sees it: saving the economy, by saving finance. Moral hazard matters, but only for the poor.

Yet will the Fed always be able to oblige? The answer is not so clear. The resolution of each crisis lays the seeds of the next. Thus, the easing by the Fed after the east Asian and Russian crises of 1997 and 1998 contributed to the subsequent stock market bubble. The dramatic easing after its bursting in 2000 contributed to the recent housing boom. The disruption in money markets brought about by the end of that boom has led to last week’s sharp cut in rates. The question, then, is what this will lead to.

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By Lawrence Summers

Central to every policy discussion in response to a financial crisis or the prospect of a crisis is the concept of moral hazard. Unfortunately, there is great confusion in many quarters about the circumstances when moral hazard is, and is not, a problem. The world has at least as much to fear from a moral hazard fundamentalism that precludes actions that would enhance confidence and stability as it does from moral hazard itself.

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 or when holders of health insurance use more healthcare than they would if they were not insured.

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 forms the basis for criticism of a wide range of measures including, among others; large International Monetary Fund loans to countries experiencing financial panics; public sector actions to facilitate co-ordination of creditors, as in the famous 1998 case of the New York Fed and Long Term Capital Management; lender of last resort activities by central banks through their discount window; aggressive cuts in interest rates following collapses in asset prices; and the extension of government guarantees or quasi-guarantees to liabilities of financial institutions, as in deposit insurance or the US government’s support for the credit of mortgage lenders Fannie Mae and Freddie Mac.

The financial markets have taken the world economy hostage. This has presented the world’s central banks with a dilemma. They fear the consequences of paying off those responsible for the mess. But they cannot let hundreds of millions of innocents suffer. Last week’s announcement of the first US monthly fall in employment for four years has made a cut in interest rates from the Federal Reserve this month a virtual certainty. So act it will. But making the right decisions is going to be hard.

Martin Feldstein of Harvard university put the case for big cuts in a powerful summing up at this year’s Jackson Hole monetary conference. He argued that the US housing sector was at the heart of three interrelated events. First was “a sharp decline in house prices and the related fall in home-building that could lead to an economy-wide recession”. Second was “a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets”. The third was “a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending”.

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We are living through the first crisis of our brave new world of securitised financial markets. It is too early to tell how economically important this upheaval will prove. But nobody can doubt its significance for the financial system. Its origins lie with credit expansion and financial innovation in the US itself. It cannot be blamed on “crony capitalism” in peripheral economies, but rather on irresponsibility in the core of the world economy.

What has happened raises important questions. Here are seven.

First, why did this crisis start in the US? The answer is: “The borrowing, stupid”. Default on debt – actual and feared – always drives big financial crises because creditors think that they ought to be repaid. US households were the world economy’s most important net borrowers in the mid-2000s, replacing the emerging markets of the 1990s.

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