Good morning. I'm Brad DeLong. And this is my morning coffee.
Stage I of a financial crisis involves a financial market that could be in a good equilibrium--with lots of capital committed to sane and sound financial intermediaries, a healthy flow of finance from savers to businesses, relatively high asset prices, and relatively low unemployment--or a bad equilibrium--with financial intermediaries near bankrupt or worse and untrusted, little flow of finance from savers to businesses, relatively low asset pices, and relatively high unemployment. It is the task of a central bank to (a) diminish the chances that we will ever get into a stage I financial crisis by providing incentives that motivate by punishing those who overleverage their businesses and induce moral hazard, and (b) to keep us at the good equilibrium by providing liquidity when a financial crisis strikes even if this goes against the requirement that overleverage and moral hazard be punished, not rewarded, in normal times. As long as we are in Stage I, however, a good central bank will provide liquidity--lend cash--at a penalty rate in order to diminish and punish moral hazard
Stage II of a financial crisis sees a financial market in which the good equilibrium has disappeared--but in which the good equilibrium can be brought back into existence by not just providing but flooding the system with liquidity, pushing safe interest rates way down and so pushing asset prices up. In this case, the idea that a good central bank should only lend cash at a penalty rate goes out the window. The stakes are too high. As Don Kohn said, it is not good to hold the jobs of tens of millions hostage in order to make sure a few feckless financiers get their just deserts.
Stage III of a financial crisis is when a central bank runs out of ammunition--when pushing interest rates too the floor and swapping out all of its assets does not restore the good equilibrium. Then you face a threefold choice: depression, inflation, or public intervention. Depression is to be avoided. Inflation--resolving the financial crisis by printing enough money to boost the price level far enough that all of a sudden everyone's incomes and real asset values are high enough to pay off their nominal debts--is generally best avoided too. As John Maynard Keynes wrote more than eighty years ago: "The Individualistic Capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring-rod of value, and cannot be efficient--perhaps cannot survive--without one."
And this leaves public action. If the good equilibrium has vanished because the supply of risky assets is too large for financial intermediaries to want to hold them given their capital, then the central government has to take action: to boost or to make financial intermediaries boost their capital so that they will demand more risky assets at high prices, and to diminish the supply of risky assets offered on the financial markets by guaranteeing some of them or by buying up some of them itself.
It's time to start thinking. If we don't want to wind up in a deep depression or a big inflation, it is time to think what kind of government action we do want to see, and how quickly we can set in in motion.
My name is Brad DeLong. And this is my morning coffee.