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Moral hazards of central banking

Well, the Fed has cut the cost of borrowing to avert what many see as a financial crisis. There are several ways to view this move, I guess. One view, as expressed here, is that central banks created the current asset price bubble and appetite for dubious credit products like collateralised debt obligations – bundles of bonds and loans – by cheap interest rates. Central banks caused this state of affairs, so they should let hedge funds and other institutions go bankrupt as part of the natural, if painful Darwinian process of the market. It sounds harsh, but a few casualties, while not much fun for the immediate investors, are a useful warning about how investments can go awry.

On the other hand, the fall in stock market prices since late July has been so fast that it threatens to cause a wider, systemic economic problem, and the rate cut was justified.

I take the former view, by and large. The underlying state of the UK economy, for example, is reasonable, if not great (thanks to the taxes and regulations of our current prime minister, Gordon Brown). But corporate earnings have been strong, consumer spending is okay – it has weakened a bit but hardly fallen off a cliff – and the cost of equities, when set against expected corporate earnings, are pretty cheap by long term standards. (The FTSE 100 index is priced on a multiple of about 12 times earnings, the cheapest since the early 1990s). The Fed, by cutting rates in this way, is more or less saying that stock market bears cannot make money, that the only way to bet is for stocks to rise. This ultimately creates a serious moral hazard by encouraging risky borrowing and lending behaviour.

I think we’ll regret what the Fed did today. Whoever said August was dull?

20 comments to Moral hazards of central banking

  • I’m glad you don’t think I’m dull, but doesn’t asking the question insinuate the possibility of dullness?

    Ah, the power of the internet! Finally, I can make stupid calendar jokes instead of having people make them to me!

    You are right about the Fed.

  • Johnathan Pearce

    August, er, okaaayyy.

  • James

    Johnathan –

    Make sure you keep your various Fed rates separate.

    Today, the Fed cut the cost for banks to borrow at the discount window, and reaffirmed that they will accept more than just Treasuries as collateral for discount window loans.

    They left untouched the Fed Funds rate (the rate everyone watches that they issue at 2:15 p.m. after the FOMC meetings). Temporarily lowering the discount rate is a move strictly aimed at maintaining liquidity in the financial system. The notable part of today’s Fed action wasn’t really their change in the discount rate (as of this a.m., banks had only borrowed a total of $6 million — yes, that’s right, million — dollars currently outstanding via the Fed window), but the part of their accompanying statement in which the FOMC said that it “is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”

    Banks do not like to borrow from the Fed window unless it’s absolutely unavoidable b/c borrowing from the Fed window is taken to mean (a) you’re totally out of money and (b) no one else will lend to you, which is a bad, bad, bad combination of messages to send.

    The “wider systemic problem” here is that there are lots (or at least potentially lots) of bad loans out there and not only loans to subprime home borrowers, but to hedge funds, businesses, etc. Compounding the problem is that the loan originators are not holding the loans, the loans (as we so well know) have been repackaged and resold not once but usually several times; the guys actually holding the loans today have no real idea who their debtors are, and so have no real idea whether they can/can’t pay or what their financial underpinnings are.

    I could go on, but I’ve made the basic point here.

  • Johnathan Pearce

    Today, the Fed cut the cost for banks to borrow at the discount window, and reaffirmed that they will accept more than just Treasuries as collateral for discount window loans.

    As someone who works in financial markets, I know this, James, but the Fed’s actions have had the effect of expanding the availability of credit, ie, loosened monetary policy. Your point is correct but also a bit of a pointless nitpick.

    As for the problems of loans, well yes, a lot of dodgy loans got packaged into CDOs etc, a lot of hedge funds have assets the value of which are a mystery, etc. But my fundamental point stands: it was the cheap credit that operated for most of this decade that made this house of cards possible; investors, in a low-rate world, were so desperate for returns that they bought into high-risk products. Junk bonds, for instance, have until recently been priced not much below safe US debt.

  • James

    Not pointless at all, Johnathan, especially when an opening sentence is ambiguous as this:

    Well, the Fed has cut the cost of borrowing to avert what many see as a financial crisis.

    would in fact reasonably suggest a cut in the Fed funds rate, not the bank rate, as it were. As it is the former rate that most everyone is familiar with, I thought it necessary to draw a distinction between it and the more esoteric bank discount rate.

    I’ve no truck with the other points that you make.

    Respectfully,
    James

  • James

    Not pointless at all, Johnathan, especially when an opening sentence ambiguous as this one:

    Well, the Fed has cut the cost of borrowing to avert what many see as a financial crisis.

    would in fact reasonably suggest a cut in the Fed funds rate, not the bank rate, as it were. As it is the former rate that most everyone is familiar with, I thought it necessary to draw a distinction between it and the more esoteric bank discount rate.

    I’ve no truck with the other points that you make.

    Respectfully,
    James

    (My apologies if this post appears more than once.)

  • Johnathan Pearce

    James, indeed, but the cost to the banks of borrowing has been cut. One part – admittedly just a part – of the interest rate structure has been cut. I don’t see how you can deny this. That is certainly what the stock market investor thinks: we’ve had a massive rise in the FTSE 100 index today.

  • Paul Marks

    “Expanding credit” or “expanding demand” (or whatever) has been the demand of monetary cranks for centuries.

    Often their first name is “John” (no disrespect intended to Johnathan Pearce) – possibly they think that as their name means praise God, the deity will help them.

    John Hales, back in the 16th century, argued that debasment was a good thing (more money for both investment and consumption) and rising prices were caused by the greed of landowners and merchants – government regulations would deal with them (over “educated” government advisers have been suggesting this since the days of Sumer and Ancient Egypt – it also becomes policy in China every couple of centuries, normally as a dynasty goes into decline).

    John Law, in the 18th century, advised the French government on credit expansion – and it did not turn out well.

    In Britain such writers as Major Douglas suggested that expanding the money supply would have a “multiplyer” effect making people better off, but their ideas did not catch on – because just handing out money to people (in various ways) just seemed a bit easy. So inflation (i.e. the expansion of the money supply – not “the rise of the price level”) was largely a tactic of major war finance, not gone in for in peace time.

    However John Keynes (later Lord Keynes) made such ideas respectable by making them complicated and obscure – by talking the language of “economics” and banking.

    As James points out any discussion of these matters can be dismissed by pointing at some detail that has been got wrong.

    After all few people will say “the Bank of England, the Federal Reserve Board and all the rest of this subsidy machine should not exist” they try and discuss the details of policy, and as policy is made as complex and obscure as possible (long books are written on it), it is normally possble to cover the whole thing in a fog.

    For example, if I were to say that the European Union central bank has “injected into the system” over one hundred and fifty billion Pounds (in Euros) over the last fews days, I am sure that a detailed response could be produced to show that I am quite wrong – indeed that I am fool.

    Ditto with the latest antics of the Federal Reserve system. To support the magic circle of important financial and other enterprises.

    The “treacle”, as F.A. Hayek called the money supply (in opposition to the “Chicago School” view that the money supply was like water rushing everywhere at once), always seems to produce mounds in certain places – in Britain London, in the United States such cities as New York, thus perhaps explaining the high incomes of certain groups of people in these cities. I have no doubt that the people with sticky, sweet smelling fingers are both intelligent and hard working – but the world they operate in is hardly the “free market” that some of them like to claim it is.

    At least one thing is being tested – the assumption of Milton Friedman that if a financial system is about to go pop, the money supply should be expanded to prevent it going pop.

    It tends to be the case that each time the powers-that-be “save the world financial system” they have to inject more money to do so. And nasty people (people like me who think that borrowing should be 100% from real savings – not clever book keeping tricks) think that the capital structure becomes more distorted each time it is “saved”.

    But there we go.

  • James

    Johnathan,

    I don’t deny the cut so much as attempt to refocus our attention in more salient matters.

    It doesn’t matter so much how the Fed makes their interest rate/liquidity plays today. What matters more was how they made those plays in the last 5 yrs.

    That said, what seems to be happening at the moment is that lenders have pulled back all over. So, what’s happening is that the snap-back of credit right now is as silly and overblown as the expansion of it was a year ago.

    The Fed has to walk a tight line. They don’t control the credit markets (or the economy for that matter), they can just influence them. Credit in the form of lending back and forth between banks is the natural grease that keeps money moving throughout the banking/financial system on an hourly/daily/weekly basis. (What happened in the liquidity/loan bubble is that the Fed put too much grease in the system by keeping the Fed Funds rate too low for too long, so that people started smoking the extra grease and getting really high on it.)

    My sense is that what they’ve done is taken a measured response aimed at keeping enough liquidity to keep the usual money flows in place. On one hand, the lenders and borrowers need to sober up, so the Fed has not cut the Fed Funds rate. But, the Fed still needs to keep enough grease in the gears to keep things operating while they wait for things in both the credit markets and the wider economy to shake out.

    Cutting the discount rate is really window dressing. My concern is not the Discount rate cut, but rather the FOMC statement which sounds like a signal that a Fed Funds rate cut is coming in Sept. I think that’s too soon, and not based as it should be on the health of the economy.

  • Paul Marks

    For the record the monetary expansion in Britain and the Euro zone has been even worse than in the United States (for years).

    As for such stuff as “the Fed has to walk a fine line…” to avoid rudeness I will say nothing about such words.

  • Power mad politicians urging (behind the scenes, since the Fed is not accountable) changes in policy on power drunk Keynesian’s walking a tightrope of razor wire between depression and a crack-up boom.

    Who says nobody lives dangerously anymore? They are perfectly willing to bet our lives that they call pull off this feat.

  • James

    As for such stuff as “the Fed has to walk a fine line…” to avoid rudeness I will say nothing about such words.

    Paul, that’s a bit too clever for my liking. Say what you have to say, or shut up.

    James

  • Midwesterner

    I think he probably (as I do) considers the Fed “walking a fine line” to be the equivalent of a drug addict “walking a fine line” between enough cocaine and enough barbiturates in order to maintain ‘sobriety’.

  • Johnathan Pearce

    Paul, that’s a bit too clever for my liking. Say what you have to say, or shut up.

    Or in your case James, learn some manners, stop leaving nit-picking remarks that miss the main point, and fuck off.

  • Paul Marks

    James.

    I had already explained the matter. But you just came out with stuff about how the Fed had to walk a fine line (etc).

    Producing, in various complex ways, more funny money (on top of the vast pile that already exists) is not “walking a fine line”. As to whether the credit bubble financial system can be saved for ever by such bail outs every time it looks like it might go pop – well Milton Friedman (for some of his life anyway) thought it could, so you are in good company Sir.

    I do not believe that economcs is an empirical subject, but I could be wrong. And for those who think it is an empirical subject the next few years will be interesting.

    If you ever want to make me “shut up” my address is 4 Northumberland Road, Kettering, Northamptonshire.

  • ian

    tsk tsk… children please.

  • Kim du Toit

    “…the loan originators are not holding the loans, the loans (as we so well know) have been repackaged and resold not once but usually several times; the guys actually holding the loans today have no real idea who their debtors are, and so have no real idea whether they can/can’t pay or what their financial underpinnings are.”

    Good point. Yeah… that’s what happens when loans are regarded purely as financial instruments, to be bartered and sold like any other commodity. The money guys are so caught up in the basis points that they forget there are actual people behind the loans.

    Screw ‘em, the soulless bastards.

  • Power mad politicians urging (behind the scenes, since the Fed is not accountable) …

    The fact the Fed is not accountable is actually the only think I like about it :-) Accountable is usually just another way of saying ‘politically directed’.

  • …and I’ll have some of what August is drinking.

  • What the Fed did was mostly symbolic. Lowering the discount rate by 50 basis points doesn’t do very much. The market rallied on the perception that they were ready to do more, like lower the fed funds rate. The market is now pricing in a 25 basis point cut at the Fed’s September meeting.

    I, for one, would love to see these non-bank mortgage lenders and some of these hedge funds go under. If they’re going to take undue risk, then they should suffer when things don’t go their way.