Three Different Cures for Three Types of Financial Crises

From the Taipei Times -- Project Syndicate:

Three cures for three crises by J. Bradford Delong: Tuesday, Jan 01, 2008, Page 9:

A full-scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers' financial reserves. The cure depends on which of three modes define the fall in asset prices.

The first -- and easiest to handle -- mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.

The cure for this mode -- a liquidity crisis caused by declining confidence in the financial system -- is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.

This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.

Once everybody is sure that, no matter how much others panic, financial institutions won't have to dump illiquid assets at a loss, the panic will subside. And the penalty rate means that financial institutions can't profit from the investment behavior that left them illiquid -- and creates an incentive to take due care to guard against such contingencies in the future.

In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.

This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.

In this case, applying the Bagehot rule would be wrong.

The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates -- and credibly commits to keeping them low in the future -- asset prices will rise. Thus, low interest rates can make the problem go away, while the Bagehot rule -- with its high lending rate for banks -- would make matters worse.

Of course, easy monetary policy causes inflation, and the failure to "punish" financial institutions that exercised poor judgment in the past may lead to more of the same in the future. But as long as the degree of insolvency is small enough that a relatively minor degree of monetary easing can prevent a major depression and mass unemployment, this is a good option in an imperfect world.

The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall in values is larger. Thus easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and ideally reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization for financial intermediation in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression.

Since late summer, the US Federal Reserve has been attempting to manage the slow-moving financial crisis triggered by the collapse of the US housing bubble.

At the start, the Fed assumed that it was facing a first-mode crisis -- a mere liquidity crisis -- and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis -- more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: "We should not hold the economy hostage to teach a small segment of the population a lesson."

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

Comments

[bersi]

I posted this at Economist's View but I think here is more appropriate.

The analysis is simple and clear. The options to policy makers do not seem to be many and what policy tool is employed very much depends on how the future unfolds.

One thing I am not very comfortable with is the inflationary approach. Does this mean that those responsible for this situation will get away with it (and probably benefit)? Won't this policy hurt the more responsible ones, i.e., those who did not adventurously throw themselves in the housing market? What does the term "massive unjust redistribution" refer to?If the policies do not lead to relatively just outcomes should they at all be on the policy list?

I am not sure I have an answer to this myself but would be happy to hear from those Brad or those who have deeper knowledge of the trade-offs involved.

[Doctor Jay]

Serious inflation will hurt everyone with fixed-price assets, bonds, cash, etc. Including "those who did not adventurously throw themselves into the housing market", but invested prudently, say in tax-free munis (like yours truly). That is an example of something that would be called a "massive unjust redistribution". Just not the only example. As Brad says, a depression would still be worse. Much worse.

Not all of the "wicked" will go unpunished; after all CEO's have lost their jobs already. Probably there's more to come. But some of them will go unpunished, and some of the innocent will suffer. It sucks, but there it is.

That said, I'm going to start working on repositioning my portfolio vs. inflationary pressures.

I'm going to feel lucky if we get out of this with a couple years of 5ish percent inflation. Cursing Alan Greenspan every day.

[Measure for Measure]

Regarding scenario 3, how is this different from the S&L crisis of the 1980s?

The answer might be to borrow massively (no problem, Treasury rates are low due to lack of confidence), shore up the FDIC fund, then bail out depositors below the $100,000 threshold. Equity holders and large depositors in insolvent banks take the hit. After that, Chapter 11 reorganization.

Since federal borrowing wouldn't lead to production of additional goods and services, this sort of budget deficit shouldn't be stimulatory. And there would be no need for federal financial takeovers. What am I missing here?

I guess that policy makers would have to think carefully about the size of the required FDIC bailout fund as well treatment of the $100,000+ group. But as I said, the S&L crisis and the Japanese slump are now familiar, so we wouldn't have to reinvent the wheel.

[christofay]

Hey, good job on getting your piece in the Taipei Times, the best of the three English language newspapers published in Taiwan.

As to the let's inflate phase of managing the popping bubble in the Greenspan Cycle, thanks no. First there should be a bailing in from the finance industry, aren't those boys in the 2nd year of record breaking bonuses? Greenspan too is cashing in on his ill-deserved rep

[christofay]

I am not looking forward to who Clinton chooses for economic advisors if she gets elected. I see that Volcker was effective in stamping out inflation, a great gift to Greenspan's reputation, while Greenspan himself has managed to create a rolling and increasingly large series of financial shocks

[christofay]

Ah, no, the CEOs and just about everyone in the financial innovation sphere will go unpunished. Mozillo is still close to billionaire-hoodness. O'Neil popped out of Merrill with a $100 million + departure handjob.

When the tech bubble blew a couple of analysts got punished and a few Wall St firms had to give up some of the shareholders' money, but few in management had to make any recompensation.

[jay]

We have, IIRC, about 80 million baby boomers about to retire. Since retirees live on past earnings, inflation hits them hard. Can policy be adjusted to soften the blow?

[touche]

For the housing market, the third mode is inevitable. The rate of foreclosures is escalating rapidly and lending standards have tightened. Hyperinflation would reduce the burden of the $12 trillion of household debt, but would not rescue financial institutions that are plagued with bad debt. Some form of the first solution for the third mode will be necessary to force the poker players to lay their cards on the table and to remove those who are insolvent. This needs to happen soon. We need both inflation and a day of reckoning.

Happy new year.

[christofay]

"The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression."

The downstroke of the Greenspan Cycle is sure looking unpleasant.

As far as I know, I know, extremely limited, this isn't a FDIC problem. Some banks will blow like WaMu, but how many depositors there will have a $100,000 maximum to recover? This isn't a commercial bank dealing with their retail solvency problem, this is an investment banks' of commercial banks, ex-Glass Seagull, and investment banks' solvency crisis. The things that have blown so far are examples of Bear Sterns', E-trade's, and others' on the investment bank side investments that have been marked down to market.

The FDIC is a solvency tool created from the lessons learned in the 1930s Depression. The solvency crisis now is in the banking sector that clamored to be free to trade with the repeal of Glass Steagal. "Regulation" was another lesson learned from that era, I was reminded on this blog that regulation of banking was a function not practiced in the Bush/Greenspan era. The FDIC too might be running short of premiums collected in respect to the liabilities carried in recent years; we should keep this public mutual insurance fund for the market tool out of the discussion.

New brooms should sweep clean. Is there reason in 2009 to request that Bernanke be Duisenberged and not fill a full term? Tradition is a conservative value, but conservative has been much redefined.

[Trainwreck]

I think it is a bad assumption to conclude that massive inflation(if that is what it would take) would be better then a depression. Inflationary measures are difficult to control. I think history stands as proof to that, not just the last 20 years in the US, but experience in other countries as well, such as 1930s Germany.

What is needed is a controlled deflation, and I think that Bernanke is doing just that with short term loans to banks. Yes Banks will fail and some companies will fail.

Hopefully the Federal Government will be able to provide assistance where needed, but inflating the money supply will not work. Money does not easily trickle down to those that need it to cover their homeownership expenses as some may believe. Even if the Federal government was to give $3k dollars to every American, that money would not cover more then 2 months of loan payments. Realize you have people paying teaser rates on no doc loans, minimum payments on option arms, and investors booking the fully amortized value of those loans as if they were AAA.

[John Drake]

“Print enough money and boost the price level enough, and the insolvency problem goes away …”

This kind of talk is going to get Ron Paul elected. We have no guarantee that trying to print enough money would not itself spiral out of control giving us something worse than a depression. Investors would not idly watch their life savings get confiscated. Any hint of a significant inflation would trigger a massive global flight from dollar denominated assets. What then? We could get controls on the outflow of capital like Britain had in the early 1970s, or a restoration of the law making the ownership ship of gold illegal. As money becomes worthless productive effort gets directed towards dealing with inflation instead of business. We saw this kind of thing happen in Brazil. Let’s face it, a lot of people will send their assets overseas and join them in the event of hyperinflation. There are worse things than a depression—a dictatorship is one of them.

[vt codger]

***As Fed Vice Chair Don Kohn recently put it: "We should not hold the economy hostage to teach a small segment of the population a lesson."*** Well, no. We probably should do exactly that. Moderate things so that the most pain is dealt out to the greediest and stupidest? Sure. Try to minimize collateral damage? Of course. But if you bail the bastards out, they'll do the same thing again ... and again ... and again. Why wouldn't they?

[zinc]

Is the current Federal Reserve competent to manage this crisis ? They sat on their hands and watched as the debt bubble inflated and spiraled out of control, refusing to recognize that it was in fact a bubble. Even as the Japanese debt bubble collapse and deflation played out. They were warned by many, many people.

The first step has to be a margin call on the businesses that are leveraged beyond their means. That is the way the market works. All of the hedge funds, investment banks, mortgage boiler rooms, are busy draining cash ahead of the deflation and as a prelude to bankruptcy. This has to be stopped. The value that is available to the market is shareholder equity, hedge fund assets, executive pay and bonuses, and corporate cash flow, that is the risky part of "risky asset" that stockholders own.

Will this precipitate a stock market crash ? Not if we believe the efficient market hypothesis. In reality, the market is substantially overvalued because of speculation. The speculation was evident 7 years ago, and should have been dealt with. Now we are going to legitimize it ?

I agree that we must deal with the crisis to prevent a depression or even a deep recession. But the first step is a massive margin call, police raids, and transparency. We forgot the lessons of the depression, the 70's, the Japanese bubble, the Asian contagion, the dot.com bubble, the LTCM collapse, and the risk taking has increased with each bail out. It is time to redirect our financial priorities away from the financial sector to production. We are busy looking for the quick fix for the benefit of the speculators.

I do not know what the solution is. But I know that a world-wide devolution of the speculative financial system is imperative and must be part of it. Let's look to history. The rules that allowed this country to recover from the depression were instigated for a reason. The speculative mess began when they were dismantled, almost to the day.

[vtcodger]

Two questions that seem relevant and I certainly don't know the answer to.

1. Busted property price bubbles have probably been around since shortly after money was invented. Has any society anywhere dealt with one other than by waiting it out? If so, what happened? Anything that we'd want to emulate?

2. Is it possible to inflate assets quickly enough to significantly affect the asset deflation that is currently underway? Maybe, 6% inflation for five years will restore average house values to last year's values (color me skeptical on that). But how many of the world's notoriously short term oriented money men are going to wait three or more years for solvency to return to the banking system? What happens in the meantime?

[darms]

Brad, I am no economist just a frugal person who has avoided debt and stupid investments all of my life. Your proposal for massive inflation scares the poo out of me - my house, bought 15 years ago, is paid for and my assets are in CDs as I am tired of being chum feeding the stock market carnivores ($12K of losses over 15 years in "safe" no-load mutual funds). I just recently experienced my money take a 1/3 devaluation against the euro. I also am sure that this time (unlike in 1978) there will not be investments with 20% returns unless there are 50% inflation rates. Why should I take the hit to bail out 1)speculators who bought houses to flip & 2)hedge fund 'gurus' who make as much in a day as I do in a year? 'Patriotic duty'? Pay me like they were paid and I'll think about it, otherwise, the f*** you say!

p.s. been a progressive Democrat the last thirty.

[Measure for Measure]

"1. Busted property price bubbles have probably been around since shortly after money was invented. Has any society anywhere dealt with one other than by waiting it out? If so, what happened? Anything that we'd want to emulate?"

Yes: Japan, late 1980s. Deflation and slow growth, 1990s. No.

Conventional wisdom had it that the US dealt with its S&L crisis better (i.e. faster) than the Japanese did with their asset bubble. If we apply that lesson, the goal would be to recognize past mistakes ASAP, allocate the losses, and move on.
------

christofay: Thanks for the response.
"This isn't a commercial bank dealing with their retail solvency problem, this is an investment banks' of commercial banks, ex-Glass Seagull, and investment banks' solvency crisis. The things that have blown so far are examples of Bear Sterns', E-trade's, and others' on the investment bank side investments that have been marked down to market."

Maybe Citigroup and Wells Fargo might be added to the WaMu list.

More to the point though, would the failure of Bear Sterns' et al lead to systemic problems in the financial markets that the regulators would be obliged to deal with? I honestly am not sure. The 1932-33 banking crisis left whole regions bereft of ordinary financial and credit services (Source: Ben Bernanke!); I'm guessing that Bear Sterns' or ETrade's hypothetical Chapter 11 reorganization would not be so crippling.

I guess the devil is in the details.

[christofay]

Citigrope too is a possible MIA.

Wells Fargo is the bank that Berkshire/Buffett buys into so I guess that didn't buy into the funny money as much as the others.

[uberdave]

Inflation as the solution is also the solution Krugman proposed in the mid-90's for Japan; they ignored him and continued to deflate and stagnate, and suffer unnecessary recessions, as mentioned by MfM.

Inflation won't bail out borrowers. In REAL terms, their houses will still go down 15-25% (nominally they'll stay flat in price -- everything else will go up more).
Of course the truly insolvent will still default, but this one-off inflation will prevent a large swath of negative equity leading to people who can pay walking away from their loans due to housing deflation, which could cause financial collapse.

Darms: Sorry, but if you put your money in CDs, you deserve to lose money for your laziness and lack of risk taking. Read up on portfolio theory and learn to invest, diversify, and take control of your savings.

[Money Mischief]

This morning Michael Shedlock attacked your reasoning... and possibly your honor, in a blog post this morning.

http://globaleconomicanalysis.blogspot.com/2008/01/keynesian-nonsense.html

He's wrong of course - when the government has spent years expressly following trade and tax policies that disincent businesses from creating new jobs in the U.S., a government job program to correct the damage (and the projected huge waves of unemployment that will hit real estate, construction, related retail, et cetera) is probably necessary.

[Lloyd_LA]

I am pressed to believe the esteemed author is joking about inflation being the cure. I don't want to think that he may be just childish or naive.

Perhaps he is thinking of how '70s hyperinflation helped (dubious as it may sound). Today, global wage pressures, reliance on foreign financing (for credit as well as equity), precarious geopolitical balance (real economy means real projection of power)... need I go on?

The inflation scenario is a rat in the maze game: the more money chasing non-existent goods (did I mention imported?) means prices always hop three steps above nominal paper presence. In the end, deflation we have to have today will still happen, but it will be larger for the three steps compounded with interest each time we revved up the presses.

The lost time will be used by US competitors (let's call them that) to screw us badly and come out on top in the world game, us being the subservients. That outcome is akin to treasonous play of words to say the least.