To What Extent Should the Fed (or any other Gubmnt Agency) Bail Out the Big-Time Risk-Takers?
The opening in Tuesday's lead financial article in the NYTimes:
I, for one, will be pretty concerned if the Fed does indeed prop up these markets by infusing extra liquidity into the markets and lowering interest rates. Doing so will send a signal that risks in these types are markets are asymmetrical: the investors get to keep the upside gains, but the gubmnt or central bank will be there to protect investors from the possibility of downside losses.
This kind of signal will encourage others in the future to take more risks, creating an even more fragile financial system in the future. Ben Bernanke and The Fed must resist this type of pressure and take the longer-run view. Otherwise the economy as a whole will see people taking inefficiently large amounts of risk, diverting financial capital away from less risky projects. That's fine so long as things go well, but should things not go so well, the required bail-outs will involve massive gubmnt interventions and less future reliance on markets. People will point and say, "See? Free-market capitalism doesn't work!" when in fact the crisis will have been caused by too much gubmnt intervention in the short run.
To avoid this scenario, The Fed and all those who have counted on its bailing them out, must bite the bullet now and not pump liquidity into the economy simply to bail out the risk takers. There might be other important reasons to keep the liquidity growing, but bailing out financial risk-takers now will only cause more problems in the longer run.
Wall Street thinks the Federal Reserve is running short of time.But it is clear from the article that many within the Fed see no reason to bail out those who persisted in taking risks in the sub-prime mortgage market long after many of the rest of us were pointing to the dangers lurking beneath the surface of that market.
After another day of restless anxiety in the world’s credit markets, most lenders and investors remained fearful of all but the very safest Treasury securities, and new figures showed that the rate of foreclosures in the housing market in July was almost double that of a year ago.
Analysts now say that the central bank’s move last Friday to restore confidence by encouraging banks to borrow directly from the Fed at a lower cost has had only limited impact so far and that the Fed will need to take more drastic action by cutting its benchmark interest rate soon if it fails to see more progress.
I, for one, will be pretty concerned if the Fed does indeed prop up these markets by infusing extra liquidity into the markets and lowering interest rates. Doing so will send a signal that risks in these types are markets are asymmetrical: the investors get to keep the upside gains, but the gubmnt or central bank will be there to protect investors from the possibility of downside losses.
This kind of signal will encourage others in the future to take more risks, creating an even more fragile financial system in the future. Ben Bernanke and The Fed must resist this type of pressure and take the longer-run view. Otherwise the economy as a whole will see people taking inefficiently large amounts of risk, diverting financial capital away from less risky projects. That's fine so long as things go well, but should things not go so well, the required bail-outs will involve massive gubmnt interventions and less future reliance on markets. People will point and say, "See? Free-market capitalism doesn't work!" when in fact the crisis will have been caused by too much gubmnt intervention in the short run.
To avoid this scenario, The Fed and all those who have counted on its bailing them out, must bite the bullet now and not pump liquidity into the economy simply to bail out the risk takers. There might be other important reasons to keep the liquidity growing, but bailing out financial risk-takers now will only cause more problems in the longer run.
Category: Economics, Economics and Law, Macroeconomics, Money Posted on
Thursday, August 23, 2007 at 1:22am
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Twenty years ago, I saw some research (I can't remember by whom, but it might have been Tom Havrlesky [sp?]) that showed a correlation between Fed actions and Economic Council of the President pronouncements, thus creating doubt about the Fed's independence even back then.
In Canada, the Governor of the Bank of Canada is obliged to submit his/her resignation should there be a clash between the Bank and cabinet. Interestingly, ever since that policy emerged in 1960-61, there have been no serious clashes... Some people take that as a sign of a lack of independence on the part of the Bank. Others see it as unwillingness by cabinets to cause such a big stink and furor, a view that seems at least as likely, given Canadian politics, in which case The Bank of Canada might well have more independence that The Fed. See James Coyne, http://en.wikipedia.org/wiki/James_Coyne