Sunday, December 02, 2007

Mark Thoma Channels St. Louis Fed President William Poole

This is important:

Some questions for William Poole, president of the FRB St. Louis. The answers are extracted from his speech Market Bailouts and the "Fed Put":

One of the arguments against the Fed taking action to reduce problems in financial markets is that this creates a moral hazard problem. Can you remind us what the concern is?

The concern over moral hazard is that monetary policy action to alleviate financial distress may complicate policy in the future, by encouraging risky investing in the securities markets.

Do we know much about financial turmoil of the type we are experiencing now?

There are so few instances of market turmoil similar to the current situation that I’ll broaden the analysis to include significant stock market declines. Doing so gives us a substantial sample to discuss.

What is the most important question to consider?

[W]hether Federal Reserve policy responses to financial market developments should be regarded as “bailing out” market participants and creating moral hazard by doing so.

Maybe an example of the types of questions we should ask would help.

The U.S. stock market, between its peak in 1929 and its trough in 1932, declined by 85 percent. Question 1: If the Fed had followed a more expansionary policy in 1930-32, sufficient to avoid the Great Depression, would the stock market have declined so much? Question 2: Assuming that a more expansionary monetary policy would have supported the stock market to some degree in 1930-32, would it be accurate to say that the Fed had “bailed out” equity investors and created moral hazard by doing so? I note that a more expansionary monetary policy in 1930-32 would, presumably, have supported not only the stock market but also the bond and mortgage markets and the banking system, by reducing the number of defaults created by business and household bankruptcies in subsequent years.

Now apply these questions to the current situation. Did the Fed “bail out” the markets with its policy adjustments starting in August of this year? Have we observed an example of what some observers have come to call the “Fed put,” typically named after the chairman in office, such as the “Greenspan put” or the “Bernanke put”? Why has no one, at least not recently to my knowledge, argued that a more expansionary Fed policy in 1930-32 would have “bailed out” the stock market at that time and, by implication, have been unwise?[1]

Some people aren't going to make it to the end of this discussion. Any chance you could give a summary of the bottom line?

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

William Poole is a monetarist (he wrote a book called Money and the Economy: A Monetarist View, so I think I am characterizing him fairly), so these comments are quite significant. As I noted in my impressions of the conference on Understanding Consumer Credit at Harvard last week, we may have reached the point where the mortgage crisis is sufficiently contagious that actions to fight it (such as freezing the interest rates on ARMS) should not create serious moral hazard problems, or in any event, the moral hazard problems pale in comparison with the problems that would arise from passivity.

1 comment:

Elvis.Jim said...

This whole notion that Government and Fed agents are acting to maintain price stability doesn't fly for me. They're only trying to lessen the impact of the downside of price movements. Was there any action to maintain price stability as home prices were rising? Of course not. Other central banks have such overall price stability goals as part of their mandate, trying to stop asset price bubbles from occurring.