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Central bankers used to have a business not, as today, a religious calling. We may soon be wishing for a return to the old model.
The central bankers’ first priority, in return for which they received their monopoly privileges, was to ensure that governments could borrow money, particularly during difficult times such as wars. After that, though, they could make a good, low-risk living buying or selling against the short-term market noise, taking a few points out of “self-liquidating” short-term transactions and, in a crisis, lending to desperate borrowers against good collateral.
Note well the last function. This wasn’t charity. It was the provision of liquidity at a price, not bailing bankrupts out of insolvency. The measurement of risk wasn’t done with value-at-risk (VAR) models, but with first hand assessments of the realisable value of the underlying assets.
They don’t do that any more, as the term credit markets noted last month.
In order to perform those valuations, central bankers used to have much more contact with grubby speculators and other real-economy operators than they do now. Within living memory – mine, for example – the presidents of regional Federal Reserve Banks would be drawn from the ranks of local businessmen, who, it was thought, would have more of a sense of underlying conditions than appointees shipped in from New York or Washington.
Now the ideal type regional Fed President would be William Poole. He gets a tip of the hat from me for calling himself “Mr” Poole in his official biography, when he could use the doctorate he has from the University of Chicago, the Qom of monetary economics.
Before ascending to the Fed, he had a distinguished career as an academic and Federal economic adviser. I would no more expect to see him in the company of reckless speculators and desperate market operators than flying to the moon.
You can tell that from the speech he gave to a gathering of Milton Friedman acolytes last week. As he told the assembled clerics: “When new information arrives, most of the time the central bank can wait for market responses and the passage of time to clarify what is happening . . . . I’m not saying the Fed should ignore what happened last week – we need to understand what is happening. However, it is important that the Fed should not permit uncertainty over policy to add to the existing uncertainty.”
I think Mr Poole and his colleagues might usefully spend more time with those reckless speculators, desperate market operators and bankers who have gotten in over their heads. This less respectable company than he usually keeps could tell him that “the passage of time to clarify what is happening” on offer is a lot shorter than it was before, even in the last decade.
The VAR models devised by the descendants of the sainted Eugene Fama of Mr Poole’s beloved University of Chicago have created systemic risks that should be unwound carefully. Otherwise, the “existing uncertainty” could turn into blind panic in the next phase of this ongoing crisis.
Mr Poole and his colleagues are right to be concerned about the moral hazard of central bank bailouts. Some “assets” and institutions should go bust. No doubt there will be prison time for some after the coming washout. But a disorderly collapse of values and seizing up of markets could lead to the inflationary reaction that they fear, as Fed Reserve governors resort to shoving bales of cash out of the helicopter doors.
What we saw last month was a toy trainset model of what is in store for us with the unwinding of the great credit bubble. Dealers and banks, whose capital committed to market making was greatly reduced by frozen bridge loans and volatility-based pricing models, were unable to perform much of their usual function. In the credit derivatives market, where mechanisms are not incorporated in the central banks’ models, adverse marks-to-market could lead to spiralling price declines.
This could come in forms such as the unwinding of synthetic “investment grade” CDOs. Even without defaults, marks could lead to the triggering of unwinds, which would require the purchase of scarce default protection, the price effect of which would lead to more triggers being pulled and lawyers being called.
Interestingly, the Fed staff studied what could be done to directly provide credit back in 2000. The sprightly prose of “Monetary Policy When the Nominal Short Term Interest Rate is Zero” (Clouse, Henderson, Orphanides, Small & Tinsley, November 27, 2000), might be dusted off and re-considered.
It turns out that the Fed has quite a few potential channels for the direct lending under sections 10B, 13(8) and 13(13) of the Federal Reserve Act, while the discounting, or purchase of paper in the secondary market is authorised under other parts of section 13. This doesn’t have to be a “bailout” of risk, since in most of these cases the credit risk remains with the institution that discounts the paper.
Direct lending is more problematic, but that wouldn’t have been necessary to stop mini-panics such as July’s.
The large and capable staffs in Washington and at the regional Feds should, at flank speed, consider how to provide crisis liquidity. This would be an especially useful exercise given the jerry-built credit derivatives structures we have built (using Chicago models).