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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:
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.
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.
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
