It is key not to confuse the two.

Labels: Economics, Financial Markets, Monetary Policy

My earlier blog with Anne Sibert on modern central banks as market makers of last resort (MMLR) rather than Bagehotian lenders of last resort (LOLR), has prompted a number of thoughtful and stimulating comments, the longest from Simon Cox of the Economist. I will try to deal with most of them here.

(1) What are the ‘welfare economics’ and efficiency arguments for the central bank acting as MMLR?

The Bagehotian LOLR intervenes for two reasons.

(i) Bank runs are unnecessary. Typically, the formal models of bank runs show that there exist (at least) two equilibria: one in which there is no bank run and at one in which there is no bank run. Without a central bank acting as LOLR (or some other device like compulsory bank holidays, in which the sequential service constraint (the first-come, first-served right of depositors to withdraw their money) is suspended), there can be a ‘coordination failure’ causing depositors to focus on the wrong equilibrium, the ‘run’. The LOLR eliminates the run equilibrium.

(ii) Bank runs are costly. They may cause banks to go bankrupt; they may impair the payment system (when checkable bank deposits are an important means of payment) and they may interfere with the ability of the banking system to extend new loans or roll over existing ones, thus impairing the supply of trade credit, working capital etc. etc. Bankruptcy is socially costly. It is not just a reshuffling of ownership claims. Real resources are wasted on lawyers, auditors, accountants and bailiffs. ‘Going concern value’, including goodwill may be destroyed. Established relationships between borrowers and loan officers may be interrupted and social capital diminished.

The efficiency argument for the MMLR function in an economy where most credit is extended through the financial markets is similar to, but even stronger than that for the LOLR in a bank-dominated credit system. That is because a market, an arrangement for bringing together and matching willing buyers and sellers, has many of the features of not just a public good, but of a public good with network externalities.

Conventional pure public goods are non-rival and non-excludable. Markets don’t, on the whole, have the non-excludability property: it is possible without incurring too high a cost, to exclude a would-be trader from operating in a market. Markets have, however, the non-rivalness property on steroids. With a non-rival good or service, my ability to consumer or enjoy it is not diminished if someone else consumes or enjoys it. With a matching mechanism like a market, the usefulness of the market to any would-be buyer or seller increases when the number of alternative buyers and sellers increases. Such network externalities mean that, if the market is also costly to establish and run, it is unlikely to function efficiently as an unregulated private, profit-maximising venture. This is why many markets are regulated either by a trade association including buyers or sellers, or by some agent of the state.

A disorderly market – one in which the matching mechanism has broken down – inflicts real costs on the would-be buyers and sellers who fail to make a match. At the very least, the gains from trade are foregone. If the sale of an asset in the market in question is the only available means to raise cash to forestall default or even bankruptcy, all the arguments about socially costly bankruptcy made in the context of the LOLR and bank failure apply here also. A ‘materiality test’ clearly applies. If the market in question is not significant, in the sense that even a complete lock-down of the market would not drive would-be market participants into bankruptcy, there is no case for a MMLR. There has to be a risk of substantive (‘material’) avoidable economic costs being incurred. Logically, that does not necessarily require that a run on an asset or asset class is spilling over into other asset markets. The asset in question could be significant enough in its own right for intervention to be warranted. I don’t believe that the case for a MMLR is significantly strengthened if the malfunctioning of certain credit markets threatens depository institutions like commercial banks. I no longer consider depository institutions of special interest in well-developed financial markets. Their checkable deposit liabilities no longer play a crucial role in the payment mechanism, and their role in extending loans and other forms of credit to businesses and households have been duplicated by non-bank institutions. With securitisation their loan asset portfolio is also more liquid than it was before (although not as liquid as the banks and their counterparties believed until recently).

Clearly, when there threatens to be a significant impact on employment and output, the ‘material damage’ test is likely to be met. But it is not necessary. Even in a world with continuous full employment, the real resource costs associated with widespread unnecessary bankruptcy and default could be sufficient reason to intervene.

(2) Would the MMLR not create moral hazard?

Of course it would, just like the LOLR. Moral hazard is almost unavoidable whenever the government intervenes anywhere. The practical issue is how moral hazard can be minimized and whether, when the moral hazard is minimized, the benefits of MMLR intervention exceed the costs. The observation that a government intervention creates moral hazard is not the end of the argument, but the beginning of an intelligent discussion.

Consider the example of a number of hedge funds that have made highly leveraged bets on CDOs, and the banks that provided the hedgefunds with the means to build up their highly leveraged portfolios. The hedgefunds are exposed to the CDOs; the banks are exposed to the hedgefunds. Then a CDO panic hits and the market for CDOs freezes. Some of the funds may have made bets whose success depends on the persistence of low risk-free rates and low credit risk spreads. These bets will go wrong. Hedgefunds that have made enough bets if this kind are insolvent and should fail. So should the banks that have lent to them. However, there may be other hedgefunds that have made bets whose success depends only on the existence of an orderly market for CDOs at prices commensurate to the true risk profile. They could fail also, if markets seize up, and so could banks exposed to them. If the central bank comes in as MMLR and names a bid price (P1) for CDOs, those illiquid hedge funds may well survive. Moral hazard would be avoided if the bid price were not so high that the insolvent institutions are bailed out also.

Given the uncertainties prevailing in times of financial crisis, it is clear that moral hazard will be hard to avoid completely when the central bank acts as market maker. The central bank should therefore not step in at the first sighting of a blip on the liquidity crisis radar screen. There must be some ‘materiality threshold’ below which the central bank does not intervene. It is hard to define that threshold in the abstract and in general, or even to list a comprehensive set of operational criteria that would be the building blocks of such a threshold. But the same applies to classic Bagehotian LOLR operations. That’s what the art of central banking is about. If it were easy, we would have nine monkeys doing it.

(3) On what terms should the MMLR enter the market?

(3a) What should be the bid-ask spread (P2-P1)?

In competitive private markets, the bid-ask spread should reflect the transaction cost of buying and selling the same instrument. In most liquid financial markets that is tiny, especially for large volume transactions. When dealing with the bid-ask spread of the MMLR, I propose something quite different. I would use the bid-ask spread to impose part of the penalty that should be faced by institutions caught with their liquidity pants down.

I would base my spread proposal on what is currently implied by the ECB’s and the Bank of England credit and deposit facilities (and on the Fed’s credit facility, or discount window)

The ECB’s Marginal Lending Facility currently charges a 5.00% rate, 1.00% above the ECB policy target rate, the Main Refinancing Operations Minimum Bid Rate, which stands at 4.00%. There is also a deposit facility which currently stands at 3.00%, 1.00% below the ECB’s policy target rate.

The Bank of England also defines its money market operations through three rates (or a central rate and a symmetric zone around the central rate). In addition, there are the Bank’s standing facilities. “Standing deposit and (collateralised) lending facilities are available to eligible UK banks and building societies. They may be used on demand. In normal circumstances, they carry a penalty, relative to the Bank’s official rate, of +/- 25 basis points on the final day of the monthly reserves maintenance period and of +/- 100 basis points on all other days.”. The policy target rate, the Repo rate currently stands at 5.75%. The Bank of England stands ready to lend, to eligible counterparties and against eligible collateral, any amount at a rate 1.00% above the Repo rate (currently that would be at 6.75%). There is also a rate, 1.00% below the Repo rate (currently that would be 4.75%) at which eligible counterparties can deposit funds with the Bank of England.

From the Bank of England’s website, we can infer some of the tensions between its monetary policy objectives and its desire not to be the liquidity port of first call in any credit crunch. Objective 1 of the Bank of England’s sterling money market operations is “: Overnight market interest rates to be in line with the Bank’s official rate, so that there is a flat money market yield curve, consistent with the official policy rate, out to the next MPC decision date, with very limited day-to-day or intra-day volatility in market interest rates at maturities out to that horizon.”

The Fed’s discount window has three different facilities and associated rates; the benchmark primary credit rate currently stands at 6.25%, 1.00% above the Federal Funds target rate; the secondary and seasonal credit rates exceed the primary rate. The ECB’s Marginal Lending Facility currently charges a 5.00% rate, also 1.00% above the ECB policy rate, the Main Refinancing Operations Minimum Bid Rate, which stands at 4.00%. Financial instruments eligible for collateral in discount operations (or repos) are valued at their market prices and a haircut (‘liquidity discount’) is applied to them. The Fed does not have a deposit facility, presumably because bank reserves in the US are non-remunerated.

So, my proposed spread P2-P1 would be equivalent to a 2.00% yield differential between the central bank’s collateralised lending rate and its deposit rate.

Note that the Bank of England has applied this philosophy also during the liquidity kerfuffles of the past week. Unlike the ECB and the Fed, which injected liquidity at lending rates equal to their policy rates, the Bank of England was willing to let the overnight interbank rate go up by almost 100bps. There would be unlimited liquidity (against suitable collateral) but only at a 100bps penalty relative to the policy rate.

I like the Bank of England’s approach, even if it conflicts with Objective 1 of its sterling money market operations. The ECB and the Fed made credit available without a penalty to any and all comers, including those who did not need it. This lays the foundations for the next credit boom.

(3b) What should be the difference between its bid price (P1) and the risk-free price of the security (P)?

How would the central bank determine the right bid price (P1)? (Honest answer: beats me, as there’s no market ….). It would have to use all its knowledge of the fundamental determinants of the value of these securities and then punt, make a bid and live with the profit or loss. That would mean recruiting a sizeable number of staff with quite different qualifications from that typical of current central banks. In addition to the macroeconomic and monetary economics skill sets familiar to the traditional central bankers, the central bank, in order to act as market maker of last resort, would have to have people with empirical asset pricing skills; so quantitative finance skills would be very important. In addition, since main-stream finance assumes perfect competitive markets, there would be a need for people with skills in ‘micro-market structure’, capable of analysing markets and price setting in markets that don’t behave like the textbook model. Behaviour finance skills would also be required.

I would, however, insist that everyone, quantitative traditional finance expert, micro-finance expert and behavioural finance expert be firmly grounded in a thorough understanding of modern dynamic macroeconomic theory and its applications. Every worker in the MMLR vineyard should be able to think intelligently about the relationship of market movements to fundamentals. Without that, we end of in Quant land, which is a very dangerous place for anyone, let alone a central bank, to be.

Which reminds me. I think it is Larry Summers who defined finance theory as the science that explains why one 12 ounce can of Pepsi should sell for the same price as two six ounce cans of Pepsi (a straightforward implication of ‘no-arbitrage’ - the only behavioural content of finance theory).

Empirical finance then shows why this relationship does not hold in practice. When done properly, finance is just a subset of partial equilibrium microeconomics, explaining the behaviour of any one asset in terms of the behaviour of the remaining assets, but never explaining the lot. Useful, but limited. Quants strip financial economics of its last bit of economic content. There is no longer any discussion of fundamentals or other factors driving prices, because past prices themselves are the only fundamental considered. What quants do is, fundamentally, no more than high-cost data mining. Not surprisingly, its affectionados make large amounts of money by shifting large amounts of money in response to small perceived anomalies in orderly markets when nothing dramatic happens; they also lose large amounts of money when there is a big change in the economic environment or when markets become disorderly.

Central banks would have to have staff who understand and can manipulate and stress-test the mathematical/statistical models used currently by financial engineers and the private institutions that employ them to ‘mark to model securities that cannot be ‘marked to market’. Central bank staff will have to get their hands dirty and deal regularly with a whole range of actual and potential counterparties, dealing in a whole range of financial instruments, both exchange-traded and OTC, to be able to understand the price discovery and price setting mechanisms in these markets.

Central banks would have to work much more closely with the rating agencies. The rating agencies will, of course have to be reformed radically given their history of rating failures not just in the subprime markets, but in a whole string of structured products and fancy derivatives, including CDSs. It is clear that rating agencies should not be engaged in any other business other than the rating business. Conflict of interest is just too pervasive if this guideline is ignored. Rating agencies should no longer be paid by the issuers of the financial instruments being rated. They should either be paid by the industry as a whole or by the holders of the instruments. There should also be much greater entry into the rating agency Walhalla; a triopoly is just too few.

Finally, central banks would have to take much more credit risk onto their balance sheets by acting as MMLR for financial instruments that are below investment grade.

It is key that the efficient functioning of the financial markets be more important to the central bank than the profit and loss account or balance sheet probity of the institution. A central bank that does it job properly may have to be recapitalised from time to time. Central bankers hate few things more than going cap-in-hand to the Treasury or ministry of finance to ask for a capital transfer. They also fear this might undermine their independence. We should, however, always remember that central bank independence is not of interest in itself, but only to the extent that it contributes to superior outcomes.

(4) How does the central bank know the difference between a disorderly market and one in which some news has reduced the fair value of banks’ assets to a lower price than the banks find acceptable? Perhaps if the central bank did nothing, liquidity would be available at some firesale prices. If so, does the LOLR function represent a subsidy to the banks and prevent the emergence of private sector vulture lenders?

Good question. The first part of the answer is: see the answer to (3b). If liquidity were to be available at firesale prices that accurately reflected a fundamentally low fundamental probability of survival of the bank (or jointly of the bank and the issuers of the instruments the bank is offering as collateral), then there would be no reason to intervene. (We would also have to believe that the private sector vulture lenders/funds were to be equally efficient managers of the portfolio they are acquiring as the banks, or at least as efficient as the publicly funded vulture fund known as the MMLR central bank I am proposing!).

We must believe, just as in the case of the LORL, that there is a clear conceptual distinction between illiquidity and insolvency and that the central bank has some reasonable chance of making that distinction operational.

(5) Should CDOs and other instruments that were not very liquid in the first place, should be made liquid (but at a price!) by the central bank?

CDOs were never very liquid in the first place. Those who viewed new-style special purpose vehicles used in securitising bank loans, or hedge funds as providers of liquidity confused cheap credit and liquidity. Old-style banks with illiquid loans on the asset side of their balance sheets provided credit, not liquidity. At times they provided cheap credit (when loan rates were low and collateral requirements or other covenants ‘lite’), but they did not provide liquidity. Neither did hedgefunds. Should the MMLR make liquid (make a market for) things during bad times that weren’t very liquid even during good times? I would argue that, under the right circumstances, yes, but at a price. The same problem of liquifying the normally illiquid applies of course to the LORL during bank runs – the LORL effectively makes illiquid bank loans liquid. If the discount at which these securities can be sold to the central bank is hefty enough, moral hazard can, I believe, be minimized.

(6) Should the MMLR accept as counterparties only suitably prudentially regulated and supervised institutions?

Another interesting question is whether access to the central bank as market maker should be restricted to institutions that accept a sufficient degree of regulatory oversight from the central bank or some other regulatory/supervisory institution.

I think it would certainly be desirable to make access to the MMRL facility contingent on prior acceptance of whatever degree of prudential regulation and oversight the central bank and the rest of the regulatory community would deem appropriate. That would create two classes of institutions, unregulated ones without access and regulated ones with access. If the central bank can commit itself to let the unregulated ones go under, should the occasion arise, this arrangement might work (a bit like FDIC-insured for deposit-taking institutions. The alternative would be to make prudential regulatory oversight mandatory for a much wider class of institutions, defined by what they do (functionally) rather by what they call themselves.

I would prefer to create two classes of institutions, across the hedgefund, investment bank etc. universe: those who accept prudential regulation and supervision and have access to the discount window and the MMLR, and those who don’t. No doubt, the ‘uninsured/unregulated’ institutions would, during a crisis, try to get ‘insured/regulated’ institutions to borrow more than the ‘insured/regulated’ institution needs in order to on-lend to the uninsured/unregulated institutions, but that would be good news, not bad news.

(7) What kinds of securities should the MMLR either purchase outright or accept as collateral for loans or in repos?

The brief answer is anything the markets are not willing to trade but which, in the opinion of the central bank, still has fundamental value. During this past week, the central banks missed a huge opportunity by sticking to their ‘normal’ times criteria for collateralisable assets when they injected liquidity into the market. The Fed made much of the fact that it enlarged the set of securities it accepted from US Federal government securities and securities issued by US Federal agencies (Fanny May, Freddie Mac etc.) to included mortgage-backed instruments guaranteed by US agencies. Big, big deal! Not! If the Fed had been had been willing to quote a price at which it would accept as collateral lower tranches of securities backed by subprime mortgages not guaranteed by any Federal agency, I would have been impressed and the liquidity crunch would have been tackled right at the point where it hurt. Instead, the Fed, like the ECB, used a blunderbus approach to provide liquidity to all and sundry, including those who did not need it.

The ECB, which injected in total probably around €140bn into the markets, has put itself outside the targeted, well-focused liquidity provision game by not accepting anything rated below the A category as collateral in repos.

So too much liquidity was pumped in overall, and too little in the right places. Until the world’s leading central banks during liquidity crunches accept complete junk as collateral in repos (appropriately, indeed punitively priced and subject to a sobering haircut), they are not doing their jobs properly.

© Willem H. Buiter 2007

Labels: Economics, Monetary Policy

Labels: Economics, Ethics, FOSS

From lender of last resort to market maker of last resort

When banks were the main providers of credit, the financial stability mandate of central banks could be summarised as their lender of last resort function: in times of crisis, lend freely, at a penalty rate and against collateral that would be good in normal times but may be impaired in times of crisis. The counterparties of the central bank in these lender of last resort operations were commercial banks (shorthand for deposit-taking institutions whose main liabilities were deposits withdrawable on demand and subject to a sequential service (first-come, first served) constraint. Their main assets were illiquid loans. This financial structure invited bank runs when confidence in the banks was undermined, for whatever reason. In the days that banks were the dominant intermediaries, a credit crunch or liquidity squeeze manifested itself in the inability of banks to borrow; a lender of last resort that targeted banks was the right vehicle for dealing with liquidity crises and credit squeezes in that set-up.

These days are gone in the globally integrated modern financial systems characterising all advanced industrial countries and an increasing number of emerging markets.

Today, external finance to non-financial corporations and to financial institutions is increasingly provided not through banks but through the issuance of tradable financial instruments directly to the financial markets or indirectly to the financial markets through banks and other financial institutions whose assets are, thanks to securitisation and similar techniques, liquid in normal times. Now that financial markets (and non-bank financial institutions) have increasingly taken over the function of providing credit and all forms of finance to deficit spending units, a credit crunch or liquidity crunch manifests itself in a different way from the world described by Walter Bagehot’s lender of last resort (see Walter Bagehot (1873), Lombard Street: A Description of the Money Market).

Today, a credit crunch or liquidity squeeze manifests itself as disorderly financial markets. Because of pervasive Knightian uncertainty (risk that is (perceived as) immeasurable and not possible to calculate or quantify), fear and in the limit, panic, little or no trade occurs in certain classes of financial instruments (say subprime mortgage-backed CDOs) because there is no market maker with both the knowledge to price these financial instruments and the deep pockets to credibly post buying and selling prices. The precise way in which such micro-market failure (the failure to match willing buyers and sellers at prices acceptable to both) occurs differs for exchange-traded instruments and over-the-counter financial instruments (instruments for which bilateral bargaining over a deal is the normal exchange mechanism), but the solution is the same: the central bank has to become the market maker of last resort.

The mechanics of the market maker of last resort function

The market maker of last resort function can be fulfilled in two ways. First, outright purchases and sales of a wide range of private sector securities. Second, acceptance of a wide range of private sector securities as collateral in repos, and in collateralised loans and advances at the discount window.

Outright purchases and sales of illiquid private sector securities The first and most direct way to discharge the market maker of last resort function is through open market operations in a much wider range of financial instruments, especially private sector securities, than central banks normally are willing to trade in. Open market operations here means outright sales and purchases of financial instruments (i.e. not collateralised loans or advances).

As regards making markets in private sector securities during times of crisis, central banks appear to have moved in the opposite direction to what the logic of financial system development would suggest. Since 1933, “,…the Federal Reserve has gradually narrowed the scope of securities that it purchases (or with which it conducts repurchase agreements in the open market0” (David H. Small and James A. Clouse (2004), “The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act”, Board of Governors of the Federal Reserve System Research Paper Series - FEDS Papers 20004-40, July; this is also the source from which the information on the Fed’s eligible counterparties and eligible securities is taken; see also the Federal Reserve Act itself). There have been no purchases of state or local government debt since 1933 and of bankers’ acceptances since 1977. Repos using bankers’ acceptances were discontinued in 1984. Outright purchases of U.S. agency debt ceased in 1981. Effectively, outright purchases and sales in the open market have in recent decades been restricted to gold and foreign exchange, and securities issued or guaranteed by the US Federal government and certain US government agencies.

For outright sales and purchases in the open market to be effective instruments with which to address a credit crunch, the Federal Reserve should be able to buy and sell outright a range of private sector credit instruments. The private instruments explicitly authorized for outright purchase and sale by the Federal Reserve Act are bankers acceptances and bills of exchange that meet certain “real bills criteria”, derived from a now defunct, at best irrelevant and in most of its versions internally inconsistent theory of credit and money. However, while the Federal Reserve Act contains no language authorising the Federal Reserve to purchase corporate bonds, bank loans, mortgages, credit-card receivables or equities, it also does not forbid it. After all, the Federal Reserve Act also does not authorise the sale or purchase of options, yet the Fed of New York sold options on overnight repo transactions with exercise dates around the 1999 year end, to forestall any Y2K problems.

The history of the ECB, which did not start operations until January 1, 1999 is short. Its legislative mandate and operating practices are less encumbered by history than those of the Fed.

The ECB accepts, in principle, a very wide range of both marketable and non-marketable assets both for outright purchase and as collateral in repos or collateralised loans (see, European Central Bank (2006), The Implementation of Monetary Policy in the Euro Area, September 2006; General Documentation on Eurosystem Monetary Policy Instruments and Procedures, ISSN 1725-714X (print), ISSN 1725-7255 (online)). The list of eligible instruments for outright open market operations (and the criteria for establishing that list) is effectively the same as that for instruments eligible as collateral in repos and discount window operations.

Among the marketable instruments it accepts are, for instance, many asset-backed securities (ABS) and mortgage-backed securities (MBS). As counterparties, it accepts central banks, public sector entities, private sector entities, or international or supranational institutions. The issuer must be established in the EEA or in one of the non-EEA G10 countries (this include the USA, Canada, Japan and Switzerland).

There are some strange restrictions. For instance, in the case of ABS, the “cash flow-generating assets backing the asset-backed securities must “… not consist, in whole or in part, actually or potentially, of credit-linked notes or similar claims resulting from the transfer of credit risk by means of credit derivatives.” (ECB(2006)). Why credit risk, or derivatives based on credit risk would be treated differently from market risk, and derivatives based on market risk, is a deep mystery. Functionally, risk is risk; as long as it can be priced, it is fungible.

There is also the rather wimpish restriction that the debt instrument must be denominated in euro, which means that it cannot be helpful to BNP Paribas in establishing a market for the (presumably dollar-denominated) CDOs backed by pools of US subprime mortgages. Why would the ECB wish to avoid collateral denominated in currencies other than the euro? Exchange rate risk can be hedged. Whether it ought to be hedged, or to what extent, should depend not on the currency composition of the balance sheet of the ECB, but on the contribution of the currency risk of the entire financial system of the Eurozone to the optimal risk-return combination of that financial system – of which currency risk and return are but one component. Clearly, the ECB should accept collateral denominated in currencies other than the euro if it takes its systemic stability role seriously.

The minimum credit rating it requires for eligible securities is A (that is, nothing below A-). This could be quite restrictive in a liquidity crunch/credit crisis. On the other hand, if the three leading rating agencies could convince themselves (and the markets) that the higher tranches of CDOs secured against a pool of subprime home mortgages could be rated AAA, there might be no lower bound to the credit worthiness of instruments rated A. Even so it would seem desirable to permit central banks, under exceptional and extreme circumstances, to accept as collateral for rediscounting, loans, advances or repos, financial instruments with any credit rating or unrated (junk) securities, provided they are appropriately priced and have appropriate haircuts applied to them.

Fortunately, the list of eligible counterparties and eligible instruments for the ECB and the ESCB is not fixed by law. It is decided by the ECB’s Governing Council and can be changed at the drop of the collective hat. We would argue that the hat has dropped and that, in extremis, the ECB should consider be broadest possible set of counterparties and the most unrestricted possible set of eligible financial instruments.

The practical implementation of the market maker of last resort function can be done in many different ways. In the simplest case, the central bank could announce that for the next N trading hours/days, it would buy at least X amount of a given type of credit-impaired, illiquid security with a risk-free price P, at a price P1 P1. The discount relative to the risk-free price and bid-ask spread P2 – P1 would reflect the central bank’s assessment of the risk fundamentals and of the penalty required to avoid moral hazard. Note that both the selling price and the buying price set by the central bank would be set without the benefit of a contemporaneous market price for the security.

Acceptance of illiquid private securities as collateral for repos and at the discount window The second way for the central bank to act as a market maker of last resort is to accept illiquid private securities as collateral for repos and at the discount window. This, indirectly, requires the central bank to establish a valuation of these securities. By engaging in both repos and reverse repos for the same illiquid private financial instruments, the central bank could establish the same implicit buying and selling prices P1 and P2 as it can through outright purchases and sales of these instruments. In the case of repos, which would, in the simplest case, be at the policy rate of interest set by the central bank, the penalty component of the contract would be determined both by the relationship of P1 and P2 to the risk-free price, and by the ‘haircuts’ (additional liquidity discounts) applied to these valuations by the central bank.

For the ECB, this should be but a small step, because the ECB already accepts non-marketable assets as collateral in repos and collateralised loans, specifically credit claims and non-marketable retail mortgage-backed debt instruments. Extending the scope of assets eligible as collateral to assets that are marketable under normal conditions but have become non-marketable owing to the disorderly markets characteristic of extreme credit crunches and liquidity crises should be simple.

It is clear from the Federal Reserve Act permits the Fed, under unusual and exigent circumstances, to lend or repo against any collateral, including dead dogs and illiquid CDOs backed by subprime mortgages.

The lender of last resort function and the discount window

While the market maker of last resort function is a defining function of the modern central bank, the traditional lender of last resort function can also be relevant in the resolution of a crisis. Repos are collateralised open market operations; we define the lender of last resort function as bilateral transactions between the central bank and a private counterparty at the discount window. With the diminished importance in the financial system of banks and similar deposit-taking institutions, it is important that the central bank be able to exercise this function also vis-à-vis a wider range of counterparties, and against a richer array of collateral than that traditionally offered by commercial banks.

Eligible counterparties and eligible securities in a crisis Fortunately, the Federal Reserve Act (1913) allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any collateral the Fed deems fit. 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, key that such (re)discounting be at a penalty rate and against collateral deemed adequate by the central bank. The Fed’s discount window has three different facilities and associated rates; the benchmark primary credit rate currently stands at 6.25%, 1.00% above the Federal Funds target rate; the secondary and seasonal credit rates exceed the primary rate. The ECB’s Marginal Lending Facility currently charges a 5.00% rate, also 1.00% above the ECB policy rate, the Main Refinancing Operations Minimum Bid Rate, which stands at 4.00%. Financial instruments eligible for collateral in discount operations (or repos) are valued at their market prices and a ‘haircut’ is applied to them.

The combination of the 100bps extra cost of the discount window over the policy rate and the haircut would be a sufficient incentive not to abuse the discount window if there were a meaningful market price at which the securities offered as collateral could be valued. Of course, in a crisis, such market prices cannot be found. This is where the job of the central bank becomes difficult, political contentious and of vital importance. In its discount window operations during crisis times, that is, when acting as lender of last resort to some institution or IPC, the central bank will also often have to act as market maker of last resort because it will have to value financial instruments for which no meaningful market price is available.

How have central banks managed liquidity crises and credit crunches? When acting as market maker of last resort, as when acting as lender of last resort, the central bank inevitably plays a central role in assessing and pricing credit risk; through this, the central bank will have a profound influence on the allocation of credit in the economy (see Small and Clouse (2004)). While the central bank should not be in this business during ordinary times, when markets are orderly and price formation and price discovery proceeds without the direct intervention of the central bank, it cannot avoid being in this business when markets are disorderly and fail to match buyers and sellers of securities.

Central banks have not been doing the job of market maker of last resort effectively, indeed they have barely been doing it at all. Following the stock market collapse of 1987, the Russian default of 1998 and the tech bubble crash of 2001, all that the key monetary authorities have done is (1) lower the short risk-free interest rate and (2) provide vast amounts of liquidity against high-grade collateral only, and nothing against illiquid collateral. The result has been that the ‘resolution’ of each of these financial crises created massive amounts of high-grade excess liquidity that was not withdrawn when market order was restored and provided the fuel that would produce the next credit boom and bust. By focusing instead on illiquid collateral, it should have been possible to achieve the same effect with a much smaller injection of liquidity

The incipient financial crunch of mid-2007 has not, thus far, be met with interest rate cuts by any of the key central banks – the Fed, the ECB, the Bank of Japan and the Bank of England. That is just as well, because there is, as yet, nothing excessive about the level of the (default-) risk-free short nominal interest rate levels in the US, the Eurozone, Japan or the UK. A credit crunch is the time for central banks to start worrying about the next credit boom. Lowering the risk-free rate is not the solution to any credit crunch/liquidity crisis problem. It only encourages further borrowing and leverage by those already excessively prone to such act.

The problems we are seeing today are the result of four to five years of (1) excessively low risk-free interest rates at all maturities in the US, Euroland and Japan, and (2) ludicrously low credit risk spreads across the board (not just in the subprime mortgage markets).

These two asset market anomalies resulted in many highly leveraged open positions that were predicated on the persistence of low risk-free rates and low spreads. Regulatory and supervisory failures compounded the magnitude of the debt and credit risk bubble that had been created. The supervisory and regulatory failures in the US mortgage markets (and not just at the subprime end of the spectrum) are so manifest that those on whose watch they occurred ought to be called to account.

When the great normalisation finally came (starting with rising risk-free real and nominal long-term rates and rising risk-free nominal short-term rates, and picking up steam with the normalisation of credit risk spreads, starting from the US subprime residential mortgage markets and derivatives based on them), a growing number of these highly leveraged open positions went belly-up. At the junk end of the market, realised default rates began to be recorded that exceeded those that had been priced into the primary and derivative securities issued in past years in these markets.

Some funds heavily invested in these mis-priced subprime mortgage-based securities went bankrupt. That is as it should be. Others, as in the case of three BNP Paribas funds exposed to the US subprime mortgage market, suspended the ability of investors to withdraw their investments from the funds, because the funds’ managers and their BNP Paribas owners argued they had no way to value the funds’ assets, which had become illiquid in the turbulent asset market conditions of the past week.

It is possible, indeed quite likely, that more funds that made highly leveraged bets whose success depended on the continuation of low risk-free rates and low credit spreads, will go bankrupt – and not only funds exposed to the US subprime mortgage market; the problem of financial hubris was much more widespread than that. Financial institutions heavily exposed to such funds and insufficiently diversified in other ways, may also go bankrupt. Among the ranks of the potential victims could be investment banks and deposit taking institutions. That again is as it should be, and does not call for intervention. It certainly does not call for lower central bank policy rates. Darwin must have his pound of flesh also in the financial markets, lest the central banks create a credit risk put that would put Greenspan’s equity puts in the shade.

What is not as it should be, is that fear and panic causes financial markets to dry up, making it impossible for firms that need to raise cash to do so either by selling assets that would have realisable value in orderly markets, or by borrowing using these assets as collateral. Even if the assets are impaired, there should still be a market to sell them at a discount appropriate to the central bank’s assessment of its risk of default and the central bank’s assessment of the orderly market price of risk. Collateralised borrowing against such impaired assets should likewise be possible at the same default-risk-appropriate discount (as assessed by the central bank). If the markets for selling impaired assets or for borrowing using impaired assets as collateral seize up and cease to function, the central bank must step in to perform its market maker of last resort function.

During the past week, the ECB, the Fed and the Bank of Japan have injected well over $200 bn worth of liquidity into the markets to stop the relevant private benchmarks from rising above their policy rate targets (in the US, the Federal Funds rate was threatening to rise sharply above 5.25%; in Euroland, the overnight interbank rate was threatening to rise above 4.00% and in Japan the overnight rate likewise was threatening (somewhat less convincingly) to rise above 0.50%). We consider this action not to have particularly helpful: even where the open market purchases were collateralised against mortgage bonds, the central banks chose high-grade mortgage bonds for which there still was a private market and price rather than illiquid mortgage bonds for which the market had stalled and no market price was available. This was a classic example of central banks trying to manage a credit crisis or liquidity squeeze using the same tools and routines they use to make monetary policy in orderly markets.

A credit crunch and liquidity squeeze is instead the time for central banks to get their hands dirty and take socially necessary risks which are not part and parcel of the art of central banking during normal times when markets are orderly. Making monetary policy under conditions of orderly markets is really not that hard. Any group of people with IQs in three digits (individually) and familiar with (almost) any intermediate macroeconomics textbook could do the job. Dealing with a liquidity crisis and credit crunch is hard. Inevitably, it exposes the central bank to significant financial and reputational risk. The central banks will be asked to take credit risk (of unknown) magnitude onto their balance sheets and they will have to make explicit judgments about the creditworthiness of various counterparties. But without taking these risks the central banks will be financially and reputationally safe, but poor servants of the public interest.

So: monetary policy is easy; preventing or overcoming a financial crisis is hard; managing the exit from a credit squeeze without laying firm foundations for the next credit and liquidity explosion is harder still. Our central bankers should earn their keep by acting as market makers of last resort. Covering the central bank’s posterior is less important than preventing avoidable financial instability.

© Willem H. Buiter and Anne C. Sibert 2007

Labels: Economics, Financial Markets, Monetary Policy

Labels: Economics, Politics, Terrorism

Labels: Culture, Ethics, Politics, Religion, Terrorism

In the markets, the short run is the next trade, the medium term is lunch and the long term is the end of the trading day. Economists should always consider the evidence of decades and, when available, of centuries.

Soon after I completed my PhD dissertation in 1975, economist began to discuss the US productivity miracle – the highly disappointing productivity growth that lasted from the first oil crisis of 1973 till the mid-1990s. Not only was US productivity growth during these years disappointing by US historical standards, it was also below that achieved in most of the rest of the industrial world.

The fact that US productivity growth had lagged behind that of most other industrial countries during Europe’s Golden Age (1950-1973) was, I think correctly, attributed to delayed catch-up and convergence of the lagging European economies following the market segmentation and ‘autarkization’ of the interwar period and the destruction and dislocation of World War II and its immediate aftermath. European integration and the removal of trade barriers generally permitted European nations to shift labour from low-productivity agriculture to high-productivity industry; its corporatist economic model brought industrial peace and a business climate conducive to emulation and catch-up.

The failure of the US to sustain the productivity growth trends of the fifties and sixties during next quarter century was a surprise at the time, and is still not, I believe, completely understood.

Then, during the second half of the 1990s, the long-expected productivity pay-off of the ICT (information and communication technology) revolution finally became visible in the aggregate and industry-level productivity data. Private non-residential investment boomed (by historical US standards) and the US economy turned, for a while, from a sloth into if not quite a tiger, then at least a more dynamic tabby cat.

Not surprisingly, the productivity growth figures of not much more than half a decade were declared to be a new trend and the new norm. The long-lasting, slow-building but ultimately explosive tech bubble started almost at the same time that the higher productivity growth finally shone through.

The tech bubble crashed in 2001. It now looks at though the ICT productivity growth miracle may have imploded around the same time. The optimism that led some to predict a growth rate of potential output as high as 3.5% (or even 4.0%) per annum appears to have increasingly fragile foundations. On recent revisions of productivity growth for the past three years, even 3.0% potential output growth looks generous.

Productivity is driven by flexibility and commitment (the willingness and ability to take the long view). Commitment for practical purposes can be measured by investment, broadly defined, in private capital, R&D, infrastructure, human capital, social capital, and environmental capital. The US was and continues to be strong on flexibility. It never was a world-beater on commitment/investment, and after the tech blip, conventionally measured capital formation rates are nothing to write home about (even after making cyclical allowances for private non-residential investment and extraordinary allowances for the residential construction). The US stock of social overhead capital is bad by the standards of most advanced countries other than the UK. It reflects decades of underinvestment in infrastructure of all kinds. As regards human capital formation, the US healthcare system provides the worst value for money of any healthcare system in the developed world. Health output indicators for morbidity, longevity etc. are also poor, by the standards of the OECD. The US educational system ranges from the sublime to the ridiculous; few would argue that primary and secondary education in the US are improving. As regards social capital, including trust, there can be little doubt that the US today is more divided, polarised and distrustful of fellow-Americans, immigrants, foreigners than at any time since I came to the country. As regards the management of its environmental capital, the US appears to be firmly stuck halfway between the other advanced industrial countries and the developing world – not a place the country wants to be.

All of these commitment/investment weaknesses of the US are remediable. That is the good news. The bad news is that some of these weaknesses (infrastructure, secondary education) have been around for decades without anything effective being done to remedy them.

Without serious changes in policy orientation at the Federal, State and Local levels, it is hard to see US productivity growth at anything like the rates touted until recently. With a bit of bad luck the country could be back to a trend growth rate of potential output of 2.5% to 2.75 % per annum.

Labels: Economics, Politics

Harvard University has an endowment of about $ 30 bn. Yale follows with around $18 bn. Then Stanford with out $14 bn and Princeton with about $13 bn. Cambridge University (including the colleges) probably has an endowment of about $3 or $ 4 bn (a surprisingly large chunk of which is owned by Trinity College). Is this money well used? Does Harvard’s endowment produce eight to ten times more academic value added than Cambridge’s endowment? Whose money is it legally and who are the de facto ‘beneficial owners’?

I’ll leave it to the lawyers to determine who the legal owner(s) is (are). It’s pretty clear who the principal beneficial owners are: current and future faculty. With future faculty selected by current faculty – we have a classic example of a self-perpetuating oligarchy.

The formal legal status of universities differs; I am considering here mainly those that have de-facto charitable status, like all the leading private American universities. In the UK, universities and Oxbridge colleges are charitable foundations.

Let’s characterise the official, mandated purpose of these institutions of higher learning as maximizing the present discounted value of teaching and scholarship (research) or PTR over an infinite horizon. As in most organisations, there is a principal-agent (or trustee/beneficiary) problem inherent in the way universities are run.

Universities like Harvard, Yale, Stanford, Princeton, Cambridge and many others, are basically run like worker-managed firms (the old Yugoslav model), with an infinite horizon (the workers cannot liquidate the business and divide the profits among themselves). These agents, even when they care about the mandate of the institution they manage and control (the maximisation of the PTR) have additional, and potentially conflicting, selfish objectives: status, creature comforts, power, prestige, income, etc. We know from the theoretical and empirical literature of worker-managed firms that they tend to pamper the incumbent workforce (paying them their average product rather than their marginal product, in the simplest example). If there is a seniority system, and the incumbents control the hiring process (and the firing of the non-tenured) , the pampering and privileges of the senior incumbents (the tenured faculty) can be massive.

Not only do universities provide significant rents and creature comforts to their beneficial owners, I would conjecture that in addition, even allowing for the complexity of their products and production processes, universities are woefully badly managed. It is still extremely difficult to bring in professional managers. Within universities, those who can, do research, those who cannot, teach and those who cannot even do that, do administration. Managing academics is like herding cats. Academics are not selected for their maturity, leadership capabilities and teamwork. Universities are a classic example of an under-performing industry.

There are some competitive spurs to efficiency in the university sector – there are new entrants, at home and abroad, and some universities (not enough, unfortunately) go broke and disappear - but the capacity for an outsider to come in, reorganise and restructure the assets of under-performing fat cat universities (UFCUs) is effectively non-existent, unless the institution is about to go broke. The weeding out of the woeful therefore proceeds far too slowly, especially when the woeful are the best but still not as good as they could and ought to be.

Assume that the leading private American universities are listed and traded on the ICP (the Intellectual Capital Market) and that what is priced and traded on this market are shares in the PTR. There is a large population of investors out there who value teaching and research. Assume also that, whatever happens to the individual academic institutions, the resources of the existing universities can only be used for the same purpose: the maximisation of the PTR.

It is my conjecture that before you could say ‘academic freedom’, private equity funds would have snapped up most of the UFCUs, fired most of the labour force, sold most of the assets, and started again with a quite different ownership and control structure.

Labels: Culture, Economics, Financial Markets, Politics

Following legalisation, production and sale of these drugs should be regulated to ensure quality and purity. They should also be taxed, as are tobacco products and alcoholic beverages. Greater resources should be devoted to educating the public, especially children and teenagers, about the health hazards associated with the drugs; more money should be spent on the rehabilitation of addicts.

Ideally legalisation should occur simultaneously in a number of neighbouring countries, preferably at the level of the EU. When the Netherlands became an enclave of tolerance of drug use, drug users from all over Europe congregated there.

The principle-based argument for legalisation is that behaviour that harms others ought to be criminalised, not behaviour that only hurts the person engaged in it. It is not the government’s job to protect adults of sound mind from the predictable consequences of their actions.

If the public is ill-informed about the consequences of drug taking, there is an educational role for the state. Children should be protected from drugs, as they are from tobacco and alcohol. So should the mentally ill and mentally incapacitated. Parents should be paternalistic, but when it comes to mentally competent grown ups, the state should not be. It is not the responsibility of the state to ensure our ‘happiness’ - whatever that is. That is the road to a Brave New World.

The argument that countries with publicly funded or subsidised healthcare have the right to proscribe the use of drugs likely to cause harm to the user is a ludicrous misuse of the concept of an externality. Should we ban rugby because it is more dangerous than tiddlywinks? If it is considered unfair that those who do not use drugs end up subsidising the care of those who do, then this is an argument for the NHS to develop a policy of discriminating among patients on the basis of how they have contributed to their illnesses.

A pragmatic argument against criminalising drugs is that criminalisation creates vast rents and encourages criminal entrepreneurs to use violence, intimidation, bribery, extortion and corruption to extract these rents.

Another pragmatic argument is that it is pointless to waste resources fighting a war that cannot be won. The losing war on drugs wastes resources that could be used to fight terrorism and other crimes.

Another important argument for legalising in particular all cultivation of poppy and of coca (and their illegal derivatives) is that this would take away a key source of income and political support for terrorist movements, including the Taliban and al-Qaeda in Afghanistan, and the FARC and various paramilitary groups in Columbia.

The UN estimates that opium production in Afghanistan grew to more than 6,000 metric tons last year with a value exceeding $3bn. It is the origin of more than 90 percent of the world’s illegally consumed opiates. A significant portion of the profits flow to the Taliban, who act as ‘middlemen’ in the opium business. They combine extortion and threats of violence towards the poppy farmers with the sale of protection to these same farmers against those who would destroy their livelihood, mainly the NATO allies and the Afghan central government.

Following legalisation, theAllies in Afghanistan could further undermine the financial strength of the Taliban and al-Qaeda by buying up the entire poppy harvest of the country. If a sufficient premium over the prevailing market price were offered, the Taliban/al-Qaeda middleman could be cut out altogether, and thus would lose his tax base. Winning the hearts and minds of poppy growers and coca growers is a lot easier when you are not seen as intent on destroying their only viable livelihood.

This proposal for legalising poppy growing regardless of what the poppy is used for is much more radical than the proposal from the Senlis Council to license the growing of poppy in Afghanistan only for the production of essential medicines. The Senlis Council proposal would not end the problem of illicit poppy cultivation co-existing with licensed cultivation. With the illicit price likely to exceed the licit price, the Taliban would retain a significant tax base.

Is legalisation of all opiates an integral part of the proposal that the Allies procure the entire poppy harvest in Afghanistan? Consider procurement without legalisation. The Allies would find themselves each year with the largest stash of poppy the world has ever seen. What to do with it?

The entire global medical demand for morphine, codeine and other ligit poppy derivatives could be satisfied - possibly even free of charge. The global demand for medicinal opiates at a zero price will greatly exceed the current medicinal use of opiates, since many developing countries are either effectively priced out of the legal market altogether or are, for budgetary reasons, restricted to purchasing inadequate quantities that leave wide-spread unnecessary suffering among poor patients. Supplying the world’s demand for medicinal opiates free of charge would create economic problems for the current licit growers of poppy for opium, in Turkey, India and elsewhere; and well-targeted development aid can address this issue.

If poppies cannot be profitably turned into bio-fuel and if opium and heroin remain illegal, the rest of the allies’ poppy stash would have to be destroyed. This would drive up the street price of opium and heroin and create even more massive rents for the remaining suppliers. Poppy growers would try to withhold poppy from the Allies’ procurement round in order to sell it later in the illicit market. The Taliban would retain a tax base.

Legalisation is crucial for the success of this squeeze play on the Taliban.

If opium and heroin were legalised, the Allies’ stash could be sold to regulated producers/distributors of opium, heroin and other formerly illegal poppy derivatives. Our chemical and pharmacological industries, and indeed our cigarette manufacturers would be well-positioned to enter this trade. The profits made by the Allies on the sale of the stash could be turned over to the Afghan government. It surely makes more sense for the government to tax the poppy harvest than for the Taliban to do so.

So legalise, regulate, tax, educate, and rehabilitate. Stop a losing war, get the government off our backs, beat the Taliban and deal a blow to al-Qaeda in the process. Not a bad deal!

Labels: Economics, Politics

Mr. Mbutu Mondondo Bienvenu is not extending his bienvenu to ‘Tintin in Africa’/’Tintin in the Congo’, a strip cartoon story written as a serial in a periodical in 1930 and first published as a book in 1931. He is quoted as saying “I want to put an end to sales of this cartoon book in shops, both for children and for adults. It’s racist and it is filled with colonial-era propaganda”. Mr. Bienvenu, a Congolese student from the Democratic Republic of Congo, has launched legal action in Belgium to have ‘Tintin in the Congo’ declared racist and removed from bookstores.

Is the book racist? It shows black Africans as stereotypical 1930s-style black characters and whites as their colonial masters. When I read it as a boy in Belgium in the late 1950s, I had to sneak it past my parents, who disapproved of cartoon books in general (books should have words, not pictures) and to Tintin in Africa in Africa specifically, because they considered it racist (even then!). So yes, the book is racist.

Should it be banned from bookstores because it is racist? Certainly not. Making the expression of racist opinions illegal is an unacceptable infringement of free speech.

Mr. Mondondo would certainly have been within his rights if he had decided to demonstrate peacefully outside bookstores stocking the offending ‘Tintin’ volume. He could have written letters to the editor calling for readers not to buy the book, he could have blogged about it, and could have tried to organise a consumer boycott of the book in any number of legitimate ways. To appeal to the law to have the book banned is both lazy and wrong.

In a world teeming with excuses for infringing on the right to say what you think, when you think it and where you think it, the inalienable right to freedom of expression must be reasserted and defended ceaselessly. Lest someone tries to be cute about this, I will recognise up front the usual exceptions: (1) it should not be legal to shout ‘house’ in a crowded fire; (2) speech directly inciting or encouraging acts of physical violence towards persons or groups, or acts of destruction towards the property of such persons or groups is not protected; (3) libel and slander should be illegal, but with a serious burden of proof on the offended party; (4) deliberately misleading advertising is not protected free speech (but again with a serious burden of proof caveat). However, ‘fighting words’ are protected free speech. Not being provoked by them is part of being a grown-up.

However, equating verbal insults with physical violence just does not wash. Clearly, children (all those under age) should be legally protected against extreme verbal abuse and verbal assault. As regards communications between independent adults, limits on what is permissible are set by good manners and social norms, not by the law. If the adults are in an inherently unequal relationship (superior-subordinate in an employment relationship, for instance), other constraints on permissible language may of course apply. In private settings, and in societies with elective membership, clubs and associations, people can be expelled or ostracized for having views unacceptable to the group. In the public domain, no such constraints should apply. It is not the responsibility of the state to enforce good manners.

The key distinction is between the private and the public spheres. I reserve the right to boot out of my home anyone making racist comments or indeed any other comments that offend me deeply. But in the public domain - in publications, on soapboxes located on street corners, in the print and electronic media, in blogs and elsewhere - these views have a right to be uttered, repulsive and repugnant as they are. You fight offensive and hurtful views in a variety of ways. Sometimes ignoring them is effective. This is unlikely to be the right approach with racism. Racism must be exposed, criticised, refuted, rejected publicly, made to look like what it is: stupid and/or evil bigotry and prejudice. But do not ban the expression of racist views. It is effective and it is wrong because it restricts that most precious and fragile of freedoms: the freedom to speak your mind, regardless of whether others agree with your views or are horrified and upset by them.

Freedom of speech and of expression must be defended even when the speech that is defended is loathsome and repugnant. We measure our commitment to freedom of speech by the degree to which racist, sexist and ageist statements get the same treatment as Methodist statements.

This defense of people’s right to speak and write the indefensible, extends also to the great taboos of modern history, including the Holocaust.

Holocaust denial is a crime in Austria and Germany and there are proposals afoot for making it a crime across the EU. It is a sick irony that the two democratic successor states of Nazi Germany, the German Federal Republic and Austria, both responded, when confronted with the expression of views they deemed unacceptable, by using the same instrument - criminalisation of the expression of these views - that would have been the reflex choice of the Nazi regime, and indeed of totalitarian regimes throughout history.

I consider anyone who denies the historical reality of the Holocaust to be either insane, terminally ignorant and stupid or deeply evil – or some combination of these three. President Ahmedinejad of Iran is but the latest in a long line of pathetic, twisted and evil souls who choose to use Holocaust denial as a rallying call for the anti-Jewish barbarians all over the world. But the response to an outrageous, ugly, deeply offensive and horribly hurtful view or opinion, including Holocaust denial, is not to make the expression of that view or opinion a crime. It is to stand up and shout out a refutation of these views. The notion that history can be legislated and that the correct version of history can be enforced in a court of law would have come naturally to the Nazis and to Stalin or Mao. It has no place in a free society.

There is no fundamental human right not to be offended. Those countries that have criminalised the expression of certain views and opinions merely because they are deemed incorrect, deeply offensive and hurtful should rethink this unacceptable encroachment on freedom of expression.

Labels: Culture, Ethics, Politics