Monthly Archives: August 2007

From the dark days when I tried to grasp non-cooperative game theory, I know that there are circumstances that may make randomised (or mixed) strategies individually rational. Even at an abstract level, I have always considered randomised strategies to be bogus, unless there is a natural randomisation mechanism present in the fundamental structure/specification of the non-cooperative game. A coin toss simply won’t do, because there is no reason why, if heads are called but tails materialise, the coin tosser would be able to impose the action dictated by the outcome of the coin toss on the player. In other words, you cannot add randomisation of strategies as a deus-ex-machina to a game where the natural strategies are ‘pure’, that is, non-stochastic functions of (possibly random) state variables (Who tosses the coin? Isn’t he also a player in the game? What are his objectives? What instruments does he have to compel the other players to abide by the outcome of the coin toss etc.?)[1]

Even if I disregard my deep conviction that randomised strategies are bogus – mathematical tricks without behavioural content – unless the randomisation device is itself part of the deep structure of the game, I have never, in the field of monetary policy, come across a configuration of circumstances that would make the deliberate creation of noise, uncertainty and ambiguity sensible, let alone optimal.

Central bankers have, however, often argued differently. I have been confronted many times with central bankers singing the praises of the pernicious doctrine of ‘constructive ambiguity’. This means that the central bank deliberately keeps the private sector in the dark about its true intentions or its true reaction function.

One example of alleged beneficial results from constructive ambiguity, is the central bank acting all coy about the circumstances that would induce it to bail out a private financial institution. This is supposed to be an efficient policy for minimising moral hazard. It’s wrong. Policy can be stated clearly and conducted transparently without creating moral hazard. For liquidity problems, there is the discount window. For this to function well, the central bank should accept as collateral a much wider range of assets, including non-investment grade and impaired assets, than it currently does. That may involve the central bank acting as Market Maker of Last Resort in order to price the illiquid collateral. In the case of insolvency of a systemically important institution, it has to be made clear that all equity of the insolvent entity is extinguished if any public money goes in and that all creditors of the insolvent institution may take a hit (including, in the case of commercial banks, depositors to the extent that they are not insured). Finally, the entire top management goes without golden handshakes. That ought to take care of most of the moral hazard.

The threat of unexpected and unannounced foreign exchange market intervention intended to inflict pain on exposed private speculators is supposed to be an effective way of discouraging speculation against the currency, is another example of alleged beneficial use of constructive ambiguity. Even the deliberate creation of unnecessary uncertainty about future central bank interest rate decisions has been justified as a way to prevent the private sector from making one-way bets on some asset price or other.

I don’t buy this cloak-and-dagger-stuff. In my view the central bank’s policy objectives are best served by maximal openness and transparency. From this perspective, the Bank of England is making a mistake, if recent reports are accurate, by instructing the banks and building societies that borrow at its discount window (its ‘standing (collateralised) lending facility’) not to comment on their use of that facility. The Bank refuses to comment on the identity of the discount window users, on the amount they borrow, and on the collateral they offer.

If secrecy is indeed what the Bank of England has imposed on its standing lending facility counterparties, it is bad policy. It is bad policy, first, because it won’t work. The £1.6bn collateralised (overnight) loan to Barclays Bank transacted on August 30, 2007, was known to everyone within e-mail distance of the Bank of England within an hour of the transaction taking place. It is bad, second, because it makes it look as though recourse to the discount window is a sign that there is something fundamentally fishy about the financial health of the discount window borrower. In fact, the mainstream press (not just the red-tops) often refers to the standing lending facility of the Bank of England as its ‘emergency’ credit facility. A major (re-) education effort by the Bank of England and its potential discount window counterparties is clearly overdue.

The only information conveyed by borrowing at the discount window ought be (1) that the loan was made at an interest rate 100bps above the Bank of England’s policy rate (which currently stands at 5.75%) and (2) that the borrower could offer appropriate (eligible) collateral. How punitive 100bps over the Bank of England’s policy rate is, depends on what the market rate is in the overnight money markets (or interbank market). During August, that rate has risen as high as 6.53%, which is only 12bps below the 6.75% rate charged at the Bank of England’s standing collateralised lending facility.

The best way to de-mystify discount window operations is for the Bank of England to report, for each transaction at the standing lending facility, the identity of the borrower, the spread charged over and above the policy rate, the amount borrowed, the nature of the collateral offered, the valuation of the collateral and the ‘haircut’ applied to it.

Secrecy about who borrows at the discount window, how much is borrowed and against what collateral, is an own goal in the struggle to restore orderly markets, as rumours, gossip, suspicion, leaks and strategic misinformation take the place of transparency and accountability – of the Bank of England to Parliament and of the borrower to its shareholders and other stakeholders. Even more dangerously, it reinforces the perception of the central bank in times of crisis as a manipulator of financial markets rather than a transparent strategic operator in the markets. The sooner this secrecy nonsense is ended, the better.


[1] In Prescottian real business cycle theory, there is, in a competitive setting, a similar triumph of mathematical convenience over behavioural plausibility. When fixed costs create non-convexities which may well preclude the existence of a competitive equilibrium, some deus-ex-machina organises lotteries to convexify the economic environment. Employment lotteries are a favourite example in models with indivisible labour supply. This is an economic nonsense because there is no plausible story as to how any worker could credibly commit himself to accept the outcome of the lottery, as the winners would be, ex-post, better off than the losers (at least which mixed strategies, the utility levels attached to the pure strategies that are subject to randomisation are the same). There is a second major conceptual embarrassment with these deus-ex-machina lotteries. Typically the models in question are complete contingent market models. However, it is not possible, by assumption, to create contracts contingent on the outcome of the convexifying lottery. Permitting such contracts would re-introduce the non-convexities the lotteries are supposed to cure. This is truly bad, tool-driven economics.

© Willem H. Buiter 2007

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Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee (and also a candidate for the Democratic nomination for the US Presidency) and by Hank Paulson, US Treasury Secretary, Fed Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Chairman Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures from the Executive or from Parliament. Also, what operational independence the Fed has, is of relative recent origin. From 1942 until the Treasury-Federal Reserve Accord of 1951 released the Federal Reserve from the obligation to support the market for U.S. government debt at pegged prices and made possible the independent conduct of monetary policy, US monetary policy was made in the Treasury. For those 9 years, the Taylor rule was: i = 2%.

Even after the Accord, the fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. The strong populist, anti-banking currents in American politics in general, and in the Congress in particular, mean that the threat that what limited operational independence there is could be taken away is not perceived as an idle one by any Fed governor.

To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the three goals of monetary policy. The other two are maximum employment and moderate long-term interest rates. There is no quantitative or numerical definition of any of the three targets in the Act. Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out.

Both the Congress and the Executive branch of government lobby mightily for Fed actions aimed at preventing or at least limiting the losses on highly leveraged bets taken by hedge funds, private equity funds and a large number and variety of other financial institutions and special purpose vehicles – ‘conduits’, ‘structured investment vehicles’; the names vary but the economic essence of highly leveraged open positions is the same. Appeals to safeguard systemic financial stability often obscure the obvious truth. The special interests that would benefit most directly from such actions as a cut in the Federal Funds rate – highly leveraged Wall Street firms and tycoons caught on the wrong end of the increase in credit risk spreads and the disappearance of liquid markets for structured products and other contingent claims –claims that had often been touted as the ‘techfin’ solution to the illiquidity of traditional forms of credit such as secured (mortgages) and unsecured (credit card debt) – rarely play a systemically indispensable role in the intermediation of saving into investment or in the efficient management of financial wealth. Were they to go bust and disappear, they would be missed only by their shareholders and other stakeholders, and those who had lent money to them. If these shareholders and creditors are systemically significant, one assumes that the prudential regulatory regimes they are subject to would have ensured sufficient portfolio diversification for them to be able to absorb the losses caused by the insolvency of a number of highly leveraged funds/institutions.

The response to financial turmoil, disorderly credit markets and the sudden illiquidity of assets previously deemed liquid, should not be a cut in the monetary policy rate – the short-term risk-free nominal rate of interest. It should not even be to provide liquidity in large amounts at the policy rate (in the US, to keep the Federal Funds rate close to the Federal Funds target, currently 5.25%; in Euroland, to keep the overnight interbank market rate near the ECB’s Main refinancing operations Minimum bid rate (currently at 4.00%); in the UK to keep the overnight interbank sterling rate near Bank Rate (the repo rate currently at 5.75%). Market participants should pay a penalty for being caught with their liquidity pants down.

In a credit crunch/liquidity crisis, the central bank should make funds available freely, but at a penalty rate and against collateral that would be good under normal circumstances, but may have become severely depreciated as a result of the liquidity crisis.

Bagehot in the 21st Century Both the Fed and the ECB failed to deliver the second part of Bagehot’s package: to lend at a penalty rate. One obvious way to provide liquidity at a penalty rate is to require banks and other eligible counterparties to access collateralised loans not at the policy rate, but at the discount rate. For the Fed, the primary discount rate used to be (until August 17, 2007), 1.00% above the Federal Funds target rate. Then, in response to the credit and liquidity crunch, the Fed, on 17 August 2007 lost its nerve and cut the primary discount rate from 6.25 percent to 5.75 percent. This reduction in the penalty for providing liquidity was the exact opposite of what Bagehot would have recommended. What is more, it is a recipe for increasing moral hazard without any appreciable gain as regards the provision of liquidity. The ECB kept its discount rate (the rate charged on its Marginal Lending Facility) at 100bps above its policy rate. It provided so much liquidity at the policy rate, however, that hardly any spontaneous takers turned up to rediscount eligible collateral at the Marginal Lending Facility. Only the Bank of England followed Bagehot’s nostrum,. Not only did it keep its discount rate (the rate on its Credit Facility) at an unchanged 100bps above its policy rate, it was quite willing to see the overnight interbank market rate rise towards the policy rate. It is not surprising that the least operationally independent of these three central banks, the Fed, bent furthest in response to financial market pressures for rate relief. It is surprising that the most operationally independent of the three, the ECB, was, in different ways, almost as accommodating as the Fed. The reason for this is probably lack of self-confidence by the ECB; they are the youngest and most untested of the three institutions. It looks as if they panicked and kicked the ball into touch by providing a massive (and excessive) injection of liquidity against high-grade collateral.

The central bank as Market Maker of Last Resort However, charging eligible counterparties during a credit crunch/liquidity crisis a penalty rate of 100bps over the policy rate is unlikely to be a sufficient deterrent to reckless and irresponsible risk-taking by these counterparties. There is a way in which the monetary authority can simultaneously address the core of the liquidity problem and provide the right incentives to encourage private financial institutions to manage their portfolios with greater regard to liquidity risk. That is for the monetary authority to act as Market Maker of Last Resort (MMLR) by expanding the range of assets eligible for rediscounting (or more generally acceptable as collateral in liquidity-providing open market purchases) to include illiquid assets, both investment grade and non-investment grade, but at a punitive price. This means that the net price received by the seller of the asset to the monetary authority represents a significant ‘haircut’ over what its fair or fundamental value would be under orderly market conditions. Operationally, this could, just to provide one example of a practical mechanism, be done through a Dutch Auction.

The monetary authority would first have to make it clear what kinds of assets (including possibly rather complex structured investment products) it is in principle willing to purchase in its auction. It would also have to specify the population of eligible counterparties. I would propose this be restricted to institutions accepting the appropriate degree of prudential regulation from the point of view of the Monetary Authority. Finally, given the eligible instruments and counterparties, the Dutch Auction could start. The central bank would announce that it would be willing to buy up to, say, $10bn (at notional or face value) worth of CDOs backed by impaired subprime mortgages. It would start the auction offering a buying price of, say, one cent on the dollar. CDOs offered at that price would be accepted, up to the total amount of the auction ($10bn face value). If the total amount offered at 1 cent on the dollar were to exceed $10bn face value, there would be pro-rata sharing among those making offers to sell. If less that $10bn face value were offered at one cent on the dollar, $ 2bn, say, the central bank would offer to buy up to $8bn at, say, 2 cents on the dollar, all the way up to 100 cents on the dollar. A further haircut could then be applied to the sequence of auction prices established through this mechanism.

Such a Dutch Auction is a price discovery mechanism. The central bank does not need to know the true value, it simply needs to have a mechanism for discovering the reservation prices of the private holders of the illiquid securities. The central bank has all it needs to conduct such an auction: deep pockets and the absence of a profit motive. It does not need superior information about the fair or fundamental value of what it buys.

Those who note that the central bank acting as Market Maker of Last Resort is effectively performing the role of a publicly-owned ‘vulture fund’, buying up distressed, illiquid assets from sellers keen/desperate to realise some value somewhere, are substantially correct. Those who then question why this job cannot be left to regular private vulture funds miss the key point about a liquidity crisis/credit crunch. If private vulture funds can do the job, so much the better: there would be no need for a market maker of last resort. Private vulture funds can do their job when there are orderly markets, generally good liquidity for most normally tradable assets, and selective, issuer-specific, solvency issues. There are times however, that waiting for private vulture funds to step forward and to what they are supposed to do risks creating an avalanche of illiquidity that creates unnecessary and socially costly defaults and bankruptcies, and in the limit risks undermining key payment, clearing and settlement mechanisms for which the banking system continues to be important. In such circumstances, only the central bank has the deep pockets at the right time – now – to act and make a market.

Policy rate cuts Policy rate cuts are justified if and only if the legally mandated objectives of the monetary authority require it. For the Fed these objectives are the triple mandate of maximum employment, stable prices and moderate long-term interest rates set out in Federal Reserve Act as amended in 1977. Credit crunches and liquidity crises therefore matter only to the extent that they affect these three goals, now or in the future. Fortunately, instruments exist with which credit squeezes and liquidity crises can be addressed effectively, and without creating moral hazard (such as the MMLR at punitive prices described above) that do not involve changing the monetary policy rate.

I hope and expect that if and when the Fed perceives that real economic activity is likely to weaken materially going forward and/or that inflation is likely to undershoot its comfort zone (wherever that may be), rates will be cut decisively and without delay.

I also fear and expect that, because of the relentless pressure being brought to bear on the Fed by all branches of the Federal Government (with the exception, as far as I know, of the Supreme Court), the Fed will be convinced to cut the Federal Funds target rate, probably as soon as the September meeting. I fear this could be not because this is the best way to guarantee the optimal trade-off between its three macroeconomic goals, but because this is the only way to salvage some measure of future independence for the Fed, in the face of irresistible pressure for a cut now from a lobby for a lower Federal Funds rate that includes special interests ranging from low income households unable to service their wildly inappropriate mortgages to extremely high net worth hedge fund managers facing massive losses and early retirement.

I hope I’m wrong on the last point.

© Willem H. Buiter 2007

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The debate between the efficient markets approach to finance, with its fully rational optimisers, trading, signal-extracting and forecasting away, and the behavioural finance approach, with its boundedly rational (or plain stupid), rule-of-thumb-bound, heuristic-addicted emoticons is pointless. It’s clear that financial markets are BPCE: bipolar- conditionally efficient.

The term bipolar is a wimpish medical euphemism for manic-depressive. Those familiar with manic-depressive illness, whether first-hand or second-hand, will agree that bipolar, with its Scott of the Antarctic connotations, doesn’t do it justice, but that manic-depressive does: Himmelhoch jauchzend – zu Tode betrübt. There are other medical euphemism that have crossed the boundary of the ridiculous. Many years ago at Yale University I found myself searching for the mental health unit (on behalf of a friend, of course!). I could not find anything resembling it, until some helpful soul pointed me to the Mental Hygiene Department. Mental hygiene!? Visions of people flossing their frontal lobes crossed my mind. What were they thinking when they came up with that term?

Back to BPCE financial markets. I don’t mean to imply that those who operate in financial markets are bipolar to a greater degree than those in any other profession, from Amish ministers to zoologists. But if one were to model the aggregate behaviour of financial markets as representing the actions of a representative agent, the choice could only be a heroically bipolar Ayn Randian figure.

An even keel is just an ephemeral, transitional state of affairs between the depth of depression and the height of mania. The mood swings can be triggered by external fundamental events, by sun spots, or be intrinsic – like the rich dynamics of non-linear differential and difference equation systems.

Unfortunately, this is where the analogy breaks down. Manic-depressive illness can in many cases be treated. Where, however, is the financial market lithium that will forestall the succession of waves of irrational exuberance and irrational despondency, the alternation of manias, panics and paralysis we have witnessed in financial markets at least since the tulip bulb mania of the 17th century Dutch Republic? Would it not be wonderful if we could have a pharmacological substitute our current inadequate prudential regulation and supervision of financial markets? A slightly more downbeat version of Aldous Huxley’s Soma perhaps?

© Willem H. Buiter 2007

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The United Nations Office on Drugs and Crime (UNODC) has published a new report on poppy cultivation and opium production in Afghanistan, the Afghanistan Opium Survey 2007. The report contains some useful and sobering facts. In 2007, the acreage cultivated with opium poppies in Afghanistan increased by 17% over the 2006 level. The amount of Afghan land used for opium is now larger than the corresponding total for coca cultivation in Latin America (Colombia, Peru and Bolivia combined). Opium yields also increased (to 42.5 kg/ha in 2007 from 37.0 kg/ha in 2006). Afghanistan therefore produced an extraordinary 8,200 tons of opium in 2007 (34% more than in 2006 and 93% of the global opiates market).

The report also contains some some ludicrous assertions and cockamamie analysis, which one suspects was dropped on the authors of the report from on high. This suspicion is strengthened by the singularly loopy statements at the launch of the document and in its Introduction by Antonio Maria Costa, Executive Director of the UNODC (and my former colleague on the Executive Committee of the European Bank for Reconstruction and Development). Mr. Costa is one of those bureaucrats for whom the conventional scientific modes of proof – proof by deduction and proof by induction – take second place to a third mode of proof (not yet recognised as fully legitimate in scholarly discourse – proof by repeated assertion.

Even someone widely acknowledged as not the sharpest arrow in the quiver should have caught the manifest absurdity of the characterisation, in his own Introduction to the Survey, of opium as “… the world’s deadliest drug…”. As regards deadliness, opium and its derivatives isn’t a patch on tobacco and alcohol.

Mr. Costa’s most accurate reported statement is “The Afghan opium situation looks grim, but it is not yet hopeless,”; this statement is half right: the Afghan opium situation is both grim and hopeless. He goes on to say: “Where anti-government forces reign, poppies flourish,” a correct statement of the observed statistical association between poppy production and the degree of Taliban control in Afghanistan since Taliban’s de-facto rule over the country was ended by the US-led Allied troops almost six years ago.

As a (former) social scientist, Mr. Costa must be aware of the pitfalls associated with the causal interpretation of a statistical association between two phenomena, A and B, say. The statistical association could mean that A causes B, that B causes A, that A and B are interdependent, or that some third factor (or set of phenomena), C, say, is driving (causes) both A and B, without either A influencing B or B influencing A – the ‘common third factor’ interpretation.[1]

Mr. Costa, however, has no doubt; as far as he is concerned, Taliban control of an area causes poppy cultivation to expand in that area. The fact that when the Taliban controlled all of the country, poppy cultivation was almost wiped out, is conveniently forgotten. The Report’s policy recommendation that tackling the Taliban insurgency is key to stemming opium cultivation misses the point completely. Key to tackling the Taliban insurgency is the legalisation of the production, sale and consumption of poppy and its currently illegal derivatives, opium and heroin. This will deprive the Taliban both of political support from farmers who see their livelihoods destroyed or threatened by the Allies’ eradication efforts, and of a ready-made tax and extortion base.

Let me expand slightly: there is indeed a third ‘common (set of) factor(s)’ at work here: the main one is the fact that poppy cultivation and the production, sale and consumption of poppy derivatives such as opium and heroine are illegal almost everywhere. US anti-drugs policy, driven by a bizarre mixture of mindless moralising and complete idiocy and inability to learn from repeated abject failure, is especially vehement, ruthless (at home and abroad) and ineffective. The US government is both the leading opponent of the Taliban and the world’s leading proponent of eradication of drugs ranging from poppy derivatives to coca and cannabis. Poppy cultivation for the illegal market in Afghanistan is more profitable for many local farmers than any other realistically cultivable crop. Attempts by the US, its allies and the Karzai government to eradicate the cultivation of poppy destroy political support for the government and increases support for the Taliban, which can offer protection to illegal poppy growers. The Taliban then tax the poppy crop and the growing share of the opium production that takes place in inside Afghanistan.

The case for legalising currently illegal drugs like opium, heroin, cocaine, and various cannabis derivatives can be made on both utilitarian and libertarian grounds. The utilitarian case has recently been effectively restated by Ethan Nadelmann, in the September/October issue of Foreign Policy. The website of the Drug Policy Alliance, of which Mr. Nadelmann is founder and Executive Director, contains useful statistics, arguments, and information about drug policies worldwide. The resurgence of the odious Taliban in Afghanistan, the illegal drug-related violence and corruption of politics in Columbia and Mexico, Peru, Bolivia and Morocco are a direct result of the criminalisation of drug use.

US anti-drugs policy is not only causing massive harm domestically, it is destroying countries that most Americans have never even visited. Whenever the Taliban extends its control over another city or province, and their barbaric suppression of women and general cult of ignorance destroys the human dignity of yet another generation of Aghanistanis, the anti-drugs Czar (the Director of the White House Office of National Drug Control Policy (ONDCP), currently John P. Walters) and his boss in the White House can take a large share of the credit. Those whom the Gods wish to destroy, they first make mad.



[1] There could also be a common third factor, C, as well as interdependence between A and B.

© Willem H. Buiter 2007

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Central banks tend to pay too much attention to high-frequency movements in financial asset prices, to financial market developments in general, and to special pleading/moaning by representatives of the financial sector. I say this despite the fact that monetary policy is the setting of prices or quantities in financial markets (mainly short-term money markets, repo markets, debt markets and foreign exchange markets) and is transmitted to the real economy in the first instance through the financial system and through expectations of future monetary policy actions. I am also well aware of the importance of efficient financial intermediation for prosperity. In modern market economies, financial markets and private financial institutions are central to the decoupling of saving and investment by economic agents (that is, to consumption smoothing over time) and to efficient domestic and cross-border risk sharing. Financial instability threatens efficient financial intermediation and the efficient management of financial wealth.

As the number of intermediaries between the ultimate savers/wealth owners (households) and the ultimate investors/custodians of the real capital stock (non-financial firms) has grown, however, and as the number of complexity of financial instruments issued by these intermediaries has exploded, there has been a growing disconnect between the well-being and profits of the financial sector and the well-being and profits of the economy as a whole. Some of the new financial institutions and many of the new financial instruments exist only because of tax avoidance (or tax efficiency, as it is often known), and regulatory arbitrage (getting around regulatory obstacles to making profits).

The rewards individuals can earn in the financial sector appear well in excess of the social marginal product of their contributions. The reasons for this market failure are not immediately obvious, although the privately rational but socially costly search for tax efficiency and regulatory arbitrage must be part of the answer. So of course, are globalisation and the fact (again not well understood), that rewards in the financial sector seem to be determined more according to the ‘winner take all’ tournament model than the conventional model of a competitive market with free entry and exit in which the most talented/lucky do indeed get the biggest rewards, but there is something meaningful left even for those coming second or lower in the ordinal ranking of performance. Whatever the reason(s), the City of London, Wall Street and the private financial sector everywhere have attracted a disproportionate share of the best and the brightest. For instance, whatever may be the contribution of ‘quants’ (specialists in mathematics, computing and finance) to the private profitability of the firms that employ them, their collective contribution to general economic well being is likely to be quite a bit below their take-home pay.

Many of the new financial institutions are very highly leveraged. This means that those who own them put up rather little risk capital of their own and borrow the rest. Examples are hedge funds and private equity funds, but investment banks and commercial banks increasingly fit this description as well. Most of the lending and the buying and selling of securities is between financial institutions, rather than between financial institutions and ultimate savers and investors in physical capital. Most of the exposure of financial institutions is to other financial institutions. Because of this, it is possible for there to be major losses by some financial institutions (say a hedge fund holding credit default swaps) that are matched by matching reductions in the exposure (that is, gains) of other financial institutions. The losers will soon call for a central bank bail-out (through interest rate cuts preferably), but the winners will quietly pocket their innings.

In my view, provided the central bank manages credit and liquidity crises properly, by acting as a market maker of last resort, there is no financial institution in the world today that is too big to fail. A market maker of last resorts intervenes when markets become disorderly, assets become illiquid and credit dries up because of massively increased uncertainty, fear and panic. The market maker offers to buy the illiquid assets on any scale necessary to prevent solvent but illiquid enterprises from going bust, but does so at a sufficiently low price to minimise moral hazard. This is, however, not what central banks have been doing. The ECB has flooded the market with liquidity in exchange for high-grade collateral, when it should have made a market for low-grade collateral. The Federal Reserve Board also did some rather indiscriminate liquidity creation against high-grade collateral (but on a smaller scale than the ECB) and cut its discount rate, for no good reason I can discern other than trying to boost some amorphous feel-good factor. The discount rate cut only benefited those already willing and able to borrow at the discount window. It did nothing to directly address the problem of asset illiquidity.

Because they work in and through financial markets, there is a risk, indeed a likelihood, that central banks will get co-opted, consciously or subconsciously, by the movers and shakers in the financial markets. For every representation made to the central bank by a spokesperson from the real economy, there will be half a dozen from the financial sector. The financial sector also speaks the same language as the central banks, which facilitates the de-facto ‘capture’ of the central bank by the financial sector collective interest. Central bankers often come from the financial sector, and, after their stint in the central bank is over , tend to take on lucrative appointments in the (private) financial sector. There is nothing wrong with that in principle, as long as conflicts of interest are avoided and a decent (preferably legally set) sabbatical or purdah period is observed between the end of the central bank appointment and the start of the private financial sector activities. Yet it all adds up to an environment in which the central bank is more likely, in its monetary policy actions, to accord a weight to the well-being of the financial sector that may well exceed that which is warranted from an economy-wide perspective.

I think some of the actions of Alan Greenspan following every significant outbreak of financial turbulence in his term in office, and, albeit to a lesser extent, the behaviour of the ECB and the Fed during the financial storm we are just emerging from, provide examples of central banks that are ‘too close’ to the financial markets and the private financial institutions that operate in them. This excessive closeness leads them to identify the health and profitability of the financial sector, and indeed at times even of highly visible individual financial institutions, with the health of the economy as a whole. That correlation is, however, far from unity most of the time and can at times even become negative.

So what can be done about this? Not much unfortunately. Two minor measures come to mind.

First, locate the central bank somewhere so far away from the nation’s (or region’s, in the case of multi-country monetary unions) financial capital.

Second, make sure that the head of the central bank, and (where monetary policy is made by committee) the vast majority of the monetary policy makers, are not so deeply immersed in the culture, values and world view of the financial sector that they have lost the ability to view the financial sector as something external to them, something they have to influence and work through and with, rather than something with which they are emotionally and cognitively inextricably intertwined. They must know how the financial sector thinks; they must understand its moods and mood swings, but they have to keep their distance, emotionally and intellectually. They can smoke it, as long as they don’t inhale.

The US and Canada have been lucky or wise in locating their central banks. It’s a good thing that the Fed is in Washington DC rather than in New York City, the financial capital of the USA. It is not a good idea, to get someone who is not only from Wall Street, but of and by Wall Street, appointed Chairman of the Federal Reserve Board.[1] We should be pleased that Alan Greenspan is gone and has been replaced by a highly respected academic economist and public servant who does not believe that Wall Street is the centre of the universe, or even of the American economy. Greenspan may not have been the worst central banker ever (there are many stronger contenders for that honour)[2], but he certainly contributed mightily to the post-2000 climate of excessive liquidity, lax enforcement of existing prudential standards on regulated financial institutions, and the spread of the misplaced belief that the new financial institutions and the issuers of most new financial instruments could be left outside any formal prudential regulatory and supervisory framework. The notion that the mere suggestion that self-regulation might be in order represents an undue imposition on hedgefunds and private equity funds will turn out to have done a disservice even to these very institutions in the slightly longer run.

Likewise, it’s a good thing that the Bank of Canada is in Ottawa rather than in Toronto. The Eurozone has no single dominant financial capital, but it is helpful to have the ECB located in Frankfurt, a provincial backwater. I would much rather have the Bank of Japan located in Kyoto rather than in Tokyo, and the Bank of England in Manchester rather than in London, but it’s hard to rewrite history. Fortunately, in the case of the UK, Mervyn King is probably the central bank Governor least likely to overestimate (or underestimate!) the significance of the financial sector for the health of the economy; nor is he likely to believe that there is a positive correlation between the wisdom of a proposition and the vehemence, volume and conviction with which it is uttered. He will need all his strength, stubbornness and intelligence to stay the course through this crisis.



[1] Paul Volcker, the greatest Chairman of the Fed thus far in the post-World War II period, did spend nine years on Wall Street with Chase Manhattan before joining the Federal Reserve Board. He did, however, also spend about 17 years with the Federal Reserve Bank of New York and in government service before becoming Chairman of the Federal Reserve Board. Familiarity with and knowledge of the modus operandi of financial markets and institutions is clearly a major plus for the head of a central bank. To have that familiarity and knowledge, yet still to maintain the proper affective and cognitive distance from the markets, can make for a truly great central banker, as it did in the case of Volcker.

[2] Alan Greenspan does have a strong claim to be the worst former central banker ever. His propensity to speak out on market-sensitive matters since his retirement as Chairman of the Federal Reserve Board, cannot but have been a source of irritation and embarrassment to Greenspan’s successor during the first few months following Greenspan’s retirement from the Fed. I know of no other example of such indelicate behaviour by a retired top central banker. The richly remunerated dinner-engagement-cum-speech with a leading Wall Street firm within a couple of days or so of leaving the Fed, revealed at best a singular lack of judgement and propriety, even if the occasion was technically a ‘closed’ event.

© Willem H. Buiter 2007

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Liquidity

Liquidity, the ability to sell an asset for cash at short notice, at a price close to its fair or fundamental value and with low transaction costs, is a property of assets that some assets never possess, others (almost) always, and yet others intermittently and/or to varying degrees. The reasons for illiquidity can be divided into three categories: (1) legal restrictions on the ability to sell; (2) technical, physical or informational obstacles resulting in the absence of organised markets and permitting only infrequent and often unpredictable opportunities to sell; (3) Knightian uncertainty, fear and panic resulting in disorderly conditions in normally well-functioning markets; at best, prices significantly below fair or fundamental value can be realised; at worst, there is the effective temporary closure of normally well-functioning markets. For this third category, the maxim holds that, as regards private securities and in the absence of state intervention of the lender or last resort or market maker of last resort variety, liquidity is everywhere when you don’t need it, but is nowhere to be found when you need it.

As regards the legal restraint reasons for illiquidity, legal restrictions account for the illiquidity of the most important form of wealth, human capital, the present discounted value of current and future labour earnings. With both slavery and indentured labour illegal (for excellent reasons not captured by conventional economic analysis), it is not possible to sell your own human capital, or that of others, or to buy the human capital of others. While you could, I suppose, sign a contract promising to make future payments that matched your own labour income, this would be a highly imperfect substitute for the ability to sell you own labour services for two reasons. The first are asymmetric information (the other party to the contract and third parties may not be able to verify your labour income, which could be private information) and moral hazard (having sold the contract, you would have an incentive to work less hard); the more important one is that your own labour income could not serve as collateral for the payments on the contract you just signed; ‘free labour’ means no court would enforce a contract that had your own future labour income as collateral.

As regards ‘technological (including informational) reasons for illiquidity, assets whose payoffs are contingent on events whose occurrence is private information are unlikely to be tradable and liquid. This may be one reason why loan contracts agreed between a commercial bank and a borrower tended to be illiquid. Banks issued loans to borrowers and kept them on their books until the loan matured. The information required to verify the reasons given by the borrower for non-performance was available, at best, to the bank’s loan officer, who might be familiar with the circumstances and characteristics of the borrower because of a long-standing relationship.

The securitisation of previously illiquid bank loans ‘solved’ the illiquidity problem of bank loans only at the cost of destroying valuable information about the borrower. The argument that this destruction of information would not happen because the originator of the loan (the commercial bank through the efforts of its loan officers) would, because of reputational considerations, spend the same amount of resources and effort selecting, supervising and monitoring the ultimate borrower, even after the loans had been sold off to some special purpose vehicle created by (and generally owned by) the bank, is unconvincing. The loan officer worked directly for the principal in the traditional illiquid bank loan scenario. When the loans have been securitised, the banks loan officer is one agency relationship further removed from the principal, and should be expected to shirk more. This point that, by adding more tiers, layers or agents into the principal-agent relationship, incentives and effort get eroded is a simple one, but has not been emphasized enough in the discussion of the effects of securitisation of bank lending (or of credit card receivables, or of mortgages) on the incentives faced by the agent in charge of selecting, supervising and monitoring the ultimate borrower. We are paying the price for this in the US markets for securities backed by mortgage receivables and in the UK in the market for securities backed by credit card receivables.

As regards uncertainty, fear and panics as reasons for illiquidity, the developments of these past few months have brought home two truths. First, many assets secured against traditionally illiquid receivables (mortgages for instance) were never very liquid to begin with. Where are the organised exchanges on which CDOs secured against subprime mortgages or high-risk credit card receivables were widely traded? Most of these assets were bought from SPVs (often created by the banks who previously held these receivables as illiquid investments) by hedge funds and other more jazzy financial institutions, who expected to hold them to maturity. These hedgefunds and similar highly leveraged private financial enterprises may, however, have believed that their investments were liquid, i.e. that they could be disposed of at short notice and with low transaction costs at a price close to their fundamental value. This may have been true when optimism, euphoria and greed ruled the roost in financial markets. It definitely was not true when uncertainty, fear and panic took over as the driving mood among the herd of financial market players.

The financial chaos of the past few weeks has made it clear that, unless the fundamental value of a security can be verified objectively and at little cost by both parties to a contract and by third parties, no security can be confidently expected to remain liquid when uncertainty, fear and panic strike. This means that no private security whose valuation requires an assessment of the default risk of the issuer (and of the payments receivable conditional on default occurring) can be expected to remain liquid when uncertainty, fear and panic strike. Only one class of securities is unaffected by this. These are securities issued by solvent central governments and denominated in the national currency. This is because default is not an issue there. The power to tax and the power to declare (some of) its liabilities to be legal tender are unique to the state, which has the monopoly of the legitimate use of force and coercion. Until private entities emulate that state as regards the use of force and coercion, the private sector will be unable to create liquidity in a credit and liquidity crunch. One could make the argument that there is a second class of securities whose liquidity is unlikely to be dramatically affected by the emergence of default risk. That would be equity. This is because equity always lives in the shadow of default, since when default occurs, equity is (supposed to have been) wiped out.

Support/bail out markets and mechanisms, not financial businesses

Central banks in times of crisis should aim to support/bail out markets and other valuable social mechanisms; they should not support or bail out companies, partnerships or individuals, unless this is an unavoidable feature of supporting markets and mechanisms. Specifically, they should not support (again subject to the same caveat) financial institutions, which are of course not institutions at all, but only misnamed financial businesses.

The mechanisms that warrant central bank support and bail outs are the payments, settlement and clearing mechanisms for goods, services and securities. The financial markets that warrant supporting are those that are, directly or indirectly, of material importance in (1) the intermediation of the flow of saving from economic agents with financial surpluses (mainly households) economic agents with financial deficits (mainly non-financial enterprises and governments), and (2) the management of the financial wealth of the ultimate wealth-owning entities in the economy, households and the state.

So the households that overextended themselves with mortgages that turned out to be too large or otherwise inappropriate should not be bailed out, either by the Fed through lower interest rates or, ex-post, by the mortgage industry regulator leaning on the lenders to delay/forestall foreclosures. If hardship and poverty result from this, the appropriate existing government programmes for dealing with hardship and poverty should be used to address these problems. It is hard to believe that hardship and poverty resulting from foreclosures is a greater social problem than hardship and poverty resulting from other causes (ill-health, for instance).

The mortgage lending institutions will take a hit if the value of their collateral (the homes against which the mortgages were secured) is less than the value of the outstanding obligations at the time of foreclosure. Its equity owners and its creditors, (including its depositors, to the extent they are not covered by deposit insurance) may lose some of all of their investments. That is as it should be, and does not call for government or central bank intervention.

If inappropriate lending practices were pursued by the mortgage lenders or if inappropriate products were offered to borrowers, the first party to be held to account, after the lending institutions themselves, are the regulators and supervisors. This may help prevent or mitigate the next crisis, but will do nothing to mitigate the current one.

The German banks that invested equity in or lent money to funds and other special purpose vehicles which decided that financial instruments backed by US subprime mortgages were a good bet should be allowed to go under, if their equity is wiped out by the subprime debacle. Many of these banks are Landesbanken (perhaps they would prefer to be Landesbänke) whose future without government guarantees in a competitive Europe-wide or even global banking market is doubtful at best. Others, like IKB, have a wholly state-owned bank as its major shareholder. If this financial crisis speeds up their exit from the market, it will be a boost to the efficiency of the European credit and capital markets.

What to do if a business is the market or the mechanism

I believe that the view developed by Anne Sibert and myself in central banks as the market maker of last resort (MMLR) (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort”; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”), is quite consistent with, and indeed encompasses, Walter Bagehot’s view of the central bank as the lender of last resort (LOLR). When Bagehot wrote, commercial banks (with sight deposits withdrawable on demand and subject so a sequential service (first-come, first-serve) constraint and illiquid business loans as assets, were the market for credit. Intermediation from saving households to investing non-financial enterprises went through the banks. So to save intermediation from ultimate savers to ultimate investors, and to save the market (a goal we agree with because the credit market is a public good ‘on steroids’ because it is subject to network externalities) the central bank had, in times of financial turmoil and panic, to save the banks. It therefore had to lend freely., To minimise moral hazard, it had to lend at a penalty rate and against collateral that would be good in normal times, with orderly markets, but could have become bad in abnormal times, with disorderly markets.

With the financial developments since Bagehot, and especially those since the 1960s, the commercial banks have become much less important in the intermediation process between households, non-financial enterprises and governments. Other financial businesses (a better name than the excessively venerable epithet ‘financial institutions’) such as investment banks, pension funds, insurance companies and highly leveraged financial businesses such as hedge funds and private equity funds, have taken away much of their business. All these players (including households, commercial banks and non-financial businesses, are now less prone to be involved in long-term relationships with each other, and are now more likely to interact through the financial markets. Of course, repeated interaction through the issuance and purchase of the securities in the financial market may establish connections that share some, but not all, of the features of the traditional long-term relationship between commercial banks as their customers on both sides of the balance sheet.

A few of these financial businesses still play a unique role in some of the key financial markets or mechanisms because of institutional inertia. Central banks tend to restrict access to the discount windows to a highly restricted set of counterparties, mainly commercial banks. It seems obvious that this legacy of history no longer makes any sense and is an obstacle to the efficient management of financial crises by the central bank. Any counterparty (individual, partnership or company) that holds the kinds of securities accepted by the central bank at its discount window should be able to access the discount window, provided the counterparty is willing to accept the appropriate prudential regulatory and supervisory restrictions on its behaviour. It is the duty of the central bank to work out what the appropriate prudential regimes for this heterogeneous collection of potential counterparties are.

In its regular liquidity-providing repo operations, I can see no reason for the eligible counterparties of the central bank to be restricted to any party that meets the central bank’s criteria for creditworthiness and is able to offer collateral that meets the central bank’s collateral eligibility requirements.

I also believe that the eligibility requirements for collateral should, at least in times of crisis, be relaxed to include non-investment grade securities and securities with much longer terms remaining to maturity than has been the case thus far. Of course, for the central bank to act sensibly in the markets for non-investment grade securities (whether through outright purchases or by accepting them as collateral in repos or discount window operations) during times of crisis, it has to be present in these markets all the time, regularly buying and selling small amounts of securities, to familiarise itself to the fullest extent possible with these markets.

Payment, clearing and settlement mechanisms

The payment, clearing and settlement mechanisms for goods and services and for securities provide a public good. This means that its provision by unregulated competitive markets will be at best inefficient and at worst disastrous.

State provision is also likely to be inefficient, basically because, as a near-universal empirical generalisation, the state is inefficient at just about any productive activity it attempts to manage and run. The ECB currently manages Target1/2 (basically the large-scale interbank payments in the Eurozone). I have no metric against which to evaluate the efficiency of their performance of this function. Nevertheless, I believe that, regardless of the efficiency of the ECB in managing and running Target1, that responsibility should be taken away from it. The reason is that the ECB is ‘too independent’ to be entrusted with any task/function other than the one for which this extraordinary degree of independence may make sense (monetary policy). The institution looking after the plumbing and wiring of the payments, settlement and clearing system should be an institution whose managers and board can be fired for incompetence, and whose mandate can be changed without a process that requires the unanimous approval of 27 EU members. The same argument applies to Target2-Securities, the clearing and settlement system for securities that the ECB proposes to own, manage and run. Even if there is a case for a public sector agency to run the securities clearing and settlement systems, it should, for substantive accountability reasons, not be the ECB (see my inaugural lecture at the LSE for details).

Private (for profit) provision under strict regulation (and possibly with the support of some state funding) is therefore the obvious arrangement. The alternative is to restrict entry into the payments, settlement and clearing system to not-for profit private ventures (a revival of mutuals perhaps?).

The payment, settlement and clearing systems in the EU and elsewhere should be taken away from private profit-oriented financial businesses for which these tasks are but a small fraction of their total portfolio of activities. The reason is that the performance of these essential but, from the point of view of the total resources involved, minor tasks of providing payment, settlement and clearing systems, allows the private businesses offering these systems and services to extract massive rents from the state and from their customers, benefiting the entirety of their business activities and not only the units devoted to providing payment, clearing and settlement services. This is most patently the case during financial crises, when the only way to safeguard the payment system often appears to be to safeguard the commercial banks that currently provide many of these payment services. The interest rate cuts sought by the commercial bank lobbyists (and by all those who stand to benefit from enhanced access to cheaper finance) are an extraordinarily inefficient way of safeguarding the payment system. Interests rate cuts aimed at supporting the payment system end up supporting those whose recklessness led them into excessively leveraged speculative activities.

The intermingling, in private profit-oriented businesses, of the provision of public goods or services with regular profit-seeking activities, represents an extremely unhealthy state of affairs. The public provision of private goods is a well-documented disaster. The private provision of a public good without effective regulation (especially when provision is by a complex private businesses for which the public good is but one concern among many), can be a disaster of comparable magnitude.

© Willem H. Buiter 2007

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There you have it. The President of the ECB, Jean-Claude Trichet, uttered the ‘strong vigilance’ mantra in August 2007. For those who don’t speak ECB, ‘strong vigilance’ means: ‘we’re going to raise rates by 25bps at the next meeting’. Not to be confused with ‘vigilance’, which means nothing at all, because central banks are always supposed to be vigilant. The language is rugged/masculine: the soldiers of monetary rectitude are on high alert and stand guard over those entrusted to their care: ‘testosterone’ and ‘rampant testosterone’ could have been used instead of ‘vigilance’ and ‘strong vigilance’ with much the same effect. And then it happened. The world changed – “Events, dear boy, events”. A little financial crisis his the Eurozone, the US – indeed in much of the known financial universe. Suddenly it looks as though 25bps in September might not be such a foregone conclusion/done deal.
And of course, Mr. Trichet and others who believe in giving guidance to the markets about the next policy move will point to many statements explaining the difference between giving guidance and preannouncing. “This is not a commitment”; “All options remain open”; “We retain full flexibility to respond to new information”.
If that is indeed the case, then why bother with giving the markets your current best guess about the next move. We know that the current interest rate decision (typically -25bps, 0 bps or +25bps ) has no macroeconomic significance in and of itself. Economic activity, including inflation are driven by past current and anticipated future policy rates. The weight of the current rate (to which the authorities are committed for at most one month), independent of what the current rate implies for future rates, is just about zero. What is true for the current policy rate is also true for next month’s policy rate. It is of no material macroeconomic significance. Yet financial market participants spend extraordinary amounts of resources trying to figure out the next policy move. That is because vasts amounts of money are bet on the outcome of next month’s monetary policy decision. The resolution and settlement of these bets is purely redistributive among market players and therefore of crucial importance to each one of them. In the aggregate it is pretty much a wash as regards its macroeconomic impact.
Yet by dropping massive hints about next month’s policy move, the ECB encourages the myopia distorting so many private financial market decisions. Instead of focusing on what matters, the central bank’s contingent policy response to news and events in the future, all eyes are on next month’s rate move. If central banks feel they must say something about future policy rates, let them say something about future policy rates from now till Kingdom Come. Let them do so either in the form of reaction functions (such as Taylor rules) or through a fan chart. But please, don’t encourage the shortening of horizons in private financial markets, where the short run is the next trade, the medium term is lunch and the long term is the end of the trading day, or whenever positions have to be squared.
Best of all, say nothing about future policy rates. Explain the central bank’s view about its mandate and objectives and about the monetary transmission mechanism. Given enough history, even that would not be necessary, because the central bank’s reaction function would be understood by all market participants who would be aware of the central bank’s track record. Ah, how sweet the sound of central bankers saying nothing at all!

© Willem H. Buiter 2007

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A common response to our proposal that the Fed expand the range of securities it purchases outright or accepts as collateral in repos or at the discount window to include illiquid securities and securities below investment grade is that the Fed would not know how to value these securities. Ms. Wendy Wang provides a clear statement of this view:
“You are assuming that, acting as market maker of last resort, central banks know intrinsically how much the securities-in-question should be priced. If this were the case, it would be better off for the CB to publish their model as to prevent crises of the sort in the first place. Personally, I don’t think there is any reason to believe that central banks are in any better position to price securities than the private sector.”

I would hope that (to be better prepared for the next financial crisis) the central bank would indeed acquire expertise that would give it a better crack at determining the fundamental value of illiquid securities than it has any hope of achieving currently. Fortunately, the central bank need not know the fundamental value of the illiquid securities in order to make a market. I am sure that many experts on auctions (such as Professors Ken Binmore, Paul Milgrom or Paul Klemperer)will be able to improve on this shorthand proposal, but I would think a Dutch auction could be a fine way to go. In a Dutch auction, the the central bank would announce that it would be willing to buy up to, say, $10bn (at face value) worth of CDOs backed by impaired subprime mortgages. It would start the auction offering a buying price of, say, one cent on the dollar. CDOs offered at that price would be accepted, up to the total amount of the auction ($10bn face value). If the total amount offered at 1 cent on the dollar exceeds $10bn face value, there would be pro-rata sharing among those making offers to sell. If less that $10bn face value is offered at one cent on the dollar, the remainder gets offered at, say, 2 cents on the dollar, all the way up to 100 cents on the dollar. Such a Dutch auction is a price discovery mechanism. The central bank does not need to know the true value, it simply needs to have a mechanism for discovering the reservation prices of the private holders of the illiquid securities. The central bank has all it needs: deep pockets and the absence of a profit motive.

© Willem H. Buiter 2007

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Joint post by Willem H. Buiter and Anne C. Sibert. Virtually the same post appears on Martin Wolf’s Economists’ Forum, August 20th, 2007.

Martin Wolf, Chief Economics Commentator of the Financial Times is correct in stating, in his FT column of August 15, 2007, Fear makes a welcome return, that in a crisis the central bank must save not specific institutions, but the market itself. It is, however, necessary to be precise about what it means to save the market, about which markets may need saving and about how the central bank should go about saving the market in such a way as to minimise undesirable side effects.

In a number of recent blog contributions, we have sketched the role of a modern central bank as ‘market maker of last resort’ (MMLR). This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks (see e.g. Willem H. Buiter and Anne C. Sibert “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort”; Willem H. Buiter “Central banks as market makers of last resort, again”; Willem H. Buiter and Anne C. Sibert “A missed opportunity for the Fed”).

The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner. The central bank of course already applies a liquidity ‘haircut’ even to liquid instruments offered as collateral in repos or at the discount window. Because the MMLR would have to establish a buying price ‘in the dark’, that is, unaided by recent relevant market prices, and would inevitably take on much more credit risk than central banks have become accustomed to, the ‘haircuts’ should be severe – a financial version of ‘short back and sides’.

Making a market for a particular type of illiquid financial asset, say a collateralised debt obligation (CDO), may require knowledge that central banks currently do not have. Central banks can acquire the necessary experience in these markets in the same way that they have gained experience in the market for domestic government securities and in the market for foreign exchange: by being regular market participants. Central banks should regularly, either on their own account or on behalf of customers, conduct a small amount of business in these markets in normal times, simply to get a sense of these markets.

Such market participation may require staff with a different expertise than central bank staff currently possess. Certainly the solution is not to hire the financial engineers and quants, who are so good at exploiting ‘arbitrage’ opportunities and extracting the large returns to risk bearing in ordinary times, but whose lack of consideration for and/or understanding of economic fundamentals significantly contributed to the current market disarray. Instead, central banks should hire economists with solid training in macroeconomics, financial economics, micro-market structure and behavioural economics and then encourage them to become interested in and knowledgeable about financial markets that may become illiquid.

From the perspective of saving or supporting markets, acting as market maker of last resort where appropriate and necessary, the recent actions of the Fed, the ECB and the Bank of England have all left something to be desired.

The ECB simply drowned the markets in high-grade liquidity, adding well over $200bn worth of liquidity against high-grade collateral. As this did nothing directly to assist the markets for illiquid and low-grade securities, the ECB’s action is an example of too much of the wrong stuff and little if any of the right stuff: it lays the foundations for the next credit boom without doing much to alleviate the current credit bust.

The Fed cut the (primary) discount rate from 100bps above the Federal Funds target rate to 50bps above the Federal Funds target rate. This was a mistake and a missed opportunity. The problem was not that eligible financial institutions were unable to pay the original, higher, Fed Funds rate and survive. It was that these financial institutions are holding a lot of assets which have suddenly become illiquid and cannot be sold at any price. Lowering the Fed Funds rate just subsidised any institution with liquid eligible collateral. The Fed should instead have effectively created a market by widening the set of eligible collateral, charging an appropriate “haircut” or penalty interest rate, and expanding the set of eligible borrowers at the discount window to include any financial entity that is willing to accept appropriate prudential supervision and regulation.

The Bank of England has been economically sensible this past week, but it has violated two of its own sterling money market management objectives. As can be verified from its website, and in The Framework for the Bank of England’s Operations in the Sterling Money Markets, it violated Objective 1 (to keep the overnight interest rate in line with the Bank’s official rate) and, as a consequence of violating Objective 1, the also violated Objective 3 (to provide a simple, straightforward and transparent operational framework).

Unlike the Fed and the ECB, the Bank of England did not keep the overnight market interest rates close to the Bank’s official rate of 5.75 percent. Instead it allowed the overnight interbank lending rate (SONIA), to average 6.19 percent on August 13, and to at times rise above 6.50 percent. Absent the Bank’s stated money market objectives this would have made perfect sense, as being illiquid is not a commercial bank condition that ought to be subsidized by the central bank. But, it is not in accordance with the Bank’s stated objective of keeping the overnight rate in line with the official rate. And, in violating this objective, it also violates the objective of providing a simple, straightforward and transparent operational framework.

Our solution to this problem is to omit Objective 1 or replace it with something that makes it clear that in disorderly markets, banks should expect to have to borrow from the central bank at the rate applicable to the standing collateralised lending facility rather than at the official (Repo) rate.

So, on balance, the Fed and the ECB are addressing the credit crunch with a larger dose of liquidity-provision-as-usual under orderly market conditions. In addition, the Fed has provided an unnecessary subsidy to discount window users. There is a real risk that either or both may be pushed into cutting monetary policy rates not because they fear developments in inflation (and in the case of the Fed) employment that would, according to their mandates, require them to use more expansionary monetary policy, but as a way of addressing a credit crunch and liquidity crisis. The Bank of England has not made an error comparable to those of the Fed and the ECB, but has created confusion about its sterling money market policy. It should clarify the policy.

On the whole, these central banks have not exactly covered themselves with glory. But there may be future opportunities, perhaps even during the next phase of the current crisis, for them to redeem their reputations.

© Willem H. Buiter and Anne C. Sibert 2007

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In response to the credit and liquidity crunch that has recently spooked global financial markets, the Federal Reserve reduced, on Friday, 17 August 2007, its primary discount rate from 6.25 percent to 5.75 percent. The discount rate is the rate that the Fed charges eligible financial institutions for borrowing from the Fed against what the Fed deems to be eligible collateral. It is normally 100 bps above the target Federal Funds rate, which is the Fed’s primary monetary policy instrument and which is currently 5.25 percent. We believe that this cut in the discount rate was an inappropriate response to the financial turmoil.

The market failure that prompted this response was not that, given that they have eligible collateral, financial institutions are unable to pay 6.25 percent at the discount window and survive. The problem is that banks and other financial institutions are holding a lot of assets which are suddenly illiquid and cannot be sold at any price. That is, there is no longer a market that matches willing buyers and sellers at a price reflecting economic fundamentals. Lowering the discount rate does not solve this problem, it just provides a 50 bps subsidy to any institution able and willing to borrow at the discount window. Instead of lowering the price at which financial institutions can borrow, provided they have suitable collateral, the Fed should have effectively created a market by expanding the set of eligible collateral and charging an appropriate “haircut” or penalty. Specifically, it should have included financial instruments for which there is no readily available market price to act as a benchmark for the valuation of the instrument for purposes of collateral.

There is no apparent legal impediment to doing this. Allowable collateral includes a wide range of government and private securities, including mortgages and mortgage-backed securities. Indeed, the Federal Reserve Act of 1913 allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any just about any collateral the Fed deems fit.[1] Specifically, if the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five out of seven governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations (IPCs) “notes, drafts and bills of exchange … indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”. The combination of the restriction of “unusual and exigent circumstances” and the further restriction that the Federal Reserve can discount only to IPCs “unable to secure adequate credit accommodations from other banking institutions”, fits the description of a credit crunch/liquidity crisis like a glove.

It is of course essential that moral hazard be minimised. This ‘bail out’ of the illiquid by the Fed should be sufficiently costly that those paying the price would still remember it during the next credit boom, and act more prudently. Second, where no market price is available, the Fed should base its valuation on conservative assumptions about the creditworthiness of the counterparty and the collateral offered by the counterparty. They counterparty should not expect to get 90 cents on the dollar for securities that it could not find a willing private taker for at any price. Third, the highest ‘liquidity haircut’ in the Fed’s arsenal should be applied to this conservative valuation.

The Fed should also enlarge the set of eligible counterparties at the discount windows. This should not just be banks and other depository institutions, but any financial entity that it willing to accept appropriate prudential supervision and regulation. The nature of the supervision and regulation required will differ depending on the nature of the institution. Hedgefunds or private equity funds need different prudential regulation from depository institutions, investment banks or pension funds. At the very minimum, however, transparency grounded in comprehensive reporting obligations should be required of any institution eligible to use the discount window.

At least the Fed did not cut the monetary policy rate (the Federal Funds target which remains at 5.25%). A cut in the Federal Funds target is warranted only if the Fed were to believe that the recent financial market kerfuffles are likely to have a material negative effect on real activity in the US or on the rate of inflation. There is no evidence as yet to support such a view. If and when it happens, the Fed should act promptly. But addressing the problem of illiquid financial markets using the blunt instrument of monetary policy, a cut in the monetary policy rate, would be clear confirmation that the Fed is concerned about financial markets over and above what these markets imply for the real economy. Such regulatory capture would effectively redirect the ‘Greenspan put’ from the equity markets in general to the profits and viability of a small number of financial institutions. It would not be a proper use of public money.

© Willem H. Buiter and Anne C. Sibert 2007

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Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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