How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)
5. Confusion of insolvency and illiquidity
Although monetary easing likely offset some part of the economic effects of the financial turmoil, that offset has been incomplete, as widening credit spreads and more restrictive lending standards have contributed to tight overall financial conditions. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Consequently, the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets.
Ben Bernanke, speech to the Greater Austin Chamber of Commerce, Dec. 1, 2008.
The Fed has made loans in various ways, Bernanke said, “to ensure that adequate liquidity is available, consistent with the central bank’s role as the liquidity provider of last resort.” This misrepresentation of insolvency for illiquidity has pulled the Fed into a policy that, in fact, violates traditional central banking. The two tasks of central banks have been the protection of the value of currency in the long-run and support of the payments system in the short run. The Fed has failed dismally in the first (after nearly equal price levels in 1789 and 1913, the purchasing power of the dollar has fallen 95% under the Fed) but it has been attentive to the latter. The central bank’s role as supporter of the payments system has been understood to include the responsibility to serve as lender of last resort.
A financial panic, or crisis, is a rush for cash, when “the rate of interest rises to a panic figure.” This normally comes at the end of an upward price movement, Irving Fisher (1922, p. 65) wrote, when those who have borrowed heavily are unable to renew their loans. They “must have currency to liquidate their obligations.” Runs on banks, even solvent banks, occur, and the central bank must come to their aid.
Liquidity is the proportion of an asset’s fundamental value that can be realized in cash quickly following the decision to sell. This is an individual concept, and differentiates assets in normal times. Market liquidity, on the other hand, refers to the general availability of cash. All assets except cash are illiquid during panics (Palgrave 1896; Wood and Wood 1985, pp. 163-66))
A traditional problem of the lender of last resort in maintaining the system’s liquidity has been to assist sound banks without bailing out the insolvent. The solution, Walter Bagehot advised in the classic Lombard Street (1873, pp. 187-88), has been to lend “freely and vigorously … at a very high rate of interest … on [the security of] good banking securities.”
None of this describes the Fed. The problem is clearly not one of liquidity, as the low interest rates on safe investments tell us. Even the safest securities, even Treasuries, are subject to panic interest rates during rushes for cash. This in seen in Frederic Mishkin’s (1991) account of seven financial crises from 1857 to 1907 (but not 1929 or 1987, when the Fed came to the aid of the money markets). Furthermore, despite the talk of the capital markets “freezing up” (simultaneously with a ”meltdown,” apparently) , bank credit was maintained and mortgages were available at traditionally low interest rates for good borrowers.
“For good borrowers” is key. The loan curtailments, except at high interest rates, of which some firms complained, and which, supported by the Fed, they called illiquidity, was due to the market’s assessment of their risk of insolvency. John Taylor and John Williams (2009) present data (see the figure) which indicate that the abrupt increase in the 3-month Libor rate relative to the overnight federal funds rate beginning August 2007 (after the failure of large banks heavily involved in mortgage-backed securities; it jumped again upon the failure of Lehman Brothers in September 2008) was due to risk rather than illiquidity. “As long as lenders who are not constrained by liquidity concerns exist, banks that seek to hoard liquidity can borrow from these lenders in the CD market…. Competition will lead to the equalization of borrowing rates across instruments for borrowers of the same credit quality. That CD rates have tracked Libor closely during the crisis …suggests that liquidity concerns at banks are not a significant factor separate from counterparty risk driving term lending rates.” Credit default swaps tell the same story, and regressions suggest that injections of Term Auction Swaps by the Fed have not affected what are clearly risk premia.
Recent Fed and Treasury actions have not been concerned with liquidity or the integrity of the payments system, which was not threatened, but rather with the salvage of particular managements (not firms, which would have continued with restructuring). Government purchases, and potential purchases, of bad assets have retarded the resolution of the crisis by preventing purchases of those assets by the many solvent firms who were able and might have been willing.
References:
Walter Bagehot, Lombard Street. 1873. (new ed. edited by H. Withers. J. Murray, 1920).
Irving Fisher. The Purchasing Power of Money, 2d ed. Macmillan, 1922.
Frederic Mishkin. “Asymmetric information and financial crises: A historical perspective,” in R. Hubbard, Financial Markets and Financial Crises. University of Chicago Press, 1991.
Palgrave, R.H.I. Dictionary of Political Economy(1896),new ed., H. Higgs, ed. Macmillan, 1923.
John Taylor and John Williams. “A black swan in the money market,” American Economic J. of Macroeconomics, Jan. 2009.
John Wood and Norma Wood. Financial Markets. Harcourt Brace Jovanovich, 1985.
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