Jonathan Chait Is Driven into Shrillness by William Kristol
John Berry Says that the Fed *Might*--Not *Will*--Cut Interest Rates

Willem Buiter, Anne Siebert, and Walter Bagehot

William Buiter and Anne Siebert write:

Maverecon - Willem Buiter's Blog: Central banks in a time of crisis: a preliminary scorecard: Martin Wolf, Chief Economics Commentator of the Financial Times is correct in stating, in his FT column of August 15, 2007,

Fear makes a welcome return, that in a crisis the central bank must save not specific institutions, but the market itself.

It is, however, necessary to be precise about what it means to save the market, about which markets may need saving and about how the central bank should go about saving the market in such a way as to minimise undesirable side effects.... [W]e have sketched the role of a modern central bank as ‘market maker of last resort’ (MMLR). This MMLR is the analogue, in a world where intermediation is increasingly through financial markets, to Bagehot’s lender of last resort (LOLR) in a world where most intermediation took place through banks.... The market maker of last resort function can be fulfilled in two ways. First, the central bank can make outright purchases and sales of a wider range of securities than they currently do. Second, central banks can accept a wider range of securities as collateral in repos, and in collateralised loans and advances at the discount window than they currently do. Following Bagehot’s rule, the MMLR should buy these securities outright or accept them as collateral only on terms that would imply a stiff financial penalty to the owner....

Making a market for a particular type of illiquid financial asset, say a collateralised debt obligation (CDO), may require knowledge that central banks currently do not have.... [T]he solution is not to hire the financial engineers and quants, who are so good at exploiting ‘arbitrage’ opportunities and extracting the large returns to risk bearing in ordinary times, but whose lack of consideration for and/or understanding of economic fundamentals significantly contributed to the current market disarray. Instead, central banks should hire economists with solid training in macroeconomics, financial economics, micro-market structure and behavioural economics and then encourage them to become interested in and knowledgeable about financial markets that may become illiquid.

From the perspective of saving or supporting markets, acting as market maker of last resort where appropriate and necessary, the recent actions of the Fed, the ECB and the Bank of England have all left something to be desired. The ECB simply drowned the markets in high-grade liquidity, adding well over $200bn worth of liquidity against high-grade collateral. As this did nothing directly to assist the markets for illiquid and low-grade securities.... The Fed cut the (primary) discount rate from 100bps above the Federal Funds target rate to 50bps above the Federal Funds target rate. This was a mistake and a missed opportunity. The problem was... that these financial institutions are holding a lot of assets which have suddenly become illiquid and cannot be sold at any price.... The Fed should instead have effectively created a market by widening the set of eligible collateral....

[O]n balance, the Fed and the ECB are addressing the credit crunch with a larger dose of liquidity-provision-as-usual under orderly market conditions. In addition, the Fed has provided an unnecessary subsidy to discount window users. There is a real risk that either or both may be pushed into cutting monetary policy rates not because they fear developments in inflation... but as a way of addressing a credit crunch and liquidity crisis....

On the whole, these central banks have not exactly covered themselves with glory...

I don't think this is right. Bagehot's rule has many formulations, but I think the central one is that the central bank should close down insolvent institutions and lend freely (at a penalty rate) to illiquid ones, where "illiquid" means that after the crisis passes and asset prices return to normal levels and the dust settles we will see that the institution is indeed solvent--it is just that right now the possibility that it will have to liquidate assets at distress prices means that we are not sure what would happen if it were closed down today.

The central bank doesn't need to make a market in dodgy assets, according to Bagehot--and there were lots of dodgy assets in the late nineteenth century. The central bank just needs to make normal-time solvency judgments. I don't think the central bank should get into the business of buying dodgy assets. But that seems to be what Buiter and Siebert want it to do with their "market maker of last resort."

I'm skeptical.