Understanding the Three Ways of Dealing with Financial Crises

As I have said before, I find it helpful to group all the things the Fed and Treasury have done, are doing, and might do into three baskets, each corresponding to a different stage of the seriousness of the financial crisis and the soundness of the financial system.

Stage I policies: dealing with a liquidity panic These are the "Bagehot rule" policies: the central bank acts to keep the economy at the "good equilibrium" in a panic when multiple equilibria--a good "confidence" equilibrium and a bad "panic" equilibrium--are possible. It does so lending freely to solvent but illiquid institutions at a penalty rate on collateral that would be good in normal timrs. Emergency discount window operations are of this kind. The conventions that the discount rate should be higher than the bank-to-bank federal funds market rate and that borrowing from the discount window should create a stigma and a presumption of a higher degree of future regulatory and counterpary scrutiny are part of the "penalty rate" charged for asking for such help from the central bank. The idea is that institutions that have gotten themselves short of reserves and need emergency liquidity should feel some pain as a result of the systemic risk they caused.

Stage II policies: These the are conventional consensus monetary policies--the central bank as central planner making the price in the short-term money market an administered price in the interest of maintaining full employment and price stability. It raises and lowers the market rate of interest to keep it near the Wicksellian natural rate of interest. It uses open-market operations to buy Treasury securities for cash to flood or drain the market with liquidity, and so push down or up real borrowing costs (thus encouraging or discouraging investment) and push up or down the cash values of all kinds of debt. In the case of a financial crisis, if there was worry about the liquidity or solvency of the system before, the hope is that stage II policy open-market purchases will drive such worry away by boosting the asset values and reducing the debt carrying costs of "banks"--that is, any financial intermediary that lends long and promises liquidity by borrowing short. The idea behind these policies is to keep the good equilibrium at the right place as far as employment and price stabilization is concerned--and, in an emergency, to do what it can to make sure that the good near full-employment equilibrium exists.

Stage III policies: These come after stage I policies aimed at curing a temporary inability to turn assets into cash at any but fire-sale prices have failed to repair matters have been exhausted. These come after the stage II policies of using normal tools of monetary stabilization to lower interest rates across the entire spectrum--flooding the system with liquidity--have failed to ease worries that one's counterparties are still insolvent or still at risk of becoming illiquid at an awkward moment.

The purpose of stage III policies is to boost demand relative to supply for risky assets, and thus to operate on the margin that is the spread in prices and yields between safe assets like Treasury securities and the risky assets whose falling prices are threatening the stability of the financial system and the macroeconomic flow of investment. It is not enough for the central bank to turn the short-term safe interest rate into an administered price, and set it at a low value (stage II). It is not enough to provide unlimited liquidity at a penalty rate (stage I). Instead, the Fed or the Treasury or both must make the price of risk or the quantity of risky assets or both an administered price. Just as for more than half a century there has been a consensus that the level of the short-term interest rate is too important a price to be left to a market full of easily spooked and not very rational financiers, so stage III leads us to the conclusion that the price of risk is also too important a price to be left to the market.

How are we to model these three stages?

Start with a version of Bernanke-Gertler: financial intermediaries can operate in one of two modes: well-capitalized or poorly-capitalized. When financial intermediaries are well-capitalized, they themselves have little problem borrowing on a large scale and serving as conduits for the flow of funds between savers and investors. Thus market demand for risky financial assets is relatively high:

And, given the (fixed in the short run) supply of risky financial assets like mortgages and private-sector bonds, the prices of such financial assets are relatively high as well--which gives businesses an incentive to expand their capital stocks and thus put people to work in the investment-goods industries:

But there is another mode of operation: if financial intermediaries are poorly-capitalized they themselves will have great problems borrowing--savers will fear the moral hazard problems that arise when those who manage their money don't themselves have a large stake in the game, and a financial intermediary without a large equity cushion leads savers to ask the American question "if you're so smart, why aren't you rich?" and shy away. So if financial intermediaries are poorly-capitalized, supply and demand looks very different:

with low demand for financial assets, a low equilibrium price of financial assets--and no incentive for businesses to expand their capital stocks, and mass unemployment, and depression.

The kicker is that large declines in the prices of financial assets--a panic--can switch financial markets from one mode to the other, because their is a large range over which declining prices do sufficient damage to financial intermediaries' capital and reputation to cause the demand curve to slope the wrong way--in what I was taught to call the "Krugman Backwards-S" demand curve:

which produces two stable equilibrium--a good, high-price, high-investment, full-employment one, and a bad, low-price, low investment depression one. The task of central banking is to keep the financial markets and the economy at the good equilibrium, and keep it from jumping to the bad one. These are crisis stage I policies--the good equilibrium is where it should be; monetary policy is appropriate; the problem is that some shock has destroyed confidence and the economy is threatening to jump to the bad, low-value, high-unemployment equilibrium. The correct response is "Bagehot rule" policies: lend freely to financial institutions that are caught short of cash so they don't have to liquidate good assets at fire-sale prices, but lend at a penalty rate so they do feel the pain appropriate to the amount of systemic risk that we have had.

Now let's jump back in time to 2001-2002. It is the aftermath of the collapse of the tech boom and of 911. The Federal Reserve has lowered interest rates to try to forestall deflation and keep the economy near full employment. By lowering interest rates it made safe assets less attractive, and thus pushed demand for risky assets outward--raising the prices of (which is the same thing as lowering the interest rates of) risky financial assets:

The outward push became larger because of two additional factors: Asia's policy of low-currency valuation and thus of providing interest-rate subsidies to America's borrowers, and relaxed lending standards coupled with real estate exuberance. In an environment in which any newly-created financial asset could be sold for a high price, construction companies undertook to build lots more houses--and thus pushed the supply of financial assets out to the right between 2002 and 2006 as all of these new houses--5 million more than trend construction--needed mortgages:

Now comes 2007: an end to irrational exuberance and a little bit of bad macroeconomic news pushes demand for financial assets back to the left. At first--last summer--the Federal Reserve thinks that its job is simply to maintain confidence, to keep the economy at the good equilibrium by making everybody understand that the Fed was not going to let the economy get to the bad, depression equilibrium. But over the fall it became clear that such "Panic Stage I" policy wasn't going to be enough:

Providing liquidity to the market in order to maintain confidence--following Bagehot's rule of lending freely at a penalty rate to organizations that could offer collateral that would be acceptable in normal times--wasn't going to be enough to avoid a depression because it was no longer a matter of maintaining confidence that banks and other financial intermediaries were and would remain well-capitalized. Why wasn't it enough? Because they weren't well capitalized. The good equilibrium was in the wrong place--had too low a price of financial assets and thus too low a level of economic activity and too high a level of unemployment. And perhaps the good equilibrium did not exist at all.

So over the winter the Federal Reserve moved on to "Panic Stage II" policy: fight the possibility of deflation and depression by doing what they did in 2002, and lowering safe interest rates in order to boost private-sector demand for risky assets. Banks borrow short and lend long. Reduce interest rates and you boost the value of their long-term assets by more than the value of their short-term liabilities. With more of a net worth cushion and with a lower cost of borrowing, their demand for risky assets will expand--the good equilibrium will move to the right place for the macroeconomy, or the good equilibrium will reappear (we hope).

That gets us to last spring, when the Federal Reserve had done almost all that it could do in the way of reducing interest rates on safe assets, of trying to recreate the good equilibrium. Yet as we see now financial markets were still not calmed, were still not confident that the good equilibrium exists.

So the Fed moved on to Stage III policies. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see). Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the demand up and to the right, like so:

And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:

That, in a nutshell with simple graphs, is what we are doing.

Five more notes:

First, last spring Larry Summers had good arguments that we had then set in motion enough policy moves to resolve the crisis and save the world economy from depression. We had implicitly guaranteed the unsecured debt of every large investment bank in the United States. And we had greatly strengthened the implicit guarantee of Fannie and Freddie. That should have been enough. But clearly it wasn't.

Second, I don't believe that after this the price of risk will ever again become a free-market price, just as after the Great Depression the short-term price of liquidity--the short term interest rate--ever became a free-market price. The federal government, in one form or another, is going to be in the business of insuring debt securities against steep declines in value. Securities that are not so insured will simply not be traded. What Fannie Mae did for "conforming" home loans, the Treasury or some other government agency will do for derivative securities. It will offer insurance, charge for that insurance, and supervise and oversee financiers much more strictly.

Third, the market fundamentalists in other sectors will need to be quiet for quite a while. We have just seen financial markets rife with moral hazard, agency, and adverse selection problems crash spectacularly. Is this a situation in which we should move health care--also rife with moral hazard, agency, and adverse selection problems--toward a free market configuration? No. Market regulation needs to be smart. But first market regulation needs to be.

Fourth, there is now no time for tolerance of the three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit:

1. It's immoral because people have a right to be treated like adults--which means that they have a right not to be rescued by the government from the consequences of their bad judgment, and we are violating that right.

2. It's unfair because feckless greedy financiers who caused the problem ought to lose money and aren't--or aren't losing enough money--and because feckless greedy imprudent thriftless borrowers who caused the problem ought to lose money and aren't--or aren't losing enough money.

3. It won't work--at least not in the long run.

I dismiss objection (1). It is made, mostly, by those who speak for the Princes of Wall Street. Note that the Princes of Wall Street themselves are not opposed to what the Federal Reserve and the Treasury and the congress doing--anything, anything at all that promises to raise asset prices is something that each of the Princes of Wall Street would trade at least one of their organs of generation for. But those who speak for the Princes of Wall Street--well, they really believed that the Princes earned their fortunes by virtue of their virtue--their intelligence, their nerve, their skill, and their willingness to run great risks for great rewards. The idea that there is a public safety net to catch the Princes when they all fall off the tightrope at once--that they are not actually rugged Randite individualists running great risks--that they are people in the right place at the right time with enough low animal cunning to cover themselves with glue and then step outside at 57th and Park or on Canary Wharf as the money blows by so that a bunch of the money sticks to them--well, this strikes those who speak for the Princes of Wall Street on the editorial page of the Wall Street Journal or in Investors' Business Daily as a betrayal of the moral order.

The response to objection (1) is that the people who make it need to grow up. There is no more a John Galt or a Jane Galt than there is a Santa Clause. There are no Randites in a financial crisis--or no even quarter-sane Randites. The fact that there is a safety net in a financial crisis is something that has been obvious to everything with a spinal column for at least a century and a half--that's what central banks are for, for Jeebus's sake! The Princes of Wall Street did not earn their fortunes by virtue of their virtue, their intelligence, their nerve, their skill, and their willingness to run great risks, et cetera, et cetera, low animal cunning, glue, money sticks as it blows by.

The response to objection (2) is "tough." Yes, it is important to design the elements of the rescue package in such a way as to give as few windfalls as possible to the undeserving feckless, greedy, imprudent, thriftless, et cetera. We will do what we can within the law to make sure as few gains ill-gotten survive going forward. But as Federal Reserve vice chair Don Kohn says, it is bad public policy to hold the jobs of tens of millions hostage in an attempt to teach a few feckless financiers (or even somewhat more thriftless borrowers) even a much-deserved lesson.

The response to objection (3) is that it was first made by Karl Marx at the end of the 1840s: that the problem is not overspeculation but rather overproduction, and cannot for long be solved by paliatives that address overspeculation only:

Karl Marx and Friedrich Engels: Neue Rheinische Zeitung Revue (1850): Speculation regularly occurs in periods when overproduction is already in full swing. It provides overproduction with temporary market outlets... but then precipitating the outbreak of the crisis and increasing its force.... What appears to the superficial observer to be the cause of the crisis is not overproduction but excess speculation, but this is itself only a symptom of overproduction. The subsequent disruption of production does not appear as a consequence of its own previous exuberance but merely as a setback caused by the collapse of speculation...

Marx was wrong then--the business cycles of the 1850s were not the harbingers of a world-wide communist revolution and not the expression of the dialectical contradictions of capitalism. "Overproduction" does not necessitate a crash. "Overproduction" simply means that the economy has built a lot of capital, and that a bunch of that capital is not going to be worth what the rich people who invested in it had hoped, and in the aftermath the economy's real interest rate will be low. Big whoop--a low long-term real interest rate. All historical evidence suggests that stage III policies can work. And that avoiding them definitely for reasons of ideological purity does not work.

Fifth, later on we should talk more about the corollary to the refutation of objection (1)--the fact that there has always been a safety net for the rich makes it an obvious matter of simple justice that there be a safety net for the poor and the middle class as well. But for the present the important thing is to make sure that people who argue for tax cuts for the rich or for welfare-state program cutbacks for the poor should not be allowed to disrupt the formulation of public policy when there is serious public busienss to be done

Comments

[Miracle Max]

Your bit at the end about Marx criticizes the passage for what it does not say. It does not refer to victorious communist revolution, nor to a "crash," but to a crisis that is inherent in capitalism. And if the only thing we had to fear now is a low long-term interest rate, then a lot of folks are apparently overwrought.

[raft]

i really appreciate this post. Thanks brad.

[Neal]

The equivalent to the proposal --wrap a building brick in shiny gold wrapping paper, present it to the government, and the government buys it at par for gold.

How long can that go on?

How many of the trillions (70+ trillion)out there in fiancial instruments need to be back-stopped by the government?

Recall that these are highly leveraged products--buying them at less than 98-95 cents on the dollar will wipe ot the investor.

[Bernard Yomtov]

This is an excellent and informative post, Brad. Thanks.

With respect to point #2, however, I think you underestimate the degree of anger and resentment at the huge gobs of money people made in the process of creating this crisis. I'm not sure what can be done, but neither do I think it will wash to just shrug our shoulders as they walk off with bags of loot while the rest of the country sees the value of its 401(k)'s and IRA's fall, and its savings threatened.

Who knows what went on here, in the bowels of these operations, as assets were "marked to model," etc. It's surely worth some investigation.

[Doctor Jay]

"Government isn't the solution to our problems, government IS the problem" - Ronald Reagan

For pretty much my entire adult life this has been the dominant political philosophy. But Katrina mortally wounded it, I think. The current crisis and need for government intervention may be the death blow. I certainly hope so.

[travis fast]

You seem to have a penchant for finding the relevant quote from Marx which actually backs up your broader point about systemic risk, origins and solutions and then missing the point.

Let me help you actually read that quote.

What Marx is saying is that speculation is not the cause of the crisis but rather is an epiphenomenal manifestation of a deeper problem: overproduction. Speculation gets going only after overproduction has set in. The exuberance Marx is referring to is not speculative activity but productive activity which has surpassed the given limits of consumption. I would think that the present stock of US housing and the declining valuation of those houses rather vindicates Marx's point. Marx will go on to say that the only resolution to such a crisis is the is the destruction of asset values: Again I think the proposal to buy up 2 trillion of assets at between 30-70 cents on the dollar rather vindicates Marx's point.

That such dynamics do not necessarily lead to the glorious revolution--historically its opposite i.e., some form of fascism--is I think by now well established. 1940s style red baiting, misquoting and dissembling should really be left to the Roves of this world. You doves just look amateurish when you try it and you sully what is otherwise a good point. We get it booby: you sir are no communist. Noted.

[Stephen Purpura]

Excellent post.

[Ken Houghton]

"the convention that the discount rate should be higher than the bank-to-bank federal funds market rate "

Uh, NO! This is not a "convention"; it's a conceit of the Bush Administration. The stigma associated with going to the discount window (because people know you did) isn't just a moral point--it's an economic one as well, as your competitors smell your blood and charge you just a bit higher on NON-cash transactions.

The Discount Rate is traditionally LOWER than the Fed Funds rate because the actual Cost of using the DW is much greater TO YOUR DAILY BUSINESS PRACTICES than the cost of paying an extra 25 or even 50 bp for overnight funds.

The rest of the post is Eminently Reasonable, with Miracle Max's caveat--so long as we NEVER AGAIN HEAR AN ECONOMIST USE THE PHRASE "MORAL HAZARD" to describe how evil it is that people who are NOT in power might pay a dollar or two less for their health insurance.

If you're not willing to put Dick Fuld, Hank Greenberg (who ruined AIG and then remained a major shareholder and ON THE F*CK*NG BOARD to hamstring any efforts at sanity), and Jimmy Cayne up against the wall (metaphorically if not literally), then you never have the right to take about "consequences" again.

Deal?

Didn't think so. So much for economists being all about Consequences and Rational Expectations. Guess we should teach that there is a Major Exception for people who actually HAVE power and influence.

[robertdfeinman]

You cannot "teach" markets a lesson (there are always new players entering who know nothing about history). You can recapture the ill gotten gains of the parasites. The way to do this is through tax reform.

Any combination of increasing the marginal income tax rate, changes to the capital gains tax and the estate tax can do the job. The Forbes 400 came out today and the plutocrats are still doing fine.

You can encapsulate the lessons learned in a disaster by creating new laws and regulations. That's how institutional memory gets preserved. The Reaganites have spent 40+ years dismantling the structures that were the lessons learned in the 1930's with the predictable results.

There seems no way in a highly imperfect democracy like that in the US to prevent the rich from trashing the laws over time, since wealth implies political power. Societies where wealth accumulation is not permitted to the same degree (via taxation again) do a better job of providing social services and responding to the needs of the citizens via democratic means.

[Sharon]

Brad,

Thank you for this post. I'm e-mailing the permalink to everyone that I know.

[ionides]

Regarding this sentence, just before the stage III diagram: "Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:"

Shouldn't this read "pushing the demand", rather than supply?

[Roland]

It would be fine if the bailout was matched by a strongly progressive tax structure and an explicit commitment to social redistribution.

Otherwise, socializing the cost of failed investments only exacerbates the wealth inequality problem, which will eventually lead to political problems.

[Mo]

What are the chances that this astounding intervention will have unintended, unexpectedly large consequences of the _good_ kind for society? Such as plummeting unemployment, rising salaries, softer mattresses, and ponies? Or do we already know that this can only make crunch time and recession a littler easier? Is it unreasonable to hope that Paulson and Bernanke have discovered a new macro lever that will make everything better than ever? Just a little?

[John Howard Brown]

Brad,
Brilliant, the best concise summary of how we got here and how to climb out of the hole. Does anyone besides me find it disquieting that the only way the American economy seems to get to above trend growth recently is through bubbles? Also if incomes had actually grown in the lower half of the distribution during the late, alleged boom would the default rate on mortgages have risen quite so high as it did to spark this crisis

[John Howard Brown]

Brad,
Brilliant, the best concise summary of how we got here and how to climb out of the hole. Does anyone besides me find it disquieting that the only way the American economy seems to get to above trend growth recently is through bubbles? Also if incomes had actually grown in the lower half of the distribution during the late, alleged boom would the default rate on mortgages have risen quite so high as it did to spark this crisis

[Dan Tyler]

I'll echo the brilliant comments and ask for a version that Jack Cafferty can use on his show. This information needs to be more widely shared.

[Nylund]

Why call it the backwards S curve? Why not simply the Z curve? Or heck, the sideways N curve if you want to get really wacky.

[lemuel pitkin]

I agree with others that this is an exceelent article. I also agree that he is wrong about what Marx quote -- its explanation of the deeper roots of a "speculative" crisis in insufficient aggregate demand is directly relevant to the current crisis. E.g. last August the FT argued that a key advantage of CDSs for investors was that “the size of the corporate bond market is limited by companies’ need for funding, which in practice has been much less than the desire of investors to trade credit.” And presumably there would have been much less pressure for mortagegs to grow the way they did, especially at the low end, if real incomes had been rising over the past decade.

But! I'm very glad he included the Marx bit, sneer and all. (A view is wrong *because* Marx held it? Really?) Because it is actually a very useful and appropriate quote, and without DeLong I wouldn't have known about it.

[mike]

A brilliant, well-written, well-reasoned justification for the liberals and neo-cons to steal money from working people. Sorry Professor, all I see are a lot of fancy words and charts whose primary purpose is to distract attention from what is simply a cold-blooded theft of the poor by the rich. The only people I can see who recommend a bail-out are those, like you, who have a vested interest in preserving the status quo. Without exception. And I think you know in your heart that this is not the best for the country or the economy or the people, just for the rich. I sure hope like hell I'm wrong, but I don't think so. This bailout won't work, tho it might last until the election. After that, it'll be like pouring gasoline on a fire, and will make things worse for decades. But we shall see.

[mike]

A brilliant, well-written, well-reasoned justification for the liberals and neo-cons to steal money from working people. Sorry Professor, all I see are a lot of fancy words and charts whose primary purpose is to distract attention from what is simply a cold-blooded theft of the poor by the rich. The only people I can see who recommend a bail-out are those, like you, who have a vested interest in preserving the status quo. Without exception. And I think you know in your heart that this is not the best for the country or the economy or the people, just for the rich. I sure hope like hell I'm wrong, but I don't think so. This bailout won't work, tho it might last until the election. After that, it'll be like pouring gasoline on a fire, and will make things worse for decades. But we shall see.

[Steve Diamond]

US population expected to grow significantly over the next thirty years. The USG is going long on housing stock and sees a chance to buy low and sell high. Could be a good deal for the government.

We seem to be learning the lesson of the Asian model of state capitalism, only in reverse: we let an atomized home building industry, an atomized home owner financing industry and an atomized banking system set up a poorly planned allocation of housing supply and only then do we realize the need to nationalize it to rationalize it.

I think that's why Marx said crisis was a form of post festum planning for capital.

We'll see.

But while they are at it why not buy GM too and start reshaping the assembly lines to produce electric vehicles at affordable prices and mass transit trains?

[kris]

This is a very nice explanation. Thanks. Regarding the Stage III policies, cannot the Govt reduce the supply of risky financial assets by writing off (individual) mortgage debt in some fashion-i.e capping mortgage rates and the like? Currently, if I understand things correctly, the taxpayer is going to be on the hook for the bailout of the big banks/insurers. Is this bailout in any way equivalent to a writeoff of many individual mortgage debts (because many of the banking entities may no longer have an ability to collect)?

[Bob]

Interesting explanation of the market conditions our leaders are trying to avoid and the reasons they're recommending the actions they are.

To me, however, there are a few pieces missing, however.

First, what does it mean to say that the government will regulate and insure "risk?" Once risk is insured, doesn't that mean it's not "risky?" And wasn't "insurance" a big part of this crisis in the first place? Wasn't the ability of investors to "insure" their returns by "diversifying" and "hedging" the factor that allowed them to leverage to the extent they did without recognizing or revealing the risks? Why would the government be better at this than the institutions that just failed at the same task?

Second, assuming that the government has to insure risk going forward to help us run back to the edge of the cliff we're falling off, why does it follow that the government has to insure past risk, as well. If the problem we're trying to avoid is that people will refuse to buy uninsured debt and that that will raise interest rates faced by companies who'd otherwise expand, why does the fix for that entail retroactive insurance on past risk?

Third, why should everyone pay for it? Why shouldn't the costs be focused on those who caused this mess and reaped great benefit from it?

Finally, I think the swipe at Marx was both gratuitous and somewhat off the mark. As others have pointed out, we have overproduced housing, and counter to what some have said, if that stock is in places without strong local economies, it may never be useful. It may just be waste, and if so, it will not lower long term interest rates. I'm not sure what the Glorious Revolution has to do with that.

The arguments I've read for why this won't do any good are not (at least on the surface) based on Marxist theories, but on the observation that their are consequences for the government stepping in. Money the government spends isn't free. It has to be borrowed, or the currency has to be devalued, or taxes have to be raised, or other government activities have to be curtailed, and that all of those things will counter the actions the government is taking, but leave the country in a weaker position to deal with them.