Better to be wise than lucky

Martin Wolf is correct when he writes in today’s Financial Times Comment: What the British authorities should try now that “It cannot make sense for US rates to be at 1 per cent and the UK’s at 4.5 per cent” (or the ECB’s rate at 3.75 per cent, for that matter). US interest rates are indeed ridiculously low. The Fed wasted 425 basis points of cuts in the Federal Funds target rate since August 2007 trying to fight a liquidity crunch. And the US recession is only just beginning.

The right way to fight a liquidity crisis depends on whether it is also a fundamental insolvency crisis (assets if held to maturity would not cover obligations) or whether it is a pure illiquidity crisis, which may of course result in an insolvency not warranted by fundamentals, if illiquidity forces premature asset liquidations that result in fire-sale prices.

Faced with a pure liquidity crisis, the central bank should act aggressively as lender of last resort to deal with funding liquidity problems and as market maker of last resort to deal with market liquidity problems. Both kinds of interventions should be on punitive terms, to minimize moral hazard and thus the likelihood and severity of future crises.

If the liquidity crisis coincides with or is merely the reflection of an underlying fundamental insolvency crisis, recapitalisation of systemically important highly leveraged institutions (HLIs) by the tax payer is called for.

In the US, the UK and the rest of the EU, the financial sector is undergoing both a fundamental solvency crisis (reflecting past reckless lending, investment and funding decisions) and a liquidity crisis. The liquidity crisis is, I would argue, more than just the reflection of an insolvency crisis. After all, (fear of) insolvency is neither necessary nor sufficient for illiquidity. Indeed, in the current phase of the crisis, when the authorities in some countries (Ireland is the most extreme example) have guaranteed most of or even all of the liabilities of the banking system, we can find ourselves in the interesting situation that banks are fundamentally insolvent but nevertheless liquid.

Interest rate cuts in a liquidity crunch are an infra-marginal transfer of resources from the central bank to the banking system. They don’t affect the marginal cost of funds to any private financial agent. Borrowers are rationed out of the credit markets and cut off from bank lending. Interest rate cuts do not relax these quantitative rationing constraints. They are ineffective in relieving the kind of extreme credit crunch we have witnessed since August 2007.

This would not matter much if there were no psychological confidence effects associated with large interest rate cuts. In that case a shrug of the shoulders – if official policy rate cuts in a credit crunch don’t help, at least they don’t hurt – would be the proper response to my claim that the Fed cut rates too fast and too far. But interest rate cuts in times of extreme private sector nervousness, fear and uncertainty do have potentially important effects on confidence, optimism and willingness to lend and borrow. They should therefore not be wasted.

While interest rate cuts do not alleviate credit rationing – the binding constraint for most borrowers – it does have a positive effect on the demand for goods and services by private agents that are not credit-constrained in their spending decisions. This effect comes mainly through the exchange rate channel. The US has benefited from the positive impact of its rate cuts, through a weaker nominal and real exchange rate, on its net trade balance. The exchange rate channel is, however, the only channel through which monetary policy works in a severe credit crunch. And the exchange rate channel is, of course, beggar-thy-neighbour. The US simply exported part of its demand deficiency to the rest of the world – mainly to Europe, which did not need this.

Martin Wolf, in the same comment, also asserts that “This is the moment at which David Blanchflower, an external member of the monetary policy committee and professor of economics at Dartmouth College in the US, is entitled to say “I told you so”. Prof Blanchflower has voted for a cut on every occasion since October 2007. In retrospect, he was right to push strongly in this direction, usually against majority opinion on the MPC. His views on the economy deserve respect now.”

I beg to disagree and intend to be ungracious. External MPC member Danny Blanchflower was not right about the need to cut rates, except in the sense that a clock that stands still is right twice a day. His views on the economy do not deserve respect now. Hindsight is useless. One has to look at the information available at the time and the arguments used at the time. It is true that, with hindsight, after you have bought a lottery ticket and have won, it was better to be lucky than wise. But that does not change the fact that, as a return-maximising policy or strategy, buying lottery tickets is unwise, because a lottery has a negative expected return for the punter.

I believe that, on the basis of the information available to Professor Blanchflower and to the rest of us, he was wrong, until late summer 2008, to advocate rate cuts for the UK, because , on the basis of that information it was unlikely that immediate rate cuts were required to achieve the Bank of England’s price stability mandate. Indeed, it was more likely that rate cuts would contribute to an overshooting of the inflation target over the horizon that the Bank can influence inflation, than that maintaining rates would contribute to an undershooting of the inflation target.

The short-term, temporary disinflationary shock and the positive supply and demand shock associated with the recent collapse in real commodity prices are the result of a global slowdown, including an emerging market slowdown of a severity that was certainly always a possible outcome but never the most likely outcome during the long period that Professor Blanchflower called for rate cuts. It certainly was not flagged at the time by Professor Blanchflower as a basis for his calls for rate cuts.

I also have seen no statements by Professor Blanchflower that suggest he foresaw the socialisation of much of the banking systems and assorted surrounding bits of the financial sectors in the north Atlantic area.

With the complete collapse of financial intermediation in the region a fact since Lehman Brothers was allowed to go belly-up in September, the case for sharp rate cuts in the UK and in the euro area has become a very strong one. Together with the more disinflation-friendly international environment, the Bank of England should cut by between 100 and 150 basis points at the next meeting and the ECB by 100 basis points.

The Fed too should cut immediately by another 100 basis points. Unfortunately, that would be the last cut the Fed could make, unless they follow my suggestions for implementing a negative nominal interest rate regime. Even a 100 basis points cut in the Federal Funds target rate would require the elimination of the 35 basis points penalty attached to commercial bank holdings of excess reserves with the Fed. The Fed has wasted its conventional monetary policy powder on inframarginal rate cuts. Let’s be grateful that the Bank of England and the ECB have kept enough of their power dry to give an effective monetary stimulus now.

For rate cuts by the Bank of England and by the ECB not to be wasted in infra-marginal funding cost reductions in the same way the Fed wasted its rate cuts, the normal transmission mechanism of monetary policy has to be restored. That requires a significant reduction in the Libor-OIS spreads. This can be achieved at short notice either through Treasury guarantees of unsecured interbank lending (charging, say, a 100 basis points guarantee fee) or the central bank acting as universal broker-dealer and counterparty of last resort in the interbank market – making unsecured loans (again, against a suitable fee).

A few countries have guaranteed interbank lending, among them Ireland and (for maturities of three months and longer) the Netherlands. But these guarantees apply only to interbank loans between banks in the same national jurisdiction. We need international agreements on the modalities of guarantees for cross-border unsecured interbank lending. Alternatively, we need cooperation and coordination between central banks in acting as universal counterparty of last resort for cross-border interbank lending. Something to be put on the agenda for November 15.

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