Panic allayed, Fed's job is done
In a famous episode, Morgan, by far the dominant figure in American finance at the time, gathered the leading New York bankers in the library of his palatial Madison Avenue home, and kept them there until they had agreed on a plan to bail out the financial system. Well, "agreed on a plan" is putting it too delicately: the bankers were told they would accept a $25-million issue of notes by the New York Clearing House as legitimate assets, or have him to answer to. The banks obeyed, using the funds as capital with which to lend to other banks. Within a few weeks, order had been restored.
One hundred years later, the U.S. financial system has changed in many ways, backstopped by layers of regulation, deposit insurance, and of course the Federal Reserve, established in 1913 in direct response to the disaster that, but for Morgan, might have engulfed the system six years earlier. Yet in fundamental terms, nothing has changed. As the events of recent weeks have shown, financial markets are still prone to the occasional cascading panic, the remedy for which is still confounded by the problem of collective action -- how to persuade financial market players to act in a way that makes sense for the system as a whole, but which each might not find in his interests to do on his own.
In the absence of a dominant private actor like Morgan, central banks are now expected to take the lead (though echoes of Morgan can be seen even today, for example in the decision by a consortium of Canadian financial institutions to bail out the commercial paper market). But if the problem in Morgan's day was how to muster an adequate response, to turn the vicious circle of panic-begetting-panic into the virtuous circle of confidence on which the system usually relies, today's central banks run the risk of overdoing it in the other direction. The stock market crash of 1987, for example, though contained, was followed by inflation and, inevitably, recession. If we are to avoid the same fate this time, it's important to be clear on precisely what role the Fed, and its cousins in this country and abroad, should and should not be playing.
People who panic often have good reason to. The job of the central banker in such times is to winnow the rational fears from the irrational, punishing unsound lenders (and, alas, those who invest in them) without undue damage to holders of other, unrelated assets. Perfect cauterization is impossible: just as the sub-prime mortgage market deserves to be unwound, so it is clear now, with the benefit of hindsight, that the broader stock market advance was financed by credit that was overly cheap, given the risks. But central bankers will do least harm if they concentrate on the part of the problem that is within their capacity to control.
When panic-stricken investors dump their holdings of short-term debt, today's equivalent of the bank runs that were Morgan's concern, they do so in exchange for something safer: namely, cash. It is only appropriate that this sudden, and presumably temporary, increase in the demand for money should be met with an equal and offsetting increase in the supply: otherwise interest rates would have to rise, far beyond what would normally be required to induce people to hold interest-bearing assets. But the increase in supply should be no less temporary. Once the panic has receded, so should the liquidity with which it was doused.
Or in more concrete terms, while the Fed was right to cut its discount rate -- the rate at which it lends to commercial banks -- to stabilize the banking system in the short term, it does not follow that it should ease monetary policy in the longer term, as many are urging it to do. Ditto the Bank of Canada. Inflationary pressures were already a mounting cause for concern in both countries before all this, and it would be a tragedy if, out of an excess of zeal to avoid a recession, central banks were in fact to make one inevitable.
The orderly functioning of financial markets is part of the responsibility of central banks. But just as they cannot insulate the economy from "real" shocks -- they can determine the level of total spending in the economy, not how it divides between output and prices -- so it is not their job to prop up stock prices, or to protect foolish lenders from the consequences of their actions.
8/22/2007
