In economic policy as in life, the urgent but not necessarily most important invariably takes precedence over the important but not necessarily most urgent. The current crisis is no exception. The financial system is falling apart in front of our eyes and nightmare visions of another Great Depression of the 1930s are haunting us not merely in our dreams but even during our waking hours.
What could therefore be more natural than the near-universal tendency to create liquidity in any old way and on any terms, to inject capital into banks and to guarantee some or all of their liabilities without paying any attention to the manner in which this is done, to cut interest rates as far and as fast as technically possible and to roll out the Keynesian deficit-spending blunderbuss? Natural and understandable, certainly. But also most unwise and dangerous. This is how we got into this mess in the first place.
Even my colleague Charles Goodhart, with whom I am generally in agreement on matters monetary and regulatory, asserts in an Financial Times column ‘Now is not the time to agonise over moral hazard’ :” The time to worry about moral hazard is in the boom. The first priority is to get out of the present hole. Worrying about moral hazard in current circumstances is rather like refusing to sell fire insurance just after the Great Fire of London for fear of adversely affecting future behaviour.”
Martin Wolf also goes overboard in stressing the need to throw everything including the kitchen sink at the immediate crisis without to much concern for moral hazard. In a recent Comment in the Financial Times, ‘Preventing a global slump must be the priority’, he writes: “Risking huge damage now in the hope of lowering moral hazard later is mad.
Everything possible must be done to prevent the inescapable recession from turning into something worse.”
Not quite. Sure, the boom looks like the right time to worry about moral hazard and to create the right legal and regulatory incentives to encourage appropriate risk taking. The problem with this recommendation is that it ignores the reality of the political economy of legal and regulatory reform of the financial sector. During financial boom years, the financial sector is rolling in resources and flush with influence. It can buy off, stop or sabotage all attempts at serious reform. The only time the authorities have both the means and the incentives to pursue far-reaching reform of the financial sector is when the financial sector is on its uppers – down and all but out. That means now, when the furies of financial crisis are howling around us.
As regards the two central objectives of establishing the correct incentives for appropriate risk taking (moral hazard, in the loose way in which this phrase is used in the debate) and mitigating the immediate recession, it makes no sense to have a lexicographic preference ordering. Houses on fire provide cute images, but they don’t capture the reality of the choices that have to be made. So the preference ordering between addressing the immediate crisis and moral hazard should not be lexicographic, with the immediate crisis in pole position. A little deeper or longer crisis can be acceptable in exchange for a material improvement in moral hazard.
In addition, Charles Goodhart, Martin Wolf and countless others overstate the extent to which the two objectives of immediate crisis mitigation and addressing moral hazard are in conflict with each other in practice. Often the same quantum of solace can be given to the crisis-hit economy in a number of different ways, some of which are vastly superior as regards their impact on long-term incentives. I will illustrate this with ten examples of what to do and what not to do.
(1) Don’t do what the Irish authorities did when they guaranteed all bank liabilities, old and new, without limit. Instead guarantee only new borrowing and new debt issuance by banks. Guarantee deposits to a limited, internationally agreed extent.
(2) Do what the Fed did as regards the financial terms imposed when the US monetary and fiscal authorities decided to bail out AIG – a supposed insurance company that turned out to house a rogue investment bank/hedge fund in its basement. With its $ 1 trillion balance sheet and global reach, AIG was deemed too big to fail – don’t ask why a massive insurance company with a global reach was regulated by the NY State insurance regulator! Make the terms of the bail-out harsh and give the tax payer some upside.
The US government got 79.9 percent of the equity of AIG and the Fed granted it an $85 billion two-year secured loan facility at 850 basis points over three-months Libor. The existing top management of the company was replaced and new executives were appointed. The US government got veto power over major decisions at the company.
(3) Don’t do what the Fed did with the second, additional, $37.8bn bailout for AIG within weeks of the first facility. The way this facility was described on the Federal Reserve Board’s website on October 8 was cute: “Under this program, the New York Fed will borrow up to $37.8 billion in investment-grade, fixed-income securities from AIG in return for cash collateral. These securities were previously lent by AIG’s insurance company subsidiaries to third parties.” While this is technically correct, it makes it sound as though the NY Fed is the needy party, borrowing AIG securities and offering cash collateral, rather than a desperate AIG borrowing cash from the NY Fed, with AIG using fixed-income securities as collateral. Framing! Framing!
From the fact that no terms and conditions were attached to the public announcement of the $37.8 collateralised lending facility I infer (perhaps cynically) that these terms were no more onerous than those on the earlier $85bn facility, and most probably lighter. To get future incentives for appropriate risk taking aligned properly, the supplementary facility should have been more expensive than the original one. Since the authorities cannot (as I understand it) take more equity in AIG without triggering a technical act of default for some of the credit default swaps written on AIG’s debt, the authorities should have made the loan more expensive than three-months Libor plus 850 basis points.
(4) Don’t do what the Fed did subsequently, when it undermined the properly punitive pricing of the original $85 billion lender-of-last resort action for AIG, by permitting AIG to borrow cheaply at the Fed’s own newly created Commercial Paper Funding Facility (CPFF) and to use the proceeds to pay off some of the more expensive loan from the Fed. This event made the Fed look weak and/or stupid – with the left hand not knowing what the right hand is doing.
(5) Don’t do what US Treasury Secretary Paulson did when he provided capital to nine large US banks at a ludicrously low financial cost. We can tell just how low, because twenty days before the Treasury put $10 billion into Goldman Sachs as part of the 9-bank recapitalisation plan, Warren Buffett invested $5 billion of his own money in Goldman Sachs. An interesting and quite convincing set of calculations using elementary option pricing techniques, attached to a letter from Leo W. Gerard, the International President of the United Steel Workers to Secretary Paulson, suggest that the terms on which the US Government invested in Goldman Sachs and the other 8 banks were vastly inferior from the perspective of the tax payer to the terms obtained by Warren Buffett. Such subsidies to banks are the essence of moral hazard.
The supposedly independent regulators of the US banks, first and foremost the Fed, but also the FDIC, should have opposed the terms of the Paulson Capital Purchase Program (I am no longer viewing the SEC as a serious regulator and the Office of the Controller of the Currency is part of the Treasury and therefore not independent). They should have fought it in private and if unsuccessful, opposed it in public, because the blatantly subsidised nature of the plan undermines long-term financial stability by encouraging excessive risk taking by banks.
(6) Do what nobody appears to have done thus far in any of the financial support operations for banks and other financial institutions, and make sure that not only the existing shareholders are hammered, but that existing holders of bank unsecured debt (including, where appropriate, senior debt) and all unsecured creditors and counterparties are also subject to a charge or haircut.
There could have been no excessive leverage for banks if there had been no excessive lending to banks and no excessive purchases of their debt. New legislation/regulation permitting such haircuts or charges, say through mandatory debt-to-equity conversions, should have been introduced forthwith where this was necessary to bring in the appropriate incentives for future purchases of bank debt and for future lending to banks.
(7) Do not weaken mark-to-market accounting and reporting. Use regulatory forbearance as regards the actions required to restore capital ratios, leverage ratios or liquidity ratios that may be distorted by distressed asset fire sales in illiquid markets.
The International Accounting Standards Board made a huge mistake when it caved in to political pressure and allowed fair value principles to be significantly undermined by accepting a ‘clarification’ of US fair value standards (set by the US Financial Accounting Standards Board, a body overseen by that Incubus of moral hazard, the SEC) that allow assets to be reclassified, supposedly under rare circumstances (as when asset markets are illiquid), so they escape fair value principles.
The current rules have three categories of assets. Assets held for ‘trading’ are valued at market prices and these valuations are reflected through the profit and loss account. Assets ‘available for sale’ are still valued at market prices, but these valuations are reflected only in the balance sheet, not through the profit and loss account. Moving assets from the first to the second category allowed Deutsche Bank to turn what would have been a reported profit into a reported loss. Schroders performed similar accounting miracles. The third category, ‘held for investment’ escapes fair value altogether. The new IASB rules allow securities (but not derivatives like CDS) to be reclassified into the ‘held for investment’ category under certain circumstances.
I think this is a dreadful decision that makes a pretty bad framework even worse. The ‘held for investment’ category should be just that. A security should be designated as ‘held for investment’ (which should be renamed ‘held to maturity’, realising that maturity can be at infinity) at the moment it is acquired. It should not be possible to move securities into this category after it has been acquired or out of this category before it matures. The ‘held for trading’ and ‘available for sale’ categories should be merged. I don’t really care whether the valuations go into the profit and loss account or not, but there should be no capacity to shift between the two.
The only reason to have three categories rather than just the two I propose, and the only reason for reclassification of assets, are the wish to engage in manipulation and deception. The weakening of mark-to-market accounting and reporting is a huge step backwards and a serious threat to long-term financial stability, because financial institutions will once again be given more scope for hiding disasters on their balance sheets.
(8) Don’t undermining the independence of the Fed by getting its Chairman to endorse fiscal stimuli. Ben Bernanke has done this twice now, most recently on October 20: “All that being said, with the economy likely to be weak for several quarters, and with some risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate.”
It is clearly desirable that the Chair of the Fed and the Secretary of the Treasury sing from mutually supporting hymn sheets during the worst financial crisis in 80 years. But just as the Secretary of the Treasury ought not to endorse or criticise Fed actions, so the Chairman of the Fed should not endorse or criticise fiscal actions. It is not his brief. It is not his business. It is not his competency.
When asked by Congress whether he supports a second fiscal action the Chairman of the Fed should give the same answer he would probably give if asked whether he supports a new Surge in Iraq: “I may have views on this as a private citizen and professional economist, but not as Chairman of the Fed. Therefore I respectfully decline to answer”.
By aligning himself so closely with the Administration, Ben Bernanke is damaging the independence of the Fed and its longer-term effectiveness. It has become increasingly difficult to determine where the US Treasury ends and the Fed begins. The Fed should not act in a way that allows it to be mistaken for a government department, a part of the executive branch of government. The by now routine (ab)use of the Fed as a quasi-fiscal agent of the US Treasury, the Fed’s silence (and implied tacit support) when Treasury actions undermine long-term financial stability, and the politicisation of the Fed through public statements of its Chairman in support of fiscal stimuli ,all threaten to undermine the independence of the Fed and its capacity to conduct effective monetary policy and to support financial stability in the future.
(9) If you are a Chancellor of the Exchequer, don’t try to claim political credit for pushing the central bank into rate cuts they would have made even without the political bleatings. There was no need for Chancellor Darling to remind the Monetary Policy Committee of the Bank of England of their mandate, as he did when he said:
“I am not going to tell the Bank of England what to do, because independence means just that, in the difficult as well as the good times,” (translation: I am now going to tell the Bank of England what to do; to hell with independence)
“The Bank is rightly independent, and neither I nor my predecessor Gordon Brown will ever tell the Bank what to do. It’s remit is sufficiently broad to enable it to tackle, first, inflation, and inflation is soon coming down, but also to support the Government in its wider economic objectives…(translation: my predecessor Gordon Brown was daft enough to make the Bank independent. But at least we both can still pretend we can tell the Bank what to do. Cut rates, you dimwits! We have an election coming up!)
“The Governor is very aware of the need to do whatever he can to support the wider economy.”
(translation: and if he doesn’t, there is always the Treasury’s Reserve Powers) .
This kind of irresponsible chatter undermines the credibility of the Bank by undermining the perception of its independence. It therefore undermines the future effectiveness of the Bank. The Chancellor should put a sock in it.
(10) Don’t engage in mindless fiscal expansions. Increases in public spending on current goods and services, especially public fixed investment, cannot really be turned on at short notice without major efficiency losses. If you want to stimulate demand, do it through tax cuts and transfer payments aimed at persons and businesses with high marginal propensities to spend out of current disposable income – households and firms that have short horizons and/or are liquidity-, cash-flfow and current-disposable-income constrained.
Deficit-financed tax cuts or public spending increases will have more limited effects on demand, the lower the fiscal credibility of the authorities. From the rising credit default swap spreads on even US and UK sovereign debt instruments, it is clear that the markets are not fully convinced that the authorities are indeed credibly committed to generate future increases in primary (non-interest) government surpluses at least equal, in present discounted value, to the additional debt they are planning to incur. That problem will only get worse as the cyclical downturn lowers revenues and increases social safety-net-related expenditures.
It will also get worse because the full extent has not yet become clear of the financial support needed to prevent a collapse of the banking system and to enable a resumption of bank lending to households and non-financial enterprises. In the UK, the balance sheet of the banking sector (the monetary financial institutions (MFIs) excluding the Bank of England), are around 420 percent of annual GDP. The government is now effectively underwriting these balance sheets. No-one has any idea as to the quality of the assets on these balance sheets. Most assurances given by the banks themselves thus far have turned out to be inaccurate and/or lies.
In addition, financial support for insurance companies and pension funds may well be required to stabilise the system. Fiscal capacity in the UK is limited. Watch those sovereign spreads and sovereign CDS swaps.
I hope these ten examples make it clear that we can fight moral hazard and the creation of bad incentives for future excessive risk taking by financial institutions and by all participants in the financial intermediation process, without undermining the effectiveness of efforts to prevent the recurrence of the Great Depression of the 1930s. A crisis is the best time, indeed the only time, to address moral hazard and other perverse incentives in the financial intermediation system.
The time to deal with moral hazard is now, in every action, every policy measure and every initiative taken to address the immediate crisis.