Lacker: The Fed Risks Moral Hazard

From today’s WSJ, we see this critique about the Bear Stearns Bailout from an insider: Federal Reserve Bank of Richmond Jeffrey Lacker’s, made in a
speech in London on Thursday. Lacker, along with former Fed Chairman Paul Volcker and others, have
raised concerns about the Fed’s rescue of the
Bear Stearns. 

The WSJ described it as a "striking insider’s critique."

"The danger is that the effect of recent credit extension on the
incentives of financial market participants might induce greater risk
taking, which in turn could give
rise to more frequent crises, in which case it might be difficult to
resist further expanding the scope of central bank lending."

-Federal Reserve Bank of Richmond Jeffrey Lacker

It is unusual for a sitting Federal Reserve policymaker to critique the lending programs of the central bank.

The moral hazard of the extraordinary steps the Fed has taken is "distort private markets, encourage risky behavior, and could
endanger the Fed’s independence."


Lacker Speech on Financial Stability
June 5, 2008 11:00 a.m.

Fed’s Lacker Raises Concerns About Deal to Rescue Bear
WSJ, June 5, 2008 11:17 a.m.

Text of the full speech after the jump

Lacker Speech on Financial Stability
June 5, 2008 11:00 a.m.
Financial Stability and Central Banks
Distinguished Speakers Seminar
European Economics and Financial Centre
London, England
June 5, 2008
Jeffrey M. Lacker
President, Federal Reserve Bank of Richmond

The financial market events of the last nine months
have raised a number of questions about our financial markets and
institutions, about financial regulation, and about the central bank’s
role in credit markets. Some analyses have focused on the drying up of
trading activity in certain structured finance products where the key
observation is how abruptly liquidity conditions in a financial market
can change. Others have focused on the underlying fundamentals of
credit quality in these financial products, with a key observation
being that, after the fact, it looks as though many decisions regarding
the extension of credit yielded quite disappointing results.

These two perspectives are clearly interrelated, since
the loss of liquidity in asset-backed and related markets appears to
have come about largely because of significant shifts in people’s
assessments of the underlying credit quality. Despite this intimate
connection, emphasis on one or the other tends to lead to very
different interpretations of recent events. An emphasis on liquidity is
often associated with a view that financial market instability
represents a breakdown in the functioning of markets, while an emphasis
on credit quality suggests the view that such disruptions are simply
the natural way that markets (even well-functioning markets) adjust to
large changes in peoples’ beliefs about fundamentals.

In my remarks here today, I would like to discuss
financial stability and central banking. I realize that a great deal of
ink has been spilled on this topic, some of the earliest and most
influential of which was spilled in this very city. But more recently,
specifically the last 30 years, there has been an outpouring of
economic research on the stability of banking institutions. What I have
to offer is a discussion of recent financial market turmoil and policy
responses from the viewpoint of this body of work.

In this line of research, economists have developed
detailed, coherent accounts of both of the views I described. These
represent competing theories of financial instability, and these
different theories have distinct implications for the appropriate
responses of government and central bank policy to market disruptions.
A breakdown of the process by which the market distributes liquidity
among its participants is often cited as a justification for a
relatively active approach to central bank lending. On the other hand,
a market adjusting, even quite awkwardly, to a shift in participants’
understanding of the underlying risks might imply that such lending, by
interfering with the price discovery process, is potentially

In some ways the research has been inconclusive – it
remains very difficult to determine the underlying causes or nature of
financial disruptions in real-time, when policy responses need to be
formulated. But this research has improved our ability to think about
costs and benefits of policy choices, I think. I will emphasize in
particular the importance of paying attention to the long-term
consequences of central bank actions in financial markets. As always,
the views I express are my own, and not necessarily shared by my
colleagues in the Federal Reserve System.

Maturity transformation is a basic function of financial institutions, instruments and markets

The traditional description of banks and the economic
role they play is that they engage in "maturity transformation." Their
lending is tailored to meet the needs of their borrowers for longer
maturity debt to finance purchases or large investment projects and to
shield them against the risk of losing funding. Their liabilities are
tailored to the desires of the ultimate providers of funds for
short-term assets to be prepared to meet unexpected expenditure needs
or investment opportunities.

In principle, one could imagine a financial
intermediary whose assets and liabilities are well matched in maturity
and liquidity. But the nature of the preferences and needs of
households and businesses that provide and use funds is such that a
deliberate mismatch – that is, a maturity transformation – has
historically been more socially useful and thus profitable. Such a
mismatch exposes the financial intermediary to obvious risks, however,
and thus requires compensation in the form of a spread between the
returns earned on lending and the returns paid to savers. Savers accept
a lower return in exchange for flexibility in accessing their funds,
and borrowers pay more in exchange for the certainty of their funding

This, then, is the traditional view of banking –
funding long-term financing needs in a way that satisfies savers’
desire for short-term, liquid assets. But this same sort of
transformation takes place in a variety of ways today outside of the
traditional (commercial) banking system. For example, asset-backed
commercial paper, which grew very rapidly between 2003 and the first
half of 2007, allowed money funds and other investors to place
short-term, liquid funds in securities backed by mortgages and other
longer term instruments. More broadly, many structured finance
arrangements involve maturity transformation. Repurchase agreements
also provide a means for investors to make very short term (overnight)
investments backed by longer term securities, as does such specialized
instruments as Auction Rate Securities.

Maturity transformation raises the possibility that a
surge in demands by liability holders to "get their money back" could
overwhelm an institution’s ability to liquefy the assets in its
portfolio. This is the traditional story of bank runs, and it
motivates, in part, the view I cited earlier that financial markets are
inherently unstable. Since banks’ assets are less liquid than their
liabilities (their deposits), they could have trouble meeting the
demands of a large number of depositors to "cash-in" all at once.
Knowing this makes depositors likely to run if they think such a large
cash-in event is looming. So a run, in this view, can become a
self-fulfilling prophecy. This means that a run can occur even if the
bank’s assets are fundamentally sound, in the sense that if held over a
longer horizon the return would be sufficient to repay liability
holders in full. The reduction in realized value associated with early
and perhaps disorderly liquidation of an intermediary’s assets in
response to such a run is a deadweight cost that presumably could be
avoided if the run could be prevented.

Fundamental runs versus self-fulfilling prophecies

Economists have made great progress in recent years in
formalizing the reasoning I just sketched, and in understanding
precisely what circumstances are required for this reasoning to make
coherent sense. Researchers have found it useful to distinguish between
what I’ll call "fundamental" and "non-fundamental" runs.
Non-fundamental runs are of the self-fulfilling variety; if all
depositors who do not need their money right away believe that other
such depositors will not withdraw their money, then no run occurs. In
another potential equilibrium, the belief that other patient depositors
will withdraw nonetheless induces all patient depositors to withdraw,
thus confirming their beliefs. Fundamental runs occur when people seek
to remove their money from an intermediary because they have
information that makes them mark-down their valuation of the
intermediary’s assets; waiting is not a reasonable option (that is, not
an equilibrium). This distinction is important because the two types of
runs have very different policy implications. Preventing a
non-fundamental run avoids the cost of unnecessarily early asset
liquidation, and in some models can rationalize government or central
bank intervention. In contrast, in the case of runs driven by
fundamentals, the liquidation inefficiencies are largely unavoidable
and government support interferes with market discipline and distorts
market prices.

The ability of theoretical models to predict
non-fundamental runs appears to be very sensitive to the assumptions
used in constructing the model. So economic theory does not provide a
clear prediction about if and when such runs would be likely to occur.
However, in most instances of runs that we have observed – for example,
the wave of U.S. bank runs in the Great Depression – careful analysis
has shown that banks that experienced runs tended to be in observably
worse condition than those that did not. That is, there usually appears
to be some fundamental impetus behind a run.

Recent events in money markets have been compared to
bank runs, even though they occurred outside the traditional commercial
banking sector. Examples include the flight from asset-backed
commercial paper last summer, the failure of auction rate security
refinancings, and the problems faced by Bear Stearns in the week
leading up to its agreement to be acquired. Can these be characterized
as non-fundamental runs? Certainly, some ABCP was backed by subprime
mortgage debt, for which there was good evidence of reduced fundamental
value, and there was uncertainty for a time about how much of any given
issue was backed by such debt. Moreover, many ABCP holders were
contractually constrained to hold only investment-grade paper, and thus
would have had to sell if it was downgraded. This, together with the
availability to issuers of other funding sources outside of the CP
market (albeit at higher rates), seems to offer a plausible
explanation, based on fundamentals, of the rapid fall in issuance
volume that began last August. Similarly, significant concerns were
circulating publicly regarding mortgage-related assets on Bear Stearns’
balance sheet, making money market counterparties (short-term
investors) reluctant to continue dealing with the firm.

The case of auction rate securities appears to be
peculiar because the underlying credit quality of most issuers –
municipalities, for instance – was not called into question. Interest
rates on auction rate securities are set at periodic auctions, in which
security holders choose whether to keep their investment in the
security by participating in the refinancing auction or to withdraw
their funds instead. Auction rate securities thus represent a maturity
transformation in which less liquid assets are funded by more liquid
liabilities. But ARS contracts also explicitly provide that if there is
insufficient interest in an auction by either new or existing
investors, then the security converts into a long-term instrument, such
as a more conventional bond, typically paying a substantially higher
rate of interest. As a result, the underlying assets need not be
liquidated. The consequences of a run-like departure of investors are
thus different than in the case of a bank run or a flight from some
other money market instruments. This is an important distinction,
because it highlights that the extent to which maturity transformation
creates the possibility of fragility or instability in financial
institutions or markets depends critically on the contractual terms
adopted by the intermediary.

Financial fragility is endogenous

The intuition behind the classic bank run story is
that banks are susceptible to runs because depositors are free, at any
time, to claim all of their money on demand. This is a contractual
choice, and one that makes some sense given depositors’ demand for
short duration, liquid savings instruments. But if a bank can restrict
its depositors’ ability to demand their funds on the spot in certain
circumstances – in the event of heavy demands for withdrawals, for
example – then the bank will be less susceptible to a run. And there is
ample precedent for deposit contracts with such characteristics. In
19th century U.S. banking panics, banks preserved their liquidity,
individually, by suspending the convertibility of their deposits into
currency. They also had recourse to collective actions through the
issuance of loan certificates by clearinghouses in the major cities,
which allowed the clearinghouse members to meet their interbank
obligations and customers to make interbank transfers without drawing
on banks’ scarce supplies of currency.

The auction failures in auction rate securities bear a
resemblance to 19th century suspensions of convertibility in that
liability holders were converted into less liquid claims. One result
from the research literature is that such contractual provisions are
capable of preventing or limiting self-fulfilling, or non-fundamental
runs. The prospect of suspension discourages liability holders from
attempting to withdraw funds unless their need is genuine, and helps
convince them that other liability holders will be similarly
discouraged. Institutions that engage in maturity transformation can
also limit their susceptibility to runs by holding a greater share of
their balance sheets in liquid assets, or by financing themselves with
less liquid liabilities – for instance, by limiting their leverage or
issuing longer-maturity debt. Note that bankruptcy itself constitutes
an enforced suspension of convertibility.

The general principle here is that while maturity
transformation can be socially useful, it is not inevitable; the extent
of maturity transformation and of vulnerability to run-like behavior is
a function of the contractual arrangements a financial intermediary
voluntarily assumes.

Any form of self-protection against run-like outcomes
is likely to be costly, though. Holding more liquid assets limits the
gains from the fundamental asset transformation that the institution is
engaged in. A policy of suspending convertibility, while making a bank
less susceptible to non-fundamental runs, could also limit the ability
of depositors to access their funds in episodes of fundamentally-driven
financial strain, and perhaps at times when they genuinely need
liquidity themselves, thus reducing the inherent value of the deposit

Central bank lending

The usual presumption is that institutions and their
counterparties implicitly weigh the expected costs and benefits of
alternative contractual arrangements in designing financial structures
that best suit their financial needs. The incentives of financial
intermediaries and their counterparties to construct resilient
arrangements are also influenced by the policy regime under which their
transactions take place. If people anticipate that in situations of
financial stress the government or central bank will intervene in a way
that limits private losses, then there is likely to be less interest in
taking costly steps to avoid those situations.

Banks have historically benefited from access to
support in the form of central bank credit. Discussions of the role of
the central bank as a lender of last resort, particularly in times of
financial stress, often cite Walter Bagehot’s account of the Bank of
England’s practices in the 19th century. Bagehot’s advice is often
summarized by the simple prescription, "lend freely at a high rate, on
good collateral."

The relevance of Bagehot’s dictum for recent central
bank lending is not at all clear, however. There is an important
distinction to be made between monetary policy operations, which vary
the total quantity of central bank liabilities, and credit policy,
which alters the composition of the central bank’s assets. Modern
central banks target an interest rate, which requires that they adjust
the quantity of their liabilities – generally bank reserves – in
response to fluctuations in the demand for those liabilities. By
itself, a central bank loan increases both the liabilities and assets
of the central bank. Absent offsetting asset sales, the additional
reserves would tend to drive the interest rate below target. Therefore,
central bank lending operations are generally "sterilized" via
offsetting asset sales. The lending programs introduced by the Federal
Reserve since December have all been sterilized.

The lending about which Bagehot wrote was
unsterilized; that is, it represented net increases in the liabilities
of the Bank of England. Bagehot’s advice was essentially to increase
the supply of central bank money when the demand for it rises in a
crisis. "Lend freely at a penalty rate" meant to supply reserves
elastically to prevent interest rates from spiking above the penalty
rate in a crisis. In short, Bagehot’s dictum was about the size of the
central bank’s balance sheet, not the composition of its asset
holdings. The credit risk thereby taken on by the central bank was a
byproduct of the lending required to expand the supply of reserves, not
the objective. (Incidentally, interest rate spikes were a common
feature of many U.S. financial panics in the late 19th century, to
which the formation of the Federal Reserve in 1913 was in part a
response. Unsterilized discount window lending was the method by which
the founders envisioned the Fed would conduct monetary policy and
prevent panics.)

There are economic models in which central bank credit
policy is capable of ameliorating or even preventing non-fundamental
runs when they can occur. By lending when other market participants are
unwilling to lend, the central bank can provide the intermediary with
resources to forestall costly closure or liquidation of assets. As I
argued earlier, however, instances of run-like behavior since last
summer appear to be attributable to real fundamental causes, as do the
broader financial market stresses. As the likely severity of the
slow-down in housing markets and the associated decline in home prices
became apparent, it also became clear that the securities backed by
mortgages originated in 2006 and early 2007 were going to perform
significantly worse than had been anticipated. This realization
affected any institution or instrument with mortgage-related exposures.
When the resulting flight from asset-backed commercial paper caused
exposures to come back on to the balance sheets of banks that had
sponsored such programs, uncertainty about some banks’ exposures raised
their funding costs, most notably in the term interbank market, as
evidenced by widening LIBOR spreads. Prices of mortgage-backed
securities were depressed by the heightened uncertainty about returns,
and also by the likelihood that low returns would be correlated with
adverse economic outcomes. This uncertainty impeded the use of such
securities as collateral for short-term financing. Investment banks
that were prominently involved in mortgage-related securities
activities were particularly affected.

The ideal central bank lending policy would require
making clear distinctions between different possible sources of bank or
financial distress. If an episode of financial disruption is a true
liquidity crisis, like a non-fundamental run on the banking system,
then aggressive central bank lending can, in theory, stem the crisis
and prevent unnecessary insolvencies that impose real losses on the
economy. Lending when in fact the financial sector is just coping with
deteriorating fundamentals, however, distorts economic allocations by
artificially supporting the prices of some assets and the liabilities
of some market participants. Moreover, it is likely to affect the
perceptions of market participants regarding future intervention, and
thus alter their incentives and future choices.

Moral hazard

Moral hazard is the central problem that the financial
safety net necessarily brings with it. And this problem exists even if
central bank lending ensures that the resolution of a problem
institution leaves its shareholders with nothing. Market discipline on
risk-taking by financial firms comes more from the cost of debt finance
than from equity holders (given the limited liability nature of
equity). So it is the potential consequences of central bank lending
for creditors that raises moral hazard concerns by reducing the cost of
debt and potentially leading to greater leverage than would otherwise
be chosen.

People often think of the moral hazard problem
associated with a financial safety net as a "due diligence" problem.
That is, investors in protected securities or lenders to protected
institutions feel less of a need to assess and monitor the
creditworthiness of their counterparties. This is a valid concern, but
I think it construes moral hazard too narrowly in this setting. My
discussion of the choice of leverage points to broader implications of
central bank lending for the contractual structure of financial
arrangements, not just on the monitoring of investment portfolios. In
particular, the expectation of safety net support can weaken the
incentive of counterparties to build provisions in to their financial
contracts that reduce their susceptibility to (non-fundamental) runs.
More broadly, an intermediary with access to the financial safety net
has less incentive to manage their liquidity in a way that suitably
minimizes the possibility of disorderly resolution of solvency problems.

Recent work by one of our Richmond Fed economists
makes this point very clearly, using the standard model of banking
theory. He and his New York Fed coauthor consider a setting in which if
there is certainty that no government (or central bank) assistance will
be forthcoming, then the banking contracts developed will include
provisions that allow for suspensions of payment and these will prevent
non-fundamental runs from occurring. On the other hand, if such central
bank assistance is possible and a non-fundamental run actually does
start, the government will choose to intervene in order to alleviate
the ex post inefficiency associated with a run. But, knowing that this
intervention is forthcoming, banks do not self-protect, and thus leave
themselves more susceptible to runs. So peoples’ expectations regarding
central bank policy choices in times of stress can affect the very
robustness of the system.

This strikes me as a deeper form of moral hazard than
what people usually have in mind. In times of financial crisis, the
understandable central bank imperative is to alleviate the stress. But
the expectations such actions engender could very well make future
crises more likely. The classic time consistency problem is as relevant
to central bank credit policy as it is to monetary policy.

Supervisory authority

The economics of central bank lending closely parallel
the economics of private line of credit lending. Both provide funding
on very short notice to entities that need liquidity. Both create moral
hazard because they can shift potential losses from short-term to
long-term claimants. To contain moral hazard, private line of credit
agreements employ an array of contractual provisions, such as giving
the lender the right to monitor the borrower and rescind the commitment
if specified loan covenants are no longer satisfied. The contracting
parties presumably calibrate loan covenants in a way that balances the
costs of intrusiveness against the benefits of improved incentive

In the case of central bank lending, the same purpose
can be served by government supervision and regulation of the
institutions that are eligible to borrow from the central bank.
Clearly, the extent of supervisory oversight should be at least
commensurate with the extent of access to central bank credit in order
to appropriately contain moral hazard. The dramatic recent expansion in
Federal Reserve lending raises the possibility that market participants
view future access to Fed credit as having been substantially
broadened. For evidence, market participants could point to the fact
that entities formerly viewed as unlikely to have access to the
discount window, such as the primary dealer subsidiaries of investment
banks, have now been granted access.

Actions and statement in the period ahead are likely
to shape the evolution of market participants’ perceptions about the
extent of the safety net. And these perceptions will shape their
choices about contractual arrangements and exposure to risk. In my
view, there is value in communicating policy intentions clearly.
Deliberate imprecision – the so-called "constructive ambiguity"
approach – leaves it to market participants to draw inferences for
future policy from our past actions. Without an articulated statement
of intention regarding lending policy, the time consistency problem is
likely to be a difficult challenge because it will be hard to resist
the future temptation to mitigate financial market stresses when they

In establishing new boundaries of central bank lending
and adjusting the supervisory regime accordingly, a number of
considerations are relevant. More expansive boundaries could
conceivably prevent more avoidable liquidation costs in the case of
non-fundamental runs, but in the case of fundamental runs more
distortions would result. In addition, supervision itself is a costly
endeavor, both in direct resource use and in the fallout effects on
economic allocations. More broadly, expansion of the government
financial safety net could substantively alter the balance between
financial entities that are closely regulated and those that are
regulated primarily by market discipline.

The crucial constraint, however, is that the
articulated policy be time consistent – that is, a commitment not to
lend beyond the new policy boundaries should be credible. Financial
market participants are likely to retain some doubt about the exact
limits of the safety net; after all, the previous, smaller version of
the safety net had fairly well-articulated limits. The danger is that
the effect of recent credit extension on the incentives of financial
market participants might induce greater risk taking, which in turn
could give rise to more frequent crises, in which case it might be
difficult to resist further expanding the scope of central bank lending.

My former colleague Marvin Goodfriend and I wrote
about this problem 10 years ago. We drew the parallel to the building
of monetary policy credibility after the inflationary experience of the
1970s. We noted that central banks, the Fed included, made many
statements about their desire to see inflation come down during the
1970s, but it was not until strong and costly actions were taken, with
broad (though not universal) public understanding and support, that
inflation was broken in the 1980s. If actions speak louder than words
in the case of central bank credit policy as well, then the only
credible way to limit expectations of future lending is to "incur the
risk of short-run disruptions in financial markets by disappointing
expectations and by not lending as freely as before."


To summarize my brief review of the economics of
financial stability; there are models in which runs are self-fulfilling
prophesies, are costly, and could be avoided, perhaps through central
bank intervention. Other runs arise from fundamental developments, and
for these, central bank intervention interferes with market discipline
and distorts market prices. My reading of recent financial market
events suggests to me that fundamentals have been at work – given the
large shortfall in mortgage returns confronting the financial sector,
the resulting strains should not be surprising. But it is almost always
impossible to know precisely how much of a market disruption is
justified by any observed shift in fundamentals, so determining whether
a run is fundamental or self-fulfilling is very difficult. With either
type of run, though, central bank support can weaken the incentive of
financial intermediaries to structure their contractual arrangements to
protect against run-like behavior. In the short-term, governments and
central banks may be able to alleviate financial market strains, but
such intervention may affect financial intermediaries’ choices in a way
that makes instances of financial distress more likely. So policymakers
face an excruciating dilemma when the potential and more immediate cost
of inaction appears greater than the longer term costs of lending

Much has been written in recent years about what role
central banks play in assuring financial stability. This is
understandable, and appropriate. Certainly, a central bank’s
macroeconomic policy can have a large impact on the stability of
financial markets, through the control of inflation and inflation
expectations. This is perhaps the greatest contribution central banks
can make to the overall performance of financial markets. Beyond that,
the central bank’s historical role as a lender of last resort places it
squarely in the center of financial disruptions as they unfold. We are
perhaps not as close to a consensus on the proper conduct of this role
as we are with regard to price stability. But as we continue to learn
about the causes and nature of financial instability, I believe we
should strive for policy that is informed by the lessons learned in the
achievement of price stability. Chief among those is that a central
bank can achieve better outcomes if it can establish credibility for a
pattern of behavior consistent with achieving its long-term goals.

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What's been said:

Discussions found on the web:
  1. michael schumacher commented on Jun 5

    Let’s ask Mishkin……

    Oh wait he jumped last week.


  2. scorpio commented on Jun 5

    funny how the SPY started moving higher just as Einhorn was making a persuasive case that LEH is the next candidate for FRB ownership

  3. TheGuru commented on Jun 5

    In addition, Plosser from the Philly Fed has come out today and stated that there are long-term dangers in further Fed intervention. I think they are telling the market in no uncertain terms that Lehman will not get the Bear treatment. Lehman could be gone in a week.

  4. Steve Barry commented on Jun 5

    I believe the Fed is also saying no more rate cuts…which means dollar rally likely…which will eliminate the tailwind to Nasdaq earnings and punch a hole in its 38 times earnings insanity.

  5. Re-REMIC commented on Jun 5

    Who’s trying to claim the Federal Reserve is independent? Perhaps independent of the government, but certainly not the banks.

  6. Chris commented on Jun 5

    Ahhh….I think the proverbial horse has left the barn….no?!


  7. Graffiti Grammarian commented on Jun 5

    did anyone happen to see this press release yesterday from Markit, which runs a lot of the derivative indices?

    They seem to be saying they are going to start reporting certain stuff to the Fed.

    I dunno, maybe it is just badly written, but it caught my eye.

    Does this mean the Fed is going to start trying to measure derivative trading volume? Ifso, kinda spooky….

  8. Steve Barry commented on Jun 5

    Markit also has several tranches of ABX under 5 cents on the dollar…wonder what they are marked to on the books.

  9. FormerlyknownasJS commented on Jun 5


    Hopefully people will start putting some thought into the Fed, what it is doing now and what the purpose of the Fed is. Being familiar with your take on some of the Feds
    recent actions, I think you might appreciate this. I went to an AA meeting to support a friend a couple of days ago and afterwards, when I was reading Bernanke’s June 3rd speech, it suddenly dawned on me how similar Fed bankers are to addicts. To wit:

    Ben: Hi, I’m Ben, and I’m addicted to rate cuts and low and negative real interest rates.

    Everyone: Hi Ben.

    Ben: I started using because everyone else was doing it. It seemed like the right thing do at the time. I mean, I think I’m addicted. I don’t think what I’ve done has really caused any problems. But I think this is the right place for me.

    Ben looks around and momentarily pauses. The others are waiting for Ben to accept the basic facts.

    Ben: I’m really stressed out right now. Prices aren’t going my way and I’m supposed to look after my friends, the Banks, and it’s starting to look like more of them might fail. A few weeks back, I lost one of my friends, and it really affected me. Rates were really getting out of control so I started using things I’ve never used before. I mean, maybe I shouldn’t have, but I just couldn’t help myself. And now I get cravings all the time, not just for low rates, rate cuts, and negative real interest rates, but I’ve started taking mispriced paper, toxic waste really, all manner of securities that aren’t really suitable as the backing of a national currency, let alone the world’s reserve currency.

    Some of the others at the meeting nod and meet Ben’s desperate and somber look.

    Ben: I’ve started taking all kinds of things, I feel kind of bad, but my friends the Banks do it, and I guess it just kind of crept up on me. Things are really bad out there. People just aren’t spending enough. I’ll lend them money to do just about anything. And I’ve really wanted to cut rates again but prices are becoming unmanageable and I know there might be a connection but it’s hard for me to accept.

    Ben shifts in his seat and takes a breather for a second while the others look on seriously and sympathetically.

    Ben: The more things get out of control the more I want to cut rates. If people would just keep spending and borrowing, to do anything, it would be better. I’m craving negative real rates right now. I know I shouldn’t, but I look around and I think “if only everyone could borrow more and with even lower rates” and then I look at prices for fuel, for energy in general, for food, for healthcare, for tuition, and…I just struggle. I really want to lower rates even more, but, like I said, I see now that my life is really becoming unmanageable.

    Ben takes a deep breath.

    Ben: I’m glad I’m here. I really needed someone to talk to. I talk to the Banks and they just want lower rates all the time, they want more money, they try to get me to take even more toxic things. I look at the Banks and examine their balance sheets, I look at all the gearing out there and all the swaps, and it’s hard.

    I…I think about just printing money sometimes, I could just give it to them and the party could keep on going. I mean I could just print and the Treasury could supply me, or I could even issue my own paper. I could take anything out there, everything out there really, and the party could keep on going. It would feel good for a bit, like the problems weren’t really there. But I know I need to stop. I know at some point I need sound collateral, well documented loans, real quality paper and that the Banks need it too. I know at some point the financial tail has to stop wagging the economic dog. I know that I really need to examine trade and currency issues, international capital flows and look more closely at the bastard child of Bretton Woods. I know that people can’t spend with prices getting out of control, that businesses will start to fail, and that the economic system will begin to distort with multiple unanticipated failures. It will be harder for people to pay their debts and I’ll start wanting to take even more toxic junk. The Banks will encourage me.
    Rates will violently adjust eventually if I don’t get prices under control, and like I said, and you know, I’m addicted to ultra low rates so this would be really hard for me.

    Ben squirms.

    Ben: I’m just…this is a difficult time for me. I want low rates, I want negative real rates, I want to cut again when the market swoons, and especially because I think I’m about to lose another one of my good friends, the Banks.

    One of the Banks squirms and smiles nervously.

    Ben: I realize that my life has become unmanageable. I tried the telegraphed baby-step program before and I failed. I know I need to stop just taking anything. I think I’m ready to try again, one rate increase at a time. Thanks for listening.

  10. KnotRP commented on Jun 5

    > Chief among those is that a central bank can achieve
    > better outcomes if it can establish credibility

    It’s less costly to keep the barn door shut, than
    it is to go locate the credibility horse a few months after
    it got out. Someone clearly misses their pony, and (wow) admits that this time the pony is fundamentally out of the barn. But all the talk and speeches in the world won’t reproduce the pony…someone is gonna have to do real tangible unpleasant hard labor. So is it correlation or causation that Fed resignations have increased markedly in the face of the upcoming hard labor?
    Or do Fed jobs not pay enough to do the bad cop role?

  11. JBL commented on Jun 5

    It’s not just Lehman. After Bear Stearns, people think the FHLMC/FNMA guarantee is practically explicit. That assumption affects pricing all around. Hopefully we’re not masking too many signals. If the agencies actually end up needing to be rescued, it’ll be messy.

  12. Estragon commented on Jun 5

    Money talks, BS walks.

    They can jawbone all they want, but the reality is they did bail out Bear Stearns debtholders, and they’re expected to do it again when the “need” arises.

  13. John commented on Jun 5

    BR.The cow’s out of the barn on this. Who really thinks they are going to let any major financial institution go down. If Lehman stumble there will be a Fed sponsored bailout and there are in fact several interested parties already hovering in the wings so finding a life raft with Fed underpinning won’t be hard. There’s also the political dimension to all this. The Dems are going to sweep the board in November and there is going to be a massive surge in regulation and a house cleaning at the regulatory agencies. In fact the latter is actually probably more important than the former. At the end of the day central banks anywhere are not going to let the financial system meltdown as the experience here and in the UK has already demonstrated. This is a dead issue really. Frankly I’d be much more impressed if the Fed and some of these guys were talking about the way in which third party investors are being allowed to steal large chunks of some financial institutions from their shareholders. Firstly, they were giving them away to management with vast pay packages and gerrymandered stock option schemes, now they are giving them away to private equity firms and sovereign wealth funds.

  14. TheGuru commented on Jun 5

    Continual taxpayer-funded bailouts + increased personal tax burdens in ’09 and thereafter will sow the seeds of their own destruction. There will be a revolt against both parties and there will be blood on the streets.

  15. Freefall commented on Jun 5

    The crass bailout of Bear absolutely guarantees that there will be more and bigger bailouts down the line. After all, how else could the banksters get their hands on taxpayer money so easily?

  16. Jim Haygood commented on Jun 5

    Part of the rationale for having a Federal Reserve as a lender of last resort to commercial banks is that banks are the lifeblood of commence — they hold consumer and business deposits, and process payments between these entities.

    No such rationale applies to investment banks. They take big risks, and their employees get handsomely compensated with bonuses when the bets pay off.

    Through regulatory failure, the investment banks were allowed to pump trillions of toxic waste debt and derivatives into the system. And now when their bets turn into losers, they want to socialize the losses.

    Instead of saving Bear Stearns, the Federal Reserve probably should have considered alternatives such as bankruptcy and liquidation. Legally, Bernanke and Paulson lacked the statutory authority to bail out Bear Stearns. If the system of checks and balances were functioning, there would be both a Congressional investigation, and a Justice Department “show cause” order before the court, seeking to bust the deal.

  17. John commented on Jun 5

    “Continual taxpayer-funded bailouts + increased personal tax burdens in ’09 and thereafter will sow the seeds of their own destruction. There will be a revolt against both parties and there will be blood on the streets.”

    Why do people post melodramatic stuff like this. There won’t be blood on the streets nor will there be a revolt against both parties.

    I had decidedly mixed feelings about the BS bailout because that’s what it was but when you looked at the alternative it was quite simply the lesser of two evils. It’s like these various schemes to prop up house prices or at least slow their decline and keep people in their homes. Theoretically it’s bad but then there are lots of things that are theoretically bad but we do them because in an imperfect world it’s preferable to all kinds of very none-theoretical nasty consequences. Basically this country is going through a massive deleveraging at the domestic and the financial industry level. How long it’s going to take who knows, probably a couple of years, but of this I’m sure it’s not in the wider public interest or that of the wider investing community to turn this into a rout although it might satisfy a desire for schadenfreude in some. If Lehman has to go down, or BS for that matter, I’d much rather see them absorbed in a semi orderly fashion into the maw of JPM or Blackstone than turned into a train wreck with all kinds of collateral damage that no one can calculate.

  18. DonKei commented on Jun 5

    There’s way too many barn animals getting loose.

    But John, really, which do you prefer–the pain of dollar devaluation causing hyperinflationary prices for food or energy, or the pain of collapsing housing prices, mortgage giants (FNMA/Freddie), and a few (but not Goldman!) investment banks?

    Either way, you’re gonna get some pain. If the Fed quits bailing, the pain will be shorter and more severe, but it, and the dollar, will survive (if it’s not too late already) with its credibility intact. And Lacker’s right–the only way for the fed to regain its credibility is to allow a major bank to fail.

    Lehman, anyone?

  19. bonghiteric commented on Jun 5

    Jim Haygood wrote,

    “Legally, Bernanke and Paulson lacked the statutory authority to bail out Bear Stearns”,

    Could you please provide your statutory citation that supports this claim?

    Get real. Serious counter-party risk was at stake. Hell, one thing they did right was not involve Congress!

  20. John commented on Jun 5

    DonKei, there isn’t going to be hyper inflation, that’s Germany in 1923 and Zimbabwe in 2008. There’s going to be inflation partially due to the weak dollar which has little or nothing to do with the Fed bail out of BS and the consequential bailout of other major financial institutions like Citi that they might have been taken down too. And no in my opinion dynamiting the house is not the safest way of fixing the plumbing. The problem with all the creative destruction, let the chips fall where they may folks like yourself is that you have no idea of what the unintended consequences might be. Yes Ben’s bumbling through it and making it up as he goes along, and yes there’s going to be some pain (this is news, this wasn’t going to happen anyway?) but it’s all a matter of degree and your dollar weakness argument and the moral hazard involved in bailing BS is essentially a bit of a non sequitur. If you want to talk about prime rate policy that’s a different matter. Yep he shouldn’t have cut as quickly and deeply as he has but they are really different issues.

  21. zell commented on Jun 5

    The Fed. is the moral hazard.

  22. TheGuru commented on Jun 5

    Lesser of two evils? The Fed created both of these evils — housing bubble and the ensuing credit crisis. Can’t stop them both nand that is exactly what they are trying to do. I am tired of hearing what “could” happen if Bear (or more to the point, JPM) was not bailed out. The public needs to start hearing what “would” happen if the bailouts do not occur. These guys are smart and can model it, I’m sure.

  23. John commented on Jun 5

    Guru: take a comprehension class. I said that the decision to bail out BS was the lesser of two evils as against NOT bailing out BS. They can model it? Oh yep, like all those models they had at BS and a host of other financial institutions that ultimately proved massively flawed. You’re mixing up issues here. The housing bubble and the credit crisis which were essentially by products of the previous Fed chairman’s easy money policies were water over the dam by the time Ben was making decisions about what he was going to save BS. I wonder if you work in the financial industry. I can’t even begin to quantify how serious it would have been if BS had gone but it would have been ugly like no one has seen since the thirties. October 1987 would have a tea party by comparison and inviting a potential meltdown in order to justify a theoretical law strikes me as the ultimate in idiocy. But then pragmatism has always been a failing of mine.

  24. TheGuru commented on Jun 5

    John — why are you and many others willing to give Bernanke a pass on the current mess? He was part of Greenspan’s posse and could have voiced dissent but chose to go along with Mr. Magoo’s insane monetary policy. Are you saying we need to bail out every damn institution that overreached during these last 5-6 years? Because that is not feasibly possible. Why would the system collapse if Bear/JPM were not bailed out? Tell me — cascading defaults? How many fingers can we have in the dike at once? Personally, I think it may get as ugly as the thirties even with the bailouts. Throwing capital at this problem reminds me of throwing money at the Newark school systems. Will it actually change anything?

  25. wunsacon commented on Jun 6

    What “system” would collapse? The system of rewarding people for being overly clever moving money around?

    – Intel would still make chips.
    – Apple would still make toys.
    – Musicians would still write new songs.
    – Farmers would farm.
    – Conoco would still deliver fuel.
    – Tata will sell you a Nano.
    – The NPV of the younger/future generations’ future labor — paid for on a cash basis — would increase significantly compared against the collapsing value of up-until-now overvalued credit.

    What the interventionists fear isn’t so bad. I suspect it’s actually good. Just not for people with large sums of accumulated IOU’s.

  26. wunsacon commented on Jun 6

    >> In my view, there is value in communicating policy intentions clearly. Deliberate imprecision – the so-called “constructive ambiguity” approach – leaves it to market participants to draw inferences for future policy from our past actions.

    Like TheGuru and Steve Barry, I wonder if this speech is intended to create a perception that the Fed will not bail out the next BS or cut rates further.

    I do find the following mildly amusing: Lasker’s speech seems more consistent with a policy of “deliberate imprecision” than with his personal “view” that “there is value in communicating policy intentions clearly”. (I imagine he’s aware of this!)

  27. John commented on Jun 6

    The Guru
    “Personally, I think it may get as ugly as the thirties even with the bailouts. Throwing capital at this problem reminds me of throwing money at the Newark school systems. Will it actually change anything?”

    Umm no. It’s not going to get as bad as the thirties for a hundred reasons which it would take me all day to describe. Even if BS had gone down it wouldn’t have taken us to thirties territory although it would probably have provoked the largest financial crisis since the war. Can I prove it, of course not, but the mere fact that the risk existed meant that Ben would have been grossly negligent in exercising his powers in pursuit of maintaining one of the Fed’s two major policy aims. As for Ben’s relative culpability, I’m not exonerating him although within the Fed system the chairman really calls the shots which you don’t seem to understand. He inherited a mess which he may or may not have had a hand in creating and is now muddling through trying to fix it and actually I think he’s making quite a good job of it on the whole although I don’t think he should have been as aggressive on rate cutting. At the end of the day I don’t want a major meltdown of the US financial system just to prove something, as you apparently do, because the people who would mainly suffer would not be the panjandrums of Wall Street but the residents of main street.

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