Government-Run Financial Stabilization Programs on a Pan-Galactic Scale
God! Don't let British editors choose your headlines. Just saying. Chris Carroll:
Punter of last resort : The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”...
This game brings to mind Joan Robinson’s comment that “utility maximization is a metaphysical concept of impregnable circularity,” and Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science.... As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the “lender of last resort” role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today’s terminology, ‘an increase in the price of risk’). Some economists, of course, view narrative history in the DeLong and Kindleberger mode as irrelevant.... For the numerically inclined, however... controlling a market price of risk is something the Federal Reserve has done since it first opened up shop... the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed. Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as ‘risk-free’ is that the Fed takes away the risk:
Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last?... A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all.... [T]here is, at least, a perception that this way of operating is hallowed by time and practice.... But... Robert Barbera, Charles Weise, and David Krisch show... that... the Federal Reserve’s choice of the short run interest rate has been powerfully correlated to market-based measures of risk....
Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet....
Let’s put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future. The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy....
Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the ‘lender of last resort’ to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed’s appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks...
How large a scale are we talking about here? I can't help but think that we are calling for a $4 trillion operation--$4 trillion of bank reserves and Treasury debt created, $4 trillion (at current market values) or risky assets pulled onto the government's balance sheet.
Can the U.S. government do this without cracking the U.S. Treasury bond's status as safe asset in the world economy? I think so. But we will see...
