August 29, 2007
One perspective on approaching the current situation
Since Jim laid out some of the proposals for addressing the mortgage problem, I thought I'd put in my two cents worth.
Now, let me say that I don't have an answer. But it seems to me one of the most illuminating posts on the subject was Yves Smith's typology of perspectives (without necessarily agreeing with the policy prescriptions). For conciseness' sake, I'll appropriate the WSJ Real Time Economics Blog summary:
1. Do Whatever It Takes. Smith says James Cramer is the "most extreme and vocal advocate" of this position, that central banks should do whatever it takes to keep the market afloat. Cramer has boasted of his much-YouTubed rant demanding that the Fed cut rates. Smith says others in this group include author and entrepreneur Don Luskin and economist Thomas Palley.
2. Cold Water Yankees. This group believes "any liquidity infusion is a bad idea," and includes Nouriel Roubini, Andy Xie, Michael Panzner, Markham Lee and Marc Faber, Smith says.
3. The Realists. "They don’t disagree that too much cheap credit for too long has caused this mess, but they think a cold turkey approach creates too much collateral damage," Smith writes. That is, "central bankers can’t sit around and let markets seize up." In this camp are the Financial Times’s Martin Wolf and Martin de Grauwe, as well as European economists Walter Buiter and Anne Siber.
4. Reframers. Smith says this group wants to reframe the problem, and believes the solution "isn't simply a matter of interest rate policy but of the larger regulatory framework" that manages the risk of asset bubbles. In this group, Smith places Australia's former Reserve Bank Governor Ian MacFarlane, economist Henry Kaufman and Morgan Stanley’s Stephen Roach.
Personally, I have the view that when one is looking into the abyss (or perhaps just a very deep ditch), one has to take the actions of the past as given, and think of what can be done in order to mitigate the financial system turmoil that might result in an economic downturn. In other words, like Bernanke, I believe the banking -- and more general financial system -- performs a vital function in screening projects and providing capital, and failure to provide liquidity at critical junctures led to the Great Depression.
At the same time, one has to consider the moral hazard issue in a dynamic context. To the extent that a looser monetary policy might bail out some firms that undertook ill-advised investments, looser monetary policy might act like an insurance policy (what was perjoratively termed the "Greenspan put" in an earlier context). Perceived insurance would then lead to even greater risk-taking, setting up the system for another bout of turmoil in the future.
Where one fits into the typology depends upon (i) how close one thinks the system is to siezing up, (ii) how strong the moral hazard effect is, (iii) and whether lowering the Fed Funds rate (as opposed to the discount rate) would actually address the problem (is it illiquidity or insolvency).
While I haven't drawn a particular conclusion regarding the right direction to move, one insight prompted by current commentary is that -- if the Fed were to opt for looser monetary policy -- greater regulation of the financial sector would make a lot of sense. While this seems like a no-brainer, several commentators have observed that greater regulation at this juncture would not help out the indebted households now, nor help the threatened firms, and indeed might be counterproductive insofar as it would exacerbate the credit crunch (e.g., see , ,  and ).
The lesson I take is that it's not an either-or proposition. Policymakers might need to lower interest rates, either to offset systemic illiquidity, or to stabilize output. But if these actions are necessary, then one needs to consider how to implement effective regulation, rather than dismissing regulation on ideological grounds (see this post on the Administration's view of financial regulation, which has in part led to the current state of affairs).
See also Mark Thoma at Economist's View, who has once again beat me to the punch with a similar perspective.
Posted by Menzie Chinn at August 29, 2007 08:16 AMdigg this | reddit
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» My Poorly Informed Opinion on the Financial Crisis from The Glittering Eye
FWIW put me in Menzie Chinn’s camp on dealing with the current lending crisis: The lesson I take is that it’s not an either-or proposition. Policymakers might need to lower interest rates, either to offset systemic illiquidity, or to stabi... [Read More]
Tracked on August 29, 2007 11:10 AM
» To Arms! The Regulators are Coming! from PrefBlog
I can see that there is going to be a lot of debate over the next year (until the day after the US Presidential elections, anyway) about regulation, so I’ve started a new category in this blog for it. Anyway … the forces of regulation are... [Read More]
Tracked on August 29, 2007 03:29 PM
Don't you have Buiter's first name wrong?
Posted by: KevinT at August 29, 2007 08:52 AM
But if these actions are necessary, then one needs to consider how to implement effective regulation, rather than dismissing regulation on ideological grounds (see this post on the Administration's view of financial regulation, which has in part led to the current state of affairs).
This is fairly vague. What sort of "effective regulation" do you have in mind?
I see a need to review banking regulations on Tier 1 & Tier 2 capital in light of recent events to ensure that the central pillars of the system can withstand market shocks.
There may also be a need to review capital requirements for brokerages.
Mainly, though, the system is working as it should. Some hedgies are going bankrupt and the market is in disarray - but creative destruction is visibly doing its work.
Posted by: James I. Hymas at August 29, 2007 08:56 AM
I want to thank Greenspan for advising me to refi into 3% rates. I saved enough on that move to pay for several years of higher rates. By the time I break even I probably won't own the property. Thank You!
Posted by: IMMA THANKFUL at August 29, 2007 10:30 AM
The Fed is in a bind.
Fed doesn't want to lower rates to seem as if it is "bailing out" any banks that took bad gambles.
But (a) declining res investment will directly hit GDP and (b) the surge in jumbo rates and curtailing of credit for first-time home buyers will hit home prices, and via the wealth effect, consumption.
And inflation is at the upper end of the band.
I think we'll need to see some impact on real activity, either inflation or GDP gap, for a rate cut.
Posted by: Morris Davis at August 29, 2007 11:37 AM
"The lesson I take is that it's not an either-or proposition."
"Give me a one-armed economist!" President Harry S. Truman
Posted by: Anonymous at August 29, 2007 12:09 PM
A fifth category should be added to the four you cite above. The fifth category is "Macro system thinkers", for lack of a better name. These are the folks who see the mortgage default and liquidity problems as just one corner of a many cornered canvas that also includes - inflation is too high, above acceptable level, and not declining appreciably; the US dollar is near a multi-year low; the current account is in a shambles; the US economy continues to grow slowly; foreign trade is growing; foreign governments continue to buy lots of US financial assets - just to name a few other corners. These folks see a want to see consideration given to the impact of proposed actions on most of the major corners of this canvas. So for example, a cut in the Fed Funds rate affects a few folks and a few billion in mortgage assets and a few homeowners, but it also affects the value of the US dollar (that trade in trillions per day), future inflation rates (for a many trillion dollar economy), and foreign purchases of Treasury bills (that is also in trillions). What's the net? Who wins, who looses - when? The US equity markets simplify everything into a closing price, and the WSJ is good at commenting in that view of things. Its interesting to me that few, if any, analysts have put the Fed Funds rate questions into a macro system perspective.
Posted by: Mike Laird at August 29, 2007 04:08 PM
Arthur Burns was the true maestro. He shrunk the Vietnam war debt with copious inflation. He made it possible for Volcker to step in, and in turn set it up for Greenspan. He orchestrated the whole sequence. Arthur, where art thou Arthur, please come home.
Posted by: bad news bear at August 29, 2007 04:45 PM
Morris Davis says the Federal Reserve doesn't want to seem as if it is bailing out banks. But doesn't the massive injection of funds through repos and the discount window amount to a bailout in progress? How can the Federal Reserve avoid seeming to be "bailing out" banks and their clients when a bailout is clearly in full swing?
Posted by: gordon at August 29, 2007 06:26 PM
Some people think the mere existence of the Fed is a bailout of someone. Who will be bailed out by a modest rate reduction? Not those foreclosed, not those in default, not even most of those facing it in the next few years as rates reset. Not the lenders that have already closed. Not the hedge funds already broke and liquidating. Not many hedge funds still holding that waste. Not the investors in it that have already lost. Waiting for the next recession to arrive and doing to little too late is just what will cause one.
Posted by: Lord at August 29, 2007 07:14 PM
when bank of america is willilng to pump a bunch of $ into countrywide and warren buffet is shopping it seems that we're pretty close to working this out.
the last ones to buy are always left holding the bag. no need to bail them out unless the market is siezing up. i've got faith in bernanke's ability to make this call but let's squeeze out everyone that bet the farm and then help those that fell victim to predatory practices. shouldn't take that long.
Posted by: oops at August 30, 2007 09:03 AM
Gordon, regarding bailouts. Bailouts seem to be in the mind of the beholder. When the Fed uses the discount window or repos, they take temporary ownership of a bank's asset, provide loaned cash, and when the bank pays the cash back plus interest, the Fed returns the asset to the bank. When Pres. Bush proposes that the Federal Housing Administration guarantee loans for mortgage borrowers with poor or limited credit, he proposes that taxpayer money will be paid to banks/lending firms when their loan to risky homeowners defaults on house payments for the second time. What is a bailout?
Posted by: Mike Laird at August 31, 2007 07:50 AM