What a difference a day or two can make! At the beginning of the week, pundits were debating whether the central banks should provide liquidity to the interbank markets. Even as savvy a central banker as the Governor of the Bank of England publicly argued that doing so was merely rewarding imprudent financial institutions and sowing the seeds of the next crisis, suggesting along the way that his colleagues across the Atlantic and the Channel were losing their nerve. Then came Northern Rock - the Bank of England has not only agreed to provide liquidity to the market as a whole, but also poured an extra bunch into a building society that had become famous for providing mortgages that exceed home values and for raising cash in the riskiest way, on the footloose markets rather than from normally sedate depositors. Whereupon the depositors proceeded to run on the bank’s offices, an unthinkable sight. Then the Fed lowered its interest rate by more than generally expected, the Federal government rushed to the defense of the allegedly gullible subprime borrowers, the Bank of England decided to follow the Fed and the ECB in feeding the dried-out interbank markets and the British Chancellor offered a blanket guarantee to depositors. A reality check of sorts. It is a safe bet that the morality patrol – keen to punish financial evil-doers – will now turn into Cassandras warning about further reckless financial practices leading to many more crises in the future.
Let’s go back to basics. Public interventions are a bad thing, unless there is a well-identified market failure. Since early August, we have witnessed a massive market failure due to acute information asymmetry. Each financial institution knows, or should know, its situation, not just on but also off its balance sheet. There are reasons to believe that this is not fully the case, but let’s overlook this first failure. What each financial institution does not know, and should not know, is what is on the books of the other financial institutions with which it trades daily. The old result, which goes under the colourful name of lemon’s markets, is that, suspecting the worst, no financial institution wants to lend to the others. The consequence is that liquidity is plentiful inside most financial institutions, but not available on the interbank market. Extreme scarcity in the midst of plenty is a big failure. In practice, it means that those institutions that need cash to carry out normal daily business can’t find it, and therefore cannot operate normally. Credit is vanishing. Since a modern economy cannot function without credit, the market failure has potentially catastrophic implications. Intervention is fully justified.
Of course, this is not a call for just any intervention. Basic principles also say that the intervention must directly address the failure. Ideally, it means full transparency whereby each financial institution’s situation is public knowledge. Unfortunately, even assuming that each institution knows what is on its books, this first-best solution is impossible for it would mean revealing too many commercial secrets. So we must go to the second-best solution: provide the needy financial institutions with the liquidity that they need to operate as normally as possible. This is what the Fed and the ECB have done for a month now.
The problem with second-best solutions is… that they are not first-best. By providing liquidity to the market, the central banks are not just helping out financial institutions that only need cash, they also bail out other institutions that have taken excessive risk and only deserve to be folded. This is what some critics have complained about, and they are right. Well almost. For they have to consider the opposite risk, that innocent institutions and their customers stand to be badly hurt if the liquidity squeeze is allowed to continue. This is unfortunate, but it could be an even better second-best solution than full scale liquidity injections. The case is hard to make but let’s try.
The first argument is that there are no innocent bystanders. All financial institutions are guilty of excessive risk taking. Their customers too are to be blamed for having continued to do business with reckless banks. The first argument is uncomfortably close to a value judgment. Who can decide what is ex ante excessive risk taking? Did the bank supervisors issue warnings? If they did not, which we do not know yet, the risks are found ex post to have been excessive. But in a world where zero probability is incompatible with risk-taking, any risk-taking stands to be found misguided ex post. As for customers, yes, theory says that they should monitor their banks. But information asymmetry and plain common sense tells us that they can’t.
A second argument will accept that the first one does not hold water, but would, reminds us that risk-takers must face the consequences of their actions when they do not pan out as expected. If they do not, they will be even more reckless the next time around. True, but the question here is one of timing. Should the punishment be imposed now or later? Imposing it now implies accepting all the consequences of an interbank market meltdown. These consequences are too frightful to contemplate. They are also unnecessary. Once the dust settles, the time of punishment will come. Inquiries should be conducted and those who violated the law must be brought to account. The problem is that reckless risk-taking is not unlawful, and rightly so. But then, what are they to be punished for? Bad judgment.
This brings us to the third argument. Bad judgment in this case is the source of a serious externality, another market failure that calls for public intervention. The problem is that deciding on bad judgment is a value judgment. Currently, dealing with the externality is entrusted to supervising agencies. Obviously, something has gone amiss here and the market failure has been compounded by a policy failure. The ball is logically thrown back in the government’s court, which seriously weakens the case for punishing the markets.
Finally, comes Bagehot and the recommendation that emergency lending be carried out at penalty rates. The ECB is lending at the normal rate and the Fed even lowered the discount rate, seriously contradicting the Bagehot principle. The problem is that Bagehot is about isolated events of illiquid individual institutions, not about a systemic drying-out of markets where most institutions are awash with cash. Most institutions that currently absorb the liquidity are illiquid not primarily because they made mistakes but because they have no way to break the information asymmetry problem.
In the end, not providing the liquidity amounts to taking an excessive risk, that of punishing millions of citizens if a credit squeeze were to create a serious recession. We are reminded of the 1929 crash. Countless studies have blamed the monetary authorities for having stood by as the world economy slid into the Great Depression. Back then, many voices argued that the markets should clean themselves and that excessive risk takers should face the consequences.