This blog is a response to Martin Wolf’s FT Economists’ Forum column “The prudent will have to pay for the profligate” – as indeed they will, because that it what God made them for.
Much of what Martin says is right. He does, however, in his discussion of government purchases of impaired assets, call a child of mine ugly, and as a co-parent (with Anne Sibert) of the Market Maker of Last Resort, I feel obliged to protest.
Martin writes: “The solution they all desire is for the government to act as lender of last resort against illiquid instruments and buyer of last resort of impaired ones. While the former activity has been known since the days of Walter Bagehot’s Lombard Street, the latter is an overt bail-out.”
Not so, or at the very least, not necessarily so. When markets are disorderly and illiquid, it is not just the prices of good or prime assets that fall below their fundamental values. The same holds for the prices of bad, impaired and sub-prime assets. Impaired assets too will have a fair or fundamental value. That fundamental value may well be far below the face value of the security, but it may also be well above the price the impaired asset would fetch in a fire-sale in an illiquid market.
If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing.
The central bank is especially well placed to play this role because, as long as the distressed/impaired assets are denominated in domestic currency, the central bank will never become illiquid or insolvent by purchasing them.
Should, despite the fact that the impaired asset was purchased at a price below its fundamental value, the central bank eventually make a loss on the asset, recapitalisation of the central bank by the Treasury (that is, the tax payer) may well be necessary, or at least desirable, if the only alternative is self-recapitalisation by the central bank through monetary issuance.
This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.
A subsidy is present only if the expected, risk-adjusted, rate of return for the central bank on the purchase of the impaired asset is less than the central bank’s opportunity cost of funds. There is no economic subsidy if the price paid to the seller exceeds what the seller would have received from a sale in the free but illiquid market, as long as the central bank expects to earn an appropriate risk-adjusted rate of return on the purchase.
It is perfectly legitimate for the central bank to take credit risk (default risk) onto its balance sheet, as long as it (and the tax payer) are properly rewarded for taking on this risk. This can be achieved by paying a price for the impaired asset that is both punitive (less than its fair or fundamental value) and better than what the seller could realise by selling in an illiquid market.
It is certainly possible that past purchases of illiquid and impaired assets have been at valuations that were excessive, and thus did indeed represent a subsidy to the seller. It is unfortunately also likely, that such buying of pig’s ear assets for silk purse prices will be repeated in the future. But it is not inherent in the performance of the market maker of last resort function. The Governor of the Bank of England is, rightly, extremely concerned with creating moral hazard – incentives for future excessive risk taking by lenders and borrowers. I would hope that the Bank of England would blaze a trail for future Market Makers of Last Resort by insisting on punitive prices for the impaired assets the Bank acquires, either as collateral or through outright purchases.
Martin should argue for appropriately punitive valuations of these official purchases of impaired assets in illiquid markets. The tools for discovering such prices exist, and don’t require the government buyer to know much or indeed anything at all about the fundamental value of what it is purchasing. Various reverse-auction mechanisms (with the central bank as the single buyer) have value-revealing properties.
The government made a mint in a regular auction as the single seller of band spectrum licenses. I am sure the auction specialists professors Paul Klemperer and Ken Binmore would be only too happy to help out with the reverse auctions. Indeed, professor Klemperer is, I believe, already advising the Bank of England on these matters.
One problem with the Market Maker of Last Resort is that there is no symmetry between illiquid and disorderly market conditions, where there is an obvious role for the buyer of last resort, and liquid and orderly market conditions. Even liquid and orderly markets can be bubble-driven rather than driven by fundamentals. We have seen a number of cases in the recent past – notably the tech bubble and the US, UK, Spanish and Irish housing bubbles.
The government (central bank) acting as seller of last resort in irrationally exuberant markets would (a) be politically unlikely and (b) be ineffective, even if the authorities were willing to engage in short selling as well as outright sales.
The Market Maker of Last Resort will indeed turn out to be only a buyer of last resort. The resulting asymmetry cannot be corrected by the use of the standard monetary policy instrument (hikes in official policy rates), except insofar as these are needed to achieve the price stability objective of the central bank.
Instead the asymmetry should be corrected by regulatory or credit controls on all highly leveraged entities, whether they call themselves banks, investment banks, hedge funds, private equity funds or whatever. Limits on leverage ratios that are varied counter-cyclically by the central bank, minimal regulatory capital requirements and minimal liquidity ratios (both also varied countercyclically by the central bank) are the natural counterpart to the buyer of last resort.
But don’t throw this beautiful baby out with the bath water.