Peter Baker of the Washington Post Does It Again
Chris Mooney: Hurricane Dean Is the Ninth Most Intense Atlantic Hurricane Ever Measured

Yves Smith on the Fed's Choices

Yves Smith writes at

A gut-wrenching two weeks in the credit markets have been capped by unprecedented moves by central bankers... However, both the Financial Times and the Wall Street Journal report that the Fed's actions have done little to stem chaos in the money markets, begging the question of whether the Fed should do more, and if so, what. Opinion about the wisdom of the central bankers' actions is coalescing into what we will characterize, broadly, as four views.... we'll focus on the Fed....

First is the group that thinks that central banks should do whatever it takes to keep the markets afloat... Jim Cramer... Don Luskin, but they have some intellectually respectable company, such as economist Thomas Palley....

In bad times, such as we are now experiencing, the Fed is obliged to come to the rescue of lenders for fear that if they stop lending the economy will tank.... The threat posed by the current crisis is such that the Fed should meet this demand. That means immediately cutting rates and continuing to judiciously provide emergency liquidity. However, once the storm passes Congress and the Fed must address the systemic problems and policy distortions that have been exposed by the current crisis.

The second group is the cold water Yankees who think that any liquidity infusion is a bad idea. They see the Fed and its buddies as having enabled massively underpriced credit, which has in turn led to asset bubbles. While they don't deny that a refusing to mitigate the credit contraction will cause considerable pain, including a recession, they argue that lowering interest rates now will rescue the perpetrators as well as the victims, merely delaying the day of reckoning.... Despite the moralistic overtones, this group (members include Nouriel Roubini, Andy Xie, Michael Panzner, Marc Faber) has some logic behind its righteous-sounding views. Roubini's critique is particularly sophisticated. He has pointed out that the credit contraction isn't simply a liquidity crisis but also a solvency crisis. More credit can't salvage insolvency.... No amount of liquidity will solve an information problem.

The third camp is the realists. They... think a cold turkey approach creates too much collateral damage.... This view is particularly strong at the Financial Times, where its well regarded economics editor Martin Wolf and commentator Martin de Grauwe have both takes a page from Walter Bagehot, who advocated that central bankers needed to create some pain even as they were alleviating a crisis. They should lend, but at penalty rates, and only against good collateral.... Walter Buiter (among other things, a member of the monetary policy committee at the Bank of England) and Anne Siber (advisor to the Committee for Economic and Monetary Affairs of the European Parliament) hew more tightly to the Bagehot line and, say quite bluntly at VoxEu that the Fed blew it:

The Fed's 17-8-07 move was a missed opportunity. It should have effectively created a market by expanding the set of eligible collateral, charging an appropriate "haircut" or penalty interest rate, and expanding the set of eligible borrowers at the discount window to include any financial entity that is willing to accept appropriate prudential supervision and regulation..... We believe that this cut in the discount rate was an inappropriate response to the financial turmoil. The market failure that prompted this response was not that financial institutions are unable to pay 6.25 percent at the discount window and survive (given that they have eligible collateral). The problem is that banks and other financial institutions are holding a lot of assets which are suddenly illiquid.... [T]he Fed should have effectively created a market by expanding the set of eligible collateral and charging an appropriate "haircut" or penalty. Specifically, it should have included financial instruments for which there is no readily available market price to act as a benchmark for the valuation of the instrument for purposes of collateral...

The fourth view comes from those who believe the... solution isn't simply a matter of interest rate policy but of the larger regulatory framework, which needs to acknowledge and manage the risk of asset bubbles.... Australia's former Reserve Bank Governor Ian MacFarlane (who to our knowledge is the only central banker to successfully deflate an asset bubble) pointed out the dilemma central bankers now face, namely, the lack of a mandate to address asset inflation.... >However, even now it's not hard to point to a few things that in retrospect might have put a damper on the recent speculative frenzy. One is that the old "prudent man" and "prudent investor" rules that used to guide fiduciaries' behavior have gone out the window. If an institution used a fund consultant to invest in products it didn't understand, it escapes liability.

The formal reimposition of some commonsensical standards that have gone by the wayside might go a considerable way towards addressing the problem. One would be to prohibit fiduciaries from investing in funds or vehicles that fail to disclose their holdings (meaning assets and liabilities) to them on at least a quarterly basis.... An improved securities regulatory regime may similarly emphasize new respect for old rules that have been widely ignored to our collective peril.

Two comments. First, the Bagehot rule seems to be widely misunderstood. It is not "lend at penalty rates on good collateral," it is "lend at penalty trates on collateral that would be good in normal times." There is a difference.

Second, "prudent man" rules do much less good than reserve requirements and capital standards--which are then waived in a crisis. Reserve requirements and capital standards make a crisis much less likely, and then their waiver gives institutions many more tools with which to deal with the crisis when it does come.