A full-scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers' financial reserves. The cure depends on which of three modes define the fall in asset prices.
The first -- and "easiest" -- mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.
The cure for this mode -- a liquidity crisis caused by declining confidence in the financial system -- is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.
This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.
Once everybody is sure that, no matter how much others panic, financial institutions won't have to dump illiquid assets at a loss, the panic will subside. And the penalty rate means that financial institutions can't profit from the investment behavior that left them illiquid -- and creates an incentive to take due care to guard against such contingencies in the future.
In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.
This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.
In this case, applying the Bagehot rule would be wrong.
The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule -- with its high lending rate for banks -- would make matters worse.
Of course, easy monetary policy can cause inflation, and the failure to "punish" financial institutions that exercised poor judgment in the past may lead to more of the same in the future. But as long as the degree of insolvency is small enough that a relatively minor degree of monetary easing can prevent a major depression and mass unemployment, this is a good option in an imperfect world.
The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.
When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out -- and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.
The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.
The inflation may be severe, implying massive unjust redistributions and at least a temporary grave degradation in the price system's capacity to guide resource allocation. But even this is almost surely better than a depression.
Since late summer, the US Federal Reserve has been attempting to manage the slow-moving financial crisis triggered by the collapse of the US housing bubble.
At the start, the Fed assumed that it was facing a first-mode crisis -- a mere liquidity crisis -- and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.
But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis -- more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.
As Fed Vice Chair Don Kohn recently put it: "We should not hold the economy hostage to teach a small segment of the population a lesson."
No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.
J. Bradford DeLong is a professor of economics at the University of California at Berkeley and was assistant US Treasury secretary during the Clinton administration.
Copyright: Project Syndicate
Eating at a breakfast shop the other day, I turned to an old man sitting at the table next to mine. “Hey, did you hear that the Legislative Yuan passed a bill to give everyone NT$10,000 [US$340]?” I said, pointing to a newspaper headline. The old man cursed, then said: “Yeah, the Chinese Nationalist Party [KMT] canceled the NT$100 billion subsidy for Taiwan Power Co and announced they would give everyone NT$10,000 instead. “Nice. Now they are saying that if electricity prices go up, we can just use that cash to pay for it,” he said. “I have no time for drivel like
A failure by the Chinese Communist Party (CCP) to respond to Israel’s brilliant 12-day (June 12-23) bombing and special operations war against Iran, topped by US President Donald Trump’s ordering the June 21 bombing of Iranian deep underground nuclear weapons fuel processing sites, has been noted by some as demonstrating a profound lack of resolve, even “impotence,” by China. However, this would be a dangerous underestimation of CCP ambitions and its broader and more profound military response to the Trump Administration — a challenge that includes an acceleration of its strategies to assist nuclear proxy states, and developing a wide array
Young supporters of former Taiwan People’s Party (TPP) chairman Ko Wen-je (柯文哲) were detained for posting the names and photographs of judges and prosecutors believed to be overseeing the Core Pacific City redevelopment corruption case. The supporters should be held responsible for their actions. As for Ko’s successor, TPP Chairman Huang Kuo-chang (黃國昌), he should reflect on whether his own comments are provocative and whether his statements might be misunderstood. Huang needs to apologize to the public and the judiciary. In the article, “Why does sorry seem to be the hardest word?” the late political commentator Nan Fang Shuo (南方朔) wrote
Chinese Minister of Foreign Affairs Wang Yi (王毅) reportedly told the EU’s top diplomat that China does not want Russia to lose in Ukraine, because the US could shift its focus to countering Beijing. Wang made the comment while meeting with EU High Representative for Foreign Affairs and Security Policy Kaja Kallas on July 2 at the 13th China-EU High-Level Strategic Dialogue in Brussels, the South China Morning Post and CNN reported. Although contrary to China’s claim of neutrality in the Russia-Ukraine conflict, such a frank remark suggests Beijing might prefer a protracted war to keep the US from focusing on
RSS