Dealing with Financial Crises

• A full-scale financial crisis happens when there is a sharp fall in the prices of a large set of assets

  • We have such a crisis ongoing now
    • Over the past seven years housing prices in the United States have risen by more than 50% in real terms
    • Americans have built three million houses over and above trend.
    • Now prices are coming down
    • And construction won't recover for a long time

• 3 million houses: roughly $900 billion of investment in housing.

  • If those who bought them can afford on average to pay not $300,000 but $250,000, there are $150 billion of financial losses to be allocated.
  • If they can afford to pay only $150,000, then there are $450 billion of financial losses to be allocated and absorbed.

• There are three potential ways that are appropriate to handle and to cure a full-fledged financial crisis, depending on the type of crisis:

• Liquidity crisis
  • Investors fear panic fire sales
  • But nobody large is bankrupt if fire sales can be avoided
  • Bagehot rule
  • Central bank should
    • Lend freely
    • At a penalty rate to punish the feckless
    • And the crisis will pass once fear of fire sales diminishes
• Solvency crisis
  • Bagehot rule makes things worse
  • Large institutions are bankrupt
  • Penalty interest rates push down asset values and make institutions even more bankrupt
  • Solution is the inverse
    • Lend freely
    • At a discount rate
    • And so push asset prices up enough to keep large financial institutions above water
      • "Bernanke put"
      • Socialization of current losses (and privatization of past profits)
      • Don Kohn: it is equally if not more unjust to hold the jobs of millions of workers hostage in order to teach lessons to a few financiers.
• "Meltdown"
  • What if even the loosest monetary policy will not make the financial system solvent?
  • Three possibilities
    • Dither
    • Inflation
    • Nationalization
• Last summer, the U.S. Federal Reserve assumed that it was facing a first-mode crisis -- a mere "liquidity" crisis
• This month the Federal Reserve has shifted decisively toward policies aimed at curing a "solvency" crisis