Tuesday, August 21, 2007

I'll see your Bagehot and raise you a Kindleberger 

(Updated with current news at bottom.)

Much has been made in the press over the fact that Federal Reserve Chair Ben Bernanke has read Walter Bagehot (first mentioned on this blog here.) Is this necessarily a good thing?

Yves Smith has an outstanding review of four views of how the central bankers have gotten this right or wrong. These are, to summarize: a group that thinks the Fed has not done enough now and must rescue the financial system (and is uncritical of its role leading up to the crisis); "cold water Yankees" who think the financial markets need to bear the pain and should thus go cold turkey; the realists of the financial markets who have been quoting Bagehot at length -- "yeah, mistakes have been made but their sunk costs and lending freely must be done now"; and a group that believes this crisis stems from both a lack of a mandate for dealing with asset bubbles like subprimes, and thereby calling for both more regulation and changing central bank charters. Smith provides a compelling case for putting people in these four camps.

I think it would be interesting to consider where to place central bankers in those four categories. If Bernanke has Bagehot on the bookstand, does that make him a realist?

I think so, but with a caveat. The general understanding of the Great Depression that Bernanke takes away from his work is that financial crises will have non-financial consequences. Willem Buiter and Anne Sibert argue that the next likely Federal Reserve move -- the cut in the Fed funds rate that Tim Duy takes as a foregone conclusion -- is warranted "only if the Fed were to believe that the recent financial market kerfuffles are likely to have a material negative effect on real activity in the US or on the rate of inflation." I think the statement on Friday has given up the inflation story but put the real activity proviso in play. This is the nature of the Fed's dual mandate (though the ECB, with a sole mandate for price stability, nevertheless intervened quite strongly. Perhaps they're realists too.) So to say, Bernanke is a realist, but he's probably more sensitive to the possibility of spillover from subprime mortgages to the rest of the economy than perhaps Alan Greenspan was.

A fuller understanding of Bernanke should include as well a reading of Charles Kindleberger's Manias, Panics, and Crashes. Kindleberger viewed bubbles as naturally arising in good times, a sign of progress in the economy as new technologies come into vogue; they tend to be overdone, he said. My shorthand for Kindleberger's thesis of how one deals with firms in financial crisis is that there are three choices: you can bail them out; you can let them burn; or you can provide a period over which they work it out for themselves. Yves Smith's first two views fit the first two choices of Kindleberger rather nicely; the third might be the view of the realists, though again one man's realism is another man's bad advice.

Two quotes from Kindleberger may help here (these are from the 4th edition, I do not own the 5th.)
I see no a priori way to answer the question of whether a central-bank policy of holding the money supply constant, limiting the liquidity of the money market, or raising the discount rate at the first sign of euphoric speculation would prevent mania leading ot crisis or correct it after it got under way. ...the weight of historical evidence strongly favors the case that while monetary policy might have moderated booms leading to bust, it would not have eliminated them all. (p. 69)

If, then, one admits the necessity for a lender of last resort after a speculative boom and believes that it is impossible for restrictive measures to slow down the boom at the optimal rate without precipitating collapse, the lender of last resort faces dilemmas about amount and timing. The dilemmas are more serious with open-market operations than with a system of [discount window operations.] In the latter case, Bagehot specified the right amount: all the market will take -- through solvent houses offering sound collateral -- at a penalty rate. With open market operations the authorities have more of a decision to make, but Bagehot is surely right not to starve the market. Given a seizure of credit in the system, more is safer than less. The excess can be mopped up later.

As for timing, it is an art. That says nothing -- and everything. (p. 178)
The first quote can be interpreted that while the Fed might have done something to slow down the expansion of the bubble, it could not stop it. While the 2000 stock market peak was about technology, this one was about risk. We learned how to repackage it, move it around. Unfortunately, as Kindleberger would have expected, we got a little ahead of ourselves (Arnold Kling's reference to hide-and-seek would not have surprised him.) I think it's fine if people want to go back and find where the Fed might have moved the funds rate up another 25 or 50 bp, but to think that would have solved the issue is folly. It is the nature of discovery of how to manage risk that someone is going to take too much unknowingly. Even if there were an asset mandate, it is doubtful that we would have gotten policy exactly right, even if it's Stephen Roach running the controls.

The second quote should be viewed as forward-looking to policy. Bernanke has been relatively incremental in his actions so far. He knows timing will be a question, and he's probably going to overshoot the amount of liquidity issued in the long run, to great consternation of Smith's second view holders. Charles Wyplosz, writing over the weekend, thought the discount rate cut last Friday was the right move for the Fed because it kept options open:
By reducing the discount rate, and accepting the infamous mortgage-linked assets as collateral, the Fed is offering markets a very strong reassurance. They can now find cash, and use the hot potato as collateral, in virtually unlimited amounts, at a cost, of course, but a very moderate one. The odds of a meltdown have now decreased.

Will that be enough to bring some much needed quiescence? Only time will tell, of course. If it does not, then the Fed can reduce its interest rate, on September 18 or anytime beforehand. Herein lays another great merit in the Fed�s actions today. It has fired a powerful shot, but it kept the heavy artillery in reserve.

This morning's troubles with other mortgage bankers may mean they still need that artillery. But better they still have the shells. Mop-up of the discount loans is also harder than the discount window lending that has been encouraged, and that's why Bernanke may have gone to a little-used policy instrument first.

UPDATED (kind of): After I wrote this I took a last tour of Bloomberg. I found this quote by Richmond Fed president Jeffery Lacker:
``Financial market volatility, in and of itself, doesn't require a change in the target federal funds rate,'' Lacker said at a luncheon of the Risk Management Association of Charlotte. ``Interest-rate policy needs to be guided by the outlook for real spending and inflation,'' and markets can change that assessment if they induce changes in growth or prices.

...``Sound discount window policy, I believe, should aim at supplying adequate liquidity without undermining the market's assessment of risk,'' Lacker said.
Bernanke has met with Sen. Chris Dodd of the Senate Banking Committee (and a Presidential candidate) and indicates he'll use all tools at his disposal to get through the crisis. Of course he will, and of course he'd say that. But that doesn't mean Bernanke is just speaking Bagehot.

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