August 15, 2007
Fear makes a welcome return
By Martin Wolf
“At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured, and there is ‘panic’.” Walter Bagehot.*
Panic follows mania as night follows day. The great 19th-century economist and journalist, Walter Bagehot, knew this better than anybody. Lombard Street, his masterpiece, is dedicated to the phenomenon. It is devoted, too, to how central banks should deal with its results.
Ours has been a world of the “no income, no job, no assets” 100 per cent mortgage; of the “do what you like with our money, as long as you pay the fees” covenant-light loan; and of the “in go poor credits and out comes a triple A-rated security” financial alchemist. It has been a world of confidence, cleverness and too much cheap credit.
This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with “displacement”, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.
The fourth stage is over-trading, when markets depend on a fresh supply of “greater fools”. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry “bubble” are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.
In the latest cycle, displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing. The easy credit was stimulated by innovations that allowed those making the loans to regard their service as somebody else’s problem. Then people started to buy dwellings to resell them, not live in them. Subprime lending was a symptom of euphoria. So, in a different way, was the rush of bankers into hedge funds and of the wealthy and big institutions into financing them. Then came profit-taking, falling prices and, last week, true revulsion.
This was what George Magnus of UBS bank calls a “Minsky moment” . It was the moment when credit dried up even to sound borrowers. Panic had arrived.
The correct policy response is also well known. It was laid down by Bagehot himself from his observation of the evolution of the Bank of England. The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.
In providing money to the markets last week and this, the European Central Bank, the Federal Reserve, the Bank of Japan and other central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.
Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust.
When William Poole, chairman of the St Louis Federal Reserve, said that “the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves”, I gave a cheer.
Not so Jim Cramer, hedge fund manager and television pundit, who declared last Friday that chairman of the Federal Reserve, Ben Bernanke, “is being an academic!…My people have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! . . . The Fed is asleep.”
So capitalism is for poor people and socialism is for capitalists. This view is not just offensive. It is catastrophic.
The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in the housing markets of much of the advanced world in the 2000s. There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.
Unfortunately, there is every chance of repeating mistakes. A bail-out has already occurred in Germany, far from the epicentre. More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.
The pressure on the Federal Reserve to cut interest rates will also grow. As Larry Hathaway and Mr Magnus of UBS note, this looks a much more significant event than the implosion of Long-Term Capital Management in the aftermath of the Russian default of August 1998. The consequences cannot be “ring-fenced”, as those of LTCM were. Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.
Such a period, desirable in itself, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system. This pressure should be resisted as long as possible.
Yet the underlying challenge confronting the world’s central banks remains: huge surplus savings in important parts of the world; corporate sectors that do not need to borrow and so limited categories of creditworthy and willing borrowers, households in rich countries foremost among them. The epoch of the US housing bubble is over. The pressure for repeated injections of cheap finance is not.
*Cited in Manias, Panics and Crashes: a History of Financial Crises, fifth edition. Charles P. Kindleberger and Robert Z. Aliber (Basingstoke: Palgrave Macmillan, 2005)
Stephen Cecchetti: Once again, Martin’s column hits all the right notes, so as a member of the Forum, I am reduced to agreement and amplification. Throwing caution and verbosity to the wind, here goes.
I have been following the events of the last week with very keen interest, collecting as much hard and anecdotal information as I can. What I learned is summarized (albeit in too many words) here
All of my sleuthing has led to one very clear conclusion: it is much easier to figure out what the Fed is doing than it is to figure out what the ECB is doing. This is a statement about hard facts as well as intentions. To see, just take a look at the New York Fed’s website and you will find that you can download every temporary and permanent open market operation since January 17 2000. In addition, you can download the effective federal funds rate, together with the range and (weighted) standard deviation of the trades. Among other things, this allows us to see easily that there were federal funds transactions at zero on Friday 10 August and Monday 13 August, suggesting that the US money market was literally drowning in funds.
There’s more esoteric and very interesting detail on the collateral that was accepted in the Fed’s repo operations. We learn that in the Friday 10 August operation, which totaled $35 billion, they took entirely mortgage-backed securities. Downloading the history, I can see that taking these securities as collateral in repo was not unusual – taking them exclusively was.
Turning to the ECB, you can see the most recent operations on its website . But even those are suspect. A close examination on Tuesday 14 August showed that they were reported as a fine-tuning operation of €7.5 billion, while the press reports (including the one in this newspaper) described an operation of €7.7 billion. My communication with the ECB’s press office confirms that the FT was right and the ECB website wrong. Not only that, but try to get information on the history of past operations off the ECB’s website. Maybe I was missing something, but I couldn’t find it. (Yes, I know that I can get the history from the ECB Bulletin, but it’s quite cumbersome and not very current.)
On a less technical level, the ECB has not said much about why its operations over the past week had to be so big. There is a particular rumor that the action was a response to funding problems at one specific institution. Unable to borrow in the market, the story goes, the ECB told the bank to borrow from them at the refi rate of 4 per cent. I hope this isn’t true, but if it is then all the moral hazard arguments that have been made are exactly right. By disclosing more details of their operations, the ECB could dispel such rumors and help us to understand exactly what it did and why.
Finally, there is the matter of Jim Cramer and his CNBC diatribe of August 3. Martin is exactly right to single this out as the single most outrageous public comment during this entire episode. When I heard it, my reaction was not only that Cramer was asking the Fed to backstop plutocrats, but also he should be better informed about how monetary policy works before he bad-mouths “academics”. His primary point was that the Fed should “open the discount window”. Well, it was open, is open, and always has been open. Banks decide when to borrow from the Fed, not the other way around. What is it that Chairman Bernanke was supposed to do? Force banks to borrow?
Posted by: Stephen G. Cecchetti | August 15th, 2007 at 5:08 pm | Report this commentAllan Meltzer: Martin’s column is again right on. The job of cental banks is NOT to bail out screaming financial firms that did dumb things. As Bagehot pointed out more than a century ago, the central bank is responsible not to foolish lenders but to the rest of us.
Bagehot did not criticize the Bank of England for failing to act as lender-of-last-resort to the market. He criticized the Bank for not announcing its policy in advance.
The Fed acted properly in this instance. But it has never announced a strategy. Sometimes it does bailouts, sometimes not. This increases uncertainty, fails to encourage financial firms to hold good collateral and encourages risk taking in the expectation of bailouts. The absence of an announced strategy encouraged the silly belief that there was a “Greenspan put”, that is a central bank rescue.
We need a clear statement of Federal Reserve strategy. Ninety years is much too long to wait.
Posted by: Allan Meltzer | August 15th, 2007 at 8:46 pm | Report this commentRicardo Caballero and Arvind Krishnamurthy: A liquidity crisis is taking place where investors, banks, and funds are scrambling for liquidity. Several hedge funds run by prominent investment banks in the US and abroad have liquidated or have suspended convertibility.
Paradoxically, when viewed as a whole there is sufficient liquidity in the financial system. Banks are well capitalised and flush with liquidity. Just a few weeks ago stock markets were soaring, investors were optimistic, and the VIX hit 13, not far from its 9.5 all time low. Yes, the residential real estate market in the US was declining and creating a mess in the subprime market.
But it was generally understood that the scale of these subprime losses was small in relation to the US and world economy. Even if all subprime mortgages and related CDOs were to lose all value, this would amount to just 2.5 per cent of US wealth. A more realistic, yet still pessimistic scenario puts the potential losses at $400bn, less than 1 per cent of US wealth. These losses could hardly have reversed the liquidity position of the financial sector. Hence, many pundits used the word “contained” in describing the subprime losses. Yet, it is clear that there is a liquidity crisis unfolding before our eyes.
Why? The reason is a rise in uncertainty - that is, a rise in unknown and immeasurable risk rather than the measurable risk that the financial sector specialises in managing. The financial instruments and derivative structures underpinning the recent growth in credit markets are complex. Market participants cannot refer to a historical record to measure how these financial structures will behave during a time of stress. Thus, today there is considerable uncertainty about who will and will not lose money in the credit market turmoil.
To understand how uncertainty can move an economy from excess liquidity to a liquidity crunch, an analogy might be useful. In the children’s game of musical chairs, when the music stops, only one child will be left without a seat. However if the children are confused about the rules and each is convinced that they will be the one left without a seat, chaos may erupt. Kids may start grabbing on to chairs, running backwards, etc.
In the same way, in today’s market uncertainty is leading every player to make decisions based on imagined worst-case scenarios. Market players that have the liquidity stay out of markets or pull back dramatically. But the financial markets need participants and their liquidity in order to function. When much of the market disengages due to uncertainty, the effective supply of liquidity in the financial system contracts. Those that need liquidity are unable to get it and financial markets turn illiquid.
What should central banks do in this case? They must find a way to re-engage the private sector’s liquidity. Understanding that uncertainty is the cause of the disengagement is the start of finding the solution. A first step in reducing agents’ uncertainty is for the central bank to clarify how it will act if agents’ worst case scenarios come to pass.
The central bank’s mission is to stabilise the economy as a whole and not individual participants. When viewed as a whole, the worst case scenarios that guide the behaviour of each market participant cannot simultaneously occur. Like musical chairs, when the music stops, only one child will be left without a seat, not every child.
The subprime shock at the end of the day is a small shock; it is only the actions of panicked investors that make it appear large. A central bank that understands this point will convincingly promise large liquidity injections in the event of a meltdown. The likelihood of having to deliver on the promise is minimal, but the reduced anxiety fostered by such a commitment restarts private liquidity circulation and helps restore normalcy.
It is important to understand that this is all about information and not about real liquidity additions. We do not have a true liquidity shortage on our hands; we only have one because of the reactions of an anxious private sector. Talking and providing information and certainty can go a long way to reducing uncertainty. A rate cut may be the right tool, but it is important not for its direct liquid addition, and instead for what it conveys about the central bank’s readiness to act if things do get worse.
Will the Fed and other central banks around the world act appropriately? The early reactions are positive. The ECB was first to act, injecting more than $214bn in the last two days. The Fed followed with a more modest $38bn on Friday, and the rest of the central banks of the world did their share, lending over $73bn to the market.
It may also be that some of investors’ uncertainty stems from not knowing how Fed chairman Bernanke will react in case of a meltdown. Is he too much of an inflation targeter and oblivious to the workings of financial market? Not likely. From his extensive academic work on these matters, it is apparent that he is quite aware of the importance of credit markets to the functioning of the economy and the cost of the central bank failing to identify a liquidity event in time. It may well be time to start buying put options on the VIX.
Reference: R Caballero and A Krishnamurthy, “Collective Risk Management in a Flight to Quality Episode”, forthcoming in The Journal of Finance
Posted by: Ricardo J. Caballero | August 16th, 2007 at 11:55 am | Report this commentMartin Wolf: I liked both Allan and Steve’s comments very much.
I think Allan is right. Central bankers like what they call “constructive ambiguity”. I have never understood its social utility. I agree with him, too, that Bagehot was clearly in two minds on lender of last resort activity. But my memory of his Lombard Street is that he thought that, by his time, it was impossible to go back to a world in which banks held sufficient quantities of gold themselves, even if that would have been better all round. So the Bank of England had to act.
I loved Stephen’s comments. I think his remarks on the ECB look particularly right. It is not very transparent. It may also have made some serious mistakes. I am particularly concerned over the collateral it used: one private correspondent of mine refers to it as “toxic waste”. If so, this is another bail out and, as such, potentially disastrous. European banks have a dreadful history of mismanagement (look at their role in the Asian crisis of 1997-98, for example). I hope the ECB has not encouraged this further.
As to Mr Cramer. Unbelievable, is all I can say.
Posted by: Martin Wolf | August 16th, 2007 at 12:05 pm | Report this commentSharada Selvanathan: I cannot agree more with Stephen Ceccetti’s comments.
What has been particularly interesting to me has been the significant injection of liquidity by the ECB when compared to that of the Fed. While ECB policymakers continue to say that the situation is under control, I have difficulty believing this. The huge addition of funds by the ECB makes me think that something more serious is brewing in the eurozone. After all the exposure of German state banks to the US subprime sector is another indication that the banking system in the Eurozone could possibly be under threat. The ECB, in my opinion, is covering something up.
The other interesting point to note is the reaction of the Fed to all this. It has been extremely calm over this repricing of risk. Under the Greenspan years, the market was always sure that the Fed would come to its rescue by easing rates and reintroducing confidence. However, recent rhetoric from the Fed and minimal action suggests that the Bernanke Fed wants to paint a new picture to that of the Greenspan Fed, in that it will not use the “Greenspan put” freely. This Fed will probably want to see further risk repricing before it decides to jump in.
The Greenspan put helped ease the situation near-term but eventually led to a creation of a new asset market bubble - time and again. Bernanke does not want to repeat history on this.
Sharada Selvanathan is a currency strategist at BNP Paribas
Posted by: Sharada Selvanathan | August 17th, 2007 at 3:17 am | Report this commentAndrew Powell: A fascinating debate and I enjoyed reading Stephen’s and Ricardo’s work as usual. I also agree with Allan Meltzer’s call for greater clarity on the lender of last resort role (LOLR) - echoing Bagehot’s call to the Bank of England over 100 years ago. However, as this debate has raged for such a long time, perhaps it’s not so straightforward. If the central bank helps then there is the specter of moral hazard (which may not be completely controlled by collateral or penalty rates) but if it does not a liquidity crisis may ensue harming good banks and bad - and it gets difficult to tell between the two as a liquidity crisis may turn a good banker into a not so good one pretty fast. So the tightrope the Fed or any central bank must walk is a fine one.
I remember Eddie George in a speech at the LSE saying the Bank of England takes care to be unpredictable with respect to the LOLR role! A truly astonishing statement and from a very well respected Governor. In a paper (JIMF 2003) written with Leandro Arozemena, admittedly on the role of the IMF, but its a close cousin to this debate), we argue that there is no easy (i.e.: pure strategy) solution to a simple (i.e.: one shot) LOLR “game” and “ambiguity” (or randomization) is then the only equilibrium - not necessarily constructive. The “central bank” cannot always help and “banks” may sometimes gamble. In a repeated game, rules may get one to a kind of first best (liquidity assistance is provided and “banks” play safe) but when the fundamentals deteriorate, cooperation breaks down and “ambiguity” may again reign; this was indeed our interpretation of Argentina’s relations with the IMF through 2001.
And finally a thought on EM’s – that are far from epicenter of this crisis. In a recent paper (and more recent blog on the rgemonitor, Juan Francisco Martinez and I claim that a) the remarkable improvements in EM credit ratings are explained by a few economic fundamentals per country but b) those ratings and the fundamentals that underlie them are largely explained by very few “global factors” ; that c) spreads came down to the end of 2006 more than warranted by the improvement in ratings and finally d) the extra reduction in spreads is explained by variables such as the VIX or US High Yield. With the VIX at its current levels its tough to see emerging spreads not rising even further than they have gone to date. In general, emerging economies have done what most analysts have wished for, many with fiscal and current account surpluses and they certainly far from the source of the current turmoil. The US markets has the Fed to watch over them, so again we come back to the role of the IMF in this kind of turbulence - Martin’s next column?
Andrew Powell is lead research economist in the research department of the Inter-American Development Bank
Posted by: Andrew Powell | August 17th, 2007 at 5:57 pm | Report this commentWillem H. Buiter and Anne C. Sibert: Martin is correct that in a crisis the central bank must save not specific institutions, but the market itself. It is, however, necessary to be precise about what it means to save the market, about which markets may need saving and about how the central bank should go about saving the market in such a way as to minimise undesirable side effects.
In a number of recent blog contributions, we have sketched the role of a modern central bank as “market maker of last resort”. This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks (see: Willem H. Buiter and Anne C. Sibert The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort ; Willem H. Buiter Central banks as market makers of last resort, again; Willem H. Buiter and Anne C. Sibert A missed opportunity for the Fed ).
The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner. The central bank of course already applies a liquidity “haircut” even to liquid instruments offered as collateral in repos or at the discount window. Because the MMLR would have to establish a buying price “in the dark”, that is, unaided by recent relevant market prices, and would inevitably take on much more credit risk than central banks have become accustomed to, the “haircuts” should be severe – a financial version of short back and sides.
Making a market for a particular type of illiquid financial asset, say a collateralised debt obligation, may require knowledge that central banks currently do not have. Central banks can acquire the necessary experience in these markets in the same way that they have gained experience in the market for domestic government securities and in the market for foreign exchange: by being regular market participants. Central banks should regularly, either on their own account or on behalf of customers, conduct a small amount of business in these markets in normal times, simply to get a sense of these markets.
Such market participation may require staff with a different expertise than central bank staff currently possess. Certainly the solution is not to hire the financial engineers and quants, who are so good at exploiting arbitrage opportunities and extracting the large returns to risk bearing in ordinary times, but whose lack of consideration for and/or understanding of economic fundamentals significantly contributed to the current market disarray. Instead, central banks should hire economists with solid training in macroeconomics, financial economics, micro-market structure and behavioural economics and then encourage them to become interested in and knowledgeable about financial markets that may become illiquid.
From the perspective of saving or supporting markets, acting as market maker of last resort where appropriate and necessary, the recent actions of the Fed, the ECB and the Bank of England have all left something to be desired.
The ECB simply drowned the markets in high-grade liquidity, adding well over $200bn worth of liquidity against high-grade collateral. As this did nothing directly to assist the markets for illiquid and low-grade securities, the ECB’s action is an example of too much of the wrong stuff and little if any of the right stuff: it lays the foundations for the next credit boom without doing much to alleviate the current credit bust.
The Fed cut the (primary) discount rate from 100 basis points above the Federal Funds target rate to 50bps above the Federal Funds target rate. This was a mistake and a missed opportunity. The problem was not that eligible financial institutions were unable to pay the original, higher, Fed Funds rate and survive. It was that these financial institutions are holding a lot of assets which have suddenly become illiquid and cannot be sold at any price. Lowering the Fed Funds rate just subsidised any institution with liquid eligible collateral. The Fed should instead have effectively created a market by widening the set of eligible collateral, charging an appropriate haircut or penalty interest rate, and expanding the set of eligible borrowers at the discount window to include any financial entity that is willing to accept appropriate prudential supervision and regulation.
The Bank of England has been economically sensible this past week, but it has violated two of its own sterling money market management objectives. As stated on its website, and in The Framework for the Bank of England’s Operations in the Sterling Money Markets.
The first of these objectives it violated is to keep the overnight interest rate in line with the Bank’s official rate. The second objective it violated is to provide a simple, straightforward and transparent operational framework.
Unlike the Fed and the ECB, the Bank of England did not keep the overnight market interest rates close to the Bank’s official rate of 5.75 percent. Instead it allowed the overnight interbank lending rate (SONIA), to average 6.19 percent on August 13, and to at times rise above 6.50 percent. Absent the Bank’s stated money market objectives this would have made perfect sense, as being illiquid is not a commercial bank condition that ought to be subsidized by the central bank. But, it is not in accordance with the Bank’s stated objective of keeping the overnight rate in line with the official rate. And, in violating this objective, it also violates the objective of providing a simple, straightforward and transparent operational framework.
Our solution to this problem is to omit Objective 1 or replace it with something that makes it clear that in disorderly markets, banks should expect to have to borrow from the central bank at the rate applicable to the standing collateralised lending facility rather than at the official (Repo) rate.
So, on balance, the Fed and the ECB are addressing the credit crunch with a larger dose of liquidity-provision-as-usual under orderly market conditions. In addition, the Fed has provided an unnecessary subsidy to discount window users. There is a real risk that either or both may be pushed into cutting monetary policy rates not because they fear developments in inflation (and in the case of the Fed) employment that would, according to their mandates, require them to use more expansionary monetary policy, but as a way of addressing a credit crunch and liquidity crisis. The Bank of England has not made an error comparable to those of the Fed and the ECB, but has created confusion about its sterling money market policy. It should clarify the policy.
On the whole, these central banks have not exactly covered themselves with glory. But there may be future opportunities, perhaps even during the next phase of the current crisis, for them to redeem their reputations.
Posted by: Willem H. Buiter and Anne C. Sibert | August 19th, 2007 at 9:29 pm | Report this commentRichard Cooper: Martin Wolf talks about a “housing bubble” as though that is an accepted fact, more or less universal. I refer him and others to an interesting paper by Smith and Smith in last year’s Brookings Papers on Economic Activity .
The Smiths look in detail at eight cities (not including San Diego, Las Vegas, or Miami) in the United States and find no support for the contention that housing is experiencing a “bubble”. On the contrary, relative to rents and tax advantages, house prices were on the low side.
Posted by: Richard Cooper | August 20th, 2007 at 9:40 am | Report this comment