Monthly Archives: September 2007

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 FOMC discretion is granted by statute and can be withdrawn by statute."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. Read more

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.

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Financial panic has hit both the public and politicians of the UK over the past week, to deliver two remarkable results: the first run on a British bank since the collapse of Overend and Gurney in 1866; and the transformation of bank deposits into public debt at the stroke of a pen. These are historic times.

How then could these astonishing events have happened? Contagion is the answer, just as it was during the Asian financial crisis of a decade ago. When Thailand announced the devaluation of the baht in July 1997, few foresaw the way the crisis would spread. Yet contagion was not random. Some countries were more vulnerable to the disease than others. Read more

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”. Read more

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. Read more