A Call for Central Bankers to Hang Tough

Yves Smith at Naked Capitalism submits:

With today's weak non-farm payrolls report, financial markets participants have turned up the volume on their calls to the Fed to lower interest rates. Even Barney Frank, chairman of the House Financial Services Committee, has weighed in, urging a "meaningful" cut.

So the Financial Times comment today by Raghuram Rajan, professor of finance at the University of Chicago, "Central banks face a liquidity trap," is particularly well-timed.

Rajan takes up a theme stressed by Nouriel Roubini, namely, that the current crisis is (among other things) a solvency crisis, and providing monetary stimulus won't make bad credits into good ones.

Rajan points out that the line between a solvency and liquidity crisis isn't hard and fast. For example, mortgages that looked good in times when there was ample liquidity in the securitized finance markets might not look so hot when things tighten up.

Reading that argument, one anticipates that Rajan is advancing it to press central bankers to make aggressive rate cuts, but it's a straw man. Rajan states that continuing to meet the market's expectations for liquidity is ultimately self-defeating. The requirements balloon, becoming so large that central bankers cannot satisfy them. Rajan instead recommends a stringent course of assuring liquidity in "unimpeachable securities," and "leaning against the wind" when liquidity rises above normal levels.

From the FT:

Because of the self-fulfilling nature of liquidity, small interventions can sometimes revive moribund markets, seemingly at low cost. However, there are indeed costs, perhaps significant ones. First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious - much as a government-funded recapitalisation hurts the taxpayer. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it. As such strategies build on each other they will eventually overwhelm the abilities of even the most deep-pocketed interventionist central bank. Thus, even from the perspective of moral hazard, the distinction between liquidity infusions and recapitalisations is fuzzy indeed.

So what should a central bank do in a time of market turmoil? It should clearly lend freely against unimpeachable securities and also maintain a liquid market in such securities. Anything more is problematic. To intervene by making a market in illiquid securities as some have suggested, or in illiquid assets such as housing, may be to imbue those securities or assets with a liquidity they never should have had and thus distort their value. And cutting rates dramatically, as Alan Greenspan's US Federal Reserve did after the technology bubble burst in 2000, would be an enormous tax on savers the world over. Better let the market weed out the reckless, unless there is a risk of total market collapse.

But knowing that the political pressure to intervene is asymmetric, asserted far more strongly when markets turn illiquid and asset prices fall than when markets are excessively liquid and asset prices booming, central banks ought also to avoid bringing such situations upon themselves. Better to "lean against the wind" with prudential norms, tightening them as liquidity exceeds historical levels, than to ignore the boom and be faced with the messy political reality of forcibly picking up the pieces after the bust.