Some questions for William Poole, president of the FRB St. Louis. The answers are extracted from his speech Market Bailouts and the "Fed Put":
One of the arguments against the Fed taking action to reduce problems in financial markets is that this creates a moral hazard problem. Can you remind us what the concern is?
The concern over moral hazard is that monetary policy action to alleviate financial distress may complicate policy in the future, by encouraging risky investing in the securities markets.
Do we know much about financial turmoil of the type we are experiencing now?
There are so few instances of market turmoil similar to the current situation that I’ll broaden the analysis to include significant stock market declines. Doing so gives us a substantial sample to discuss.
What is the most important question to consider?
[W]hether Federal Reserve policy responses to financial market developments should be regarded as “bailing out” market participants and creating moral hazard by doing so.
Maybe an example of the types of questions we should ask would help.
The U.S. stock market, between its peak in 1929 and its trough in 1932, declined by 85 percent. Question 1: If the Fed had followed a more expansionary policy in 1930-32, sufficient to avoid the Great Depression, would the stock market have declined so much? Question 2: Assuming that a more expansionary monetary policy would have supported the stock market to some degree in 1930-32, would it be accurate to say that the Fed had “bailed out” equity investors and created moral hazard by doing so? I note that a more expansionary monetary policy in 1930-32 would, presumably, have supported not only the stock market but also the bond and mortgage markets and the banking system, by reducing the number of defaults created by business and household bankruptcies in subsequent years.
Now apply these questions to the current situation. Did the Fed “bail out” the markets with its policy adjustments starting in August of this year? Have we observed an example of what some observers have come to call the “Fed put,” typically named after the chairman in office, such as the “Greenspan put” or the “Bernanke put”? Why has no one, at least not recently to my knowledge, argued that a more expansionary Fed policy in 1930-32 would have “bailed out” the stock market at that time and, by implication, have been unwise?
Some people aren't going to make it to the end of this discussion. Any chance you could give a summary of the bottom line?
I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.
For those who do want to hear the details, how are you going to answer these questions?
My approach will be to start by discussing bailouts and moral hazard in general. I will examine the record of stock market declines and Fed policy adjustments and then analyze how monetary policy changes the nature of risks in financial and goods markets. Finally, I’ll argue that the ways in which monetary policy alters risks in the markets yields benefits for the economy and does not create moral hazard.
Then let's get started. Maybe you could explain how bailouts work.
A traditional bailout involves governmental assistance to a particular firm, group of firms or group of individuals. For ease of exposition, I’ll concentrate on bailouts of firms, but the same issues apply to bailouts of households.
Let's start with firms and move on to banks later. Should the Fed or government bailout firms that are "too big to fail"?
There may be occasions when a government infusion of capital to save a firm is justified, such as a bailout of a major defense contractor during wartime. However, most economists believe that bailouts are rarely justified and only in compelling circumstances should the government bail out individuals or firms.
An important reason for opposition to bailouts is that it is essentially impossible for a bailout not to set a precedent for the future. A bailout creates what in the economics and insurance literature is known as “moral hazard” by creating a presumption that in the future the government may again rescue a failing firm. That presumption encourages a firm and its investors to be less careful ... about taking risks. ... When the government is expected to absorb losses, bailouts unavoidably increase inappropriate risk taking, which increases the likelihood of losses in the future.
A standard problem in writing and administering insurance contracts is that the buyer of insurance has less incentive, by virtue of being insured, to control risk. ... The very existence of insurance may change the behavior of the insured person. Insurance companies try to deal with moral hazard in a variety of ways, such as by writing contracts with substantial deductibles or loss sharing. Such contract provisions provide an incentive for the insured to control risk. ...
When they are justified, or I suppose even when they are not, how does the Fed do bailouts?
The Federal Reserve has no funds and no authority to provide capital or guarantees to firms to provide a bailout in the traditional sense. The Fed cannot even bail out banks. The Fed can make loans to banks, but only loans that are fully secured by good collateral and only to banks that are well-capitalized. The Fed can lend to weak banks requiring emergency assistance to prevent immediate collapse, but again only with adequate collateral.
So this different from, say, a bank working with a customer who is having trouble paying a loan?
Creditors sometimes bail out debtors to a degree, by restructuring obligations to extend the repayment period or to reduce the interest rate. Restructuring a mortgage is often in the interest of the borrower, who may be able to avoid foreclosure. Restructuring may make sense for the lender to avoid the costs of bankruptcy and to obtain the maximum possible return from a failing loan. Nevertheless, lenders obviously must be careful not to make terms too easy for a borrower lest other borrowers ask for similar terms or future borrowers fail to service their obligations. A bailout of this sort is fundamentally different from a government bailout because the lender suffers the loss and not the taxpayer. Losses motivate lenders to be more disciplined in their future decisions.
Before moving on to the "Fed put," if it exists, are there any other distinctions we should be aware of?
Why do we use the term “moral hazard”? ... The “moral” in “moral hazard” refers to behavior the insured knows is adverse to the insurer’s interest—behavior the insured would not engage in were he to suffer the full consequences of the behavior. Insurance companies try to maintain practices designed to encourage appropriate behavior. If an insurance company provides a premium discount for a driver with a certain number of years without insurance claims and the discount in fact encourages safer driving, then that effect is not “moral hazard.” From the perspective of the insurer, the policy changes behavior in a desirable rather than a harmful way. This point is a critical one in the context of monetary policy, to which I now turn.
Okay. let's move to the "Fed put". What is it?
The “Fed put” argument is usually stated in terms of monetary policy reactions to stock market declines. Consider the figure, which plots the natural log of the S&P 500 index and identifies all stock market declines of 10 percent or more since 1950. The figure also shows a measure of the Federal Reserve’s policy rate. The policy rate in the figure is the discount rate before Oct. 1, 1982, and the federal funds target rate thereafter. Shaded areas show recessions as defined by the National Bureau of Economic Research.
Click to enlarge
The figure shows 21 stock market declines of 10 percent or more. Within three months of these stock market peaks, the Fed held the policy rate constant or increased it on 12 occasions. There was a Fed rate cut within three months on nine occasions, but for five of these nine rate cuts, the Fed acted before the stock market peak; its policy actions could not have been motivated by stock market declines. Fed rate cuts did follow the stock market peak in late September 1976; the first rate cut came nine weeks later. The other case was the market peak in July 1998; a Fed rate cut in late September was a response to the situation in the money markets following the near collapse of Long-Term Capital Management and not a response to the stock market per se. ...
Hope you don't mind if I cut you off - I know you have quite a bit more evidence on this - but what does this show us overall? [Yikes, from the look on his face I think he did mind.]
This history makes clear that it just is not true that the FOMC has eased policy in systematic fashion at the time of stock market declines, with the exception of the period following the 1987 stock market crash. Even this experience, however, reinforces the argument that the FOMC’s primary concern is with its macroeconomic objectives and not with the stock market itself. ... Clearly, ... on numerous occasions the Fed has held its policy rate constant, or raised it, as stock prices declined.
So, does this mean there is no put at all, or just that it isn't the reason for the policy action?
While there is no evidence that the Fed responds to the stock market per se, there is an element of truth to the argument that Fed policy can limit downside risk in the stock market. The same Fed policy that succeeds in stabilizing the price level and the real economy should tend to stabilize financial markets as well. Thus, the element of truth in the “Fed put” view reflects expected and desirable outcomes from successful monetary policy. General economic stability, by which I mean both stability of the price level and of the real economy, does change the nature of risks in the financial markets and, therefore, changes investor strategies.
How has this affected investor behavior?
Consider the second of Graham and Dodd’s “Four Principles for the Selection of Issues of the Fixed-Income Type.”
The rule that a sound investment must be able to withstand adversity seems self-evident enough to be termed a truism. Any bond or preferred stock can do well when conditions are favorable; it is only under the acid test of depression that the advantages of strong over weak issues become manifest and vitally important. For this reason prudent investors have always favored the obligations of old-established enterprises which have demonstrated their ability to come through bad times as well as good. (Graham and Dodd, 1951, p.289)
...How many investors today measure the value of a bond by the likelihood that it will continue to pay interest “under the acid test of depression”? How many investors today maintain portfolios robust against the possibility of inflation of the magnitude experienced in the 1970s or deflation of the magnitude experienced in the early 1930s? The answer, I believe, is “not many.”
I'm guessing this is where the point you made above that it is not moral hazard if behavior changes in a desirable way comes into play?
The fact that few investors worry about extreme economic instability is a benefit of sound monetary policy and not a cost; changes in investor practice are conducive to higher productivity growth. The same is true for changes in household and firm behavior reflecting the greatly reduced risk of economic depression or even severe recession of the magnitude of 1981-82. If we did not believe that economic stability is good for the economy and for society, why would a stable price level and high employment be monetary policy goals? Just as a deductible changes behavior of insurance policyholders, so also does economic stability change investor behavior.
You seem to be arguing that Fed policy makes us better off overall, so it's not a cost and hence not a bailout. Can you explain this further?
Economists have long argued that price stability improves economic efficiency, in part because businesses and individuals can make decisions under the assumption that they do not need to pursue strategies designed to cope with a changing price level. Inflation and deflation distort relative prices; such distortion leads to misallocations of resources. With greatly reduced risk of price level instability, investors concentrate on risks relating to changes in demands, technology and relative prices. Better evaluation of these risks promotes more efficient allocation of capital and fosters higher economic growth. ... One of the reasons the Great Inflation was so costly was that economic agents in 1965 did not anticipate the inflation. Decisions and institutions that had been sensible and efficient in an environment of price stability became unprofitable as inflation rose after 1965.
When events threaten to create inflation or deflation, the Fed ought to act to maintain price stability. It is true that Fed actions in such circumstances “bail out” investors who would lose large sums should inflation or deflation take hold. But “bail out” is a completely inappropriate term to use in this context, for it implies costs of the sort discussed earlier when the government provides capital to support firms that would otherwise go bankrupt. The central bank is supposed to stabilize the price level; the economy is better off when people act on a justified belief that the central bank will be successful.
Do the same arguments apply to the Fed's other goal, output stability?
Exactly the same argument applies to central bank actions in response to events or shocks that might drive the economy into recession or into an unsustainable boom. Provided that the central bank does not sacrifice long-run price stability, it can and should respond to new information indicating an increased risk of recession. There is no conflict between the goals of price stability and high employment. ... Those who still believe that there is a trade-off between inflation and unemployment should reflect on the fact that the Great Depression was a consequence of deflation and the recessions of 1969, 1973-75, 1980 and 1981-82 were consequences of the Great Inflation.
Can financial market instability be analyzed in the same way?
With respect to financial instability, the central bank has the responsibility to do what it can to alleviate market turmoil. When there is a widespread increase in risk aversion and a flight to safe assets, the central bank ought to provide extra liquidity to prevent bank runs from bringing down the banking system. Provision of extra central bank liquidity does “bail out” firms that had not maintained sufficient liquidity themselves. Here again, though, the term “bail out,” with its pejorative connotations, is completely inappropriate. ... Widespread bank failures will destroy the claims of prudent investors, as well as of the imprudent.
For a fractional reserve banking system to work, a central bank must stand ready to be the ultimate source of liquidity for solvent banks, and banks in turn take the credit risk of providing liquidity to solvent non-bank firms. By “solvent,” what I mean in this context is that a firm’s assets valued at a normal level of economic activity cover the firm’s liabilities, leaving a reasonable level of net worth. The firm’s capital can absorb losses occasioned by normal business risks. We can argue about what “normal business risks” should be covered, but in my view economic depression, hyperinflation and financial implosion are not included.
So there is a "Fed put", but that's a good thing, not a bad thing, correct?
When there is a high degree of confidence in the central bank, everyone should believe that the central bank will respond to events that might otherwise drive the economy into recession. In this sense, a “Fed put” should exist. A central bank is supposed to do what it can to maintain employment at a high level.
I've been hearing about the “leave it alone, liquidationist school”. What is that?
In the Employment Act of 1946, Congress charged the Fed with promoting “maximum employment, production, and purchasing power.” Not that long before the Employment Act a different view prevailed. David Cannadine, in his Mellon: An American Life,wrote recently about Andrew Mellon’s attitudes during the early part of the Great Depression.
Mellon constantly lectured the president on the importance of letting things be. The secretary belonged (as Hoover would recall) to the “leave it alone, liquidationist school,” and his formula was “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”
That's quite different from what you argued above.
That view is long gone. Macroeconomists today do not believe that policies to stabilize the price level and aggregate economic activity create a hazard. Federal Reserve policy that yields greater stability has not and will not protect from loss those who invest in failed strategies, financial or otherwise. Investors and entrepreneurs have as much incentive as they ever had to manage risk appropriately. What they do not have to deal with is macroeconomic risk of the magnitude experienced all too often in the past.
In the present situation, many investors in subprime paper will take heavy losses and there is no monetary policy that could avoid those losses. Clearly, recent Fed policy actions have not protected investors in subprime paper. The policy objective is not to prevent losses but to restore normal market processes. The issue is not whether subprime paper will trade at 70 cents on the dollar, or 30 cents... Since August, such paper has traded hardly at all. An active financial market is central to the process of economic growth and it is that growth, not prices in financial markets per se, that the Fed cares about.
Summing up, then, what would you say to those who make the moral hazard, "Fed put" argument?
One of the most reliable and predictable features of the Fed’s monetary policy is action to prevent systemic financial collapse. If this regularity of policy is what is meant by the “Fed put,” then so be it, but the term seems to me to be extremely misleading. The Fed does not have the desire or tools to prevent widespread losses in a particular sector but should not sit by while a financial upset becomes a financial calamity affecting the entire economy. .... But one thing should be clear: The Fed does not have the power to keep the stock market at the “proper” level, both because what is proper is never clear and because the Fed does not have policy instruments it can adjust to have predictable effects on stock prices.
From time to time, to be sure, Fed action to stabilize the economy—to cushion recession or deal with a systemic financial crisis—will have the effect of pushing up stock prices. That effect is part of the transmission mechanism through which monetary policy affects the economy. However, it is a fundamental misreading of monetary policy to believe that the stock market per se is an objective of policy. It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices.
I suppose this is just another way of asking the moral hazard question, but will market discipline be preserved when the Fed continuously moves to stabilize the economy?
It makes no sense to let the economy suffer from continuing declines in stock prices for the purpose of “teaching stock market speculators a lesson.” “Teaching a lesson” is eerily reminiscent of Mellon’s liquidationist view. Nor should the central bank attempt to protect investors from their unwise decisions. Doing so would only divert policy from its central responsibility to maintain price stability and high employment.
The Fed would create moral hazard if it were to attempt to pump up the stock market whenever it fell regardless of whether or not such policy actions served the fundamental objectives of monetary policy. I have observed no evidence to suggest that the Fed has pursued such a course. To the extent that financial markets are more stable because market participants expect the Fed to be successful in achieving its policy objectives, then that is a desirable and expected outcome of good monetary policy. There is no moral hazard when largely predictable policy responses to new information have effects on financial markets.
I'm in full agreement with you, but I will note that there seems to be a lot of confusion about the Fed policy, moral hazard issue.
That the monetary policy principles I have discussed here are unclear to many in the financial markets is unfortunate. Macroeconomic stabilization does not raise moral hazard issues because a stable economy provides no guarantee that individual firms and households will be protected from failure. Improved public understanding of this point will not only help the Fed to do its job more effectively but also will help private sector firms to understand better how to manage risk.
Thanks for the pretend interview.
[Pretend to hear "You're welcome."]
Here are the footnotes and references:
1. A put option contract provides that the buyer of the contract can sell an item, such as 100 shares of common stock of a particular company, for a certain price—the strike price—for a certain period. The contract protects the buyer from declines in the stock price beyond the strike price. The “Fed put” terminology implies that Fed policy adjustments, by analogy with a put option, will prevent stock price declines beyond some point.
2. Of course, the Federal Deposit Insurance Corp. is obligated to protect depositors from loss on covered deposits and it is sometimes true that the cheapest way to handle a failed bank is to merge it with another bank with the FDIC providing a capital infusion. To the extent that there is a safety net for uninsured depositors, a bank bailout does raise moral hazard issues. I do not mean to imply that “too big to fail” is not an important issue for federal policy.
3. The S&P 500 series is the weekly close (Friday close unless Friday a holiday). Each market peak was defined this way: Under criterion 1, the peak exceeded the previous peak and the market declined by 10 percent or more following the peak. Under criterion 2, the peak, followed by a decline of at least 10 percent, did not exceed the previous peak, but a recovery of at least 10 percent had occurred between the two peaks.
4. The policy rate in the figure is the Fed’s discount rate before October 1982 and the FOMC’s federal funds target rate thereafter. Other measures are available for certain parts of the period before 1982, but using them would create several discontinuities in the policy rate series. See Rudebusch (1995), Table 3a, for a federal funds target rate series for 1974-79.
5. One of the nine was the market peak in November 1968. As the figure makes clear, the rate cut preceding this market peak was small and temporary. Subsequently, the Fed raised rates and the cuts did not begin until the end of the 1969-70 recession, at which point stock prices started to rise.
6. Rudebusch (1995), Table 3a, identifies two cuts totaling 25 basis points in the FOMC’s target federal funds rate in July 1976 and two more totaling another 25 basis points in October. By this measure, therefore, Fed rate cuts began before the September 1976 stock market peak.
7. The transcripts of FOMC meetings in 1998 provide excellent insight into the Committee’s motivation in dealing with the LTCM situation. Of course, motivation is not the end of the matter; well-intentioned actions can have unintended adverse effects. The 1998 and 1999 transcripts show that the Committee was well aware of the potential for inflationary consequences of policy easing in response to the LTCM situation. Transcripts are available at http://www.federalreserve.gov/fomc/transcripts/.
8. A convenient bibliography of Minsky’s work and of work about his ideas can be found at http://cepa.newschool.edu/het/profiles/minsky.htm.
9. Cannadine (2006), p. 445.
Cannadine, David (2006), Mellon: An American Life (New York: Alfred A. Knopf).
Graham, Benjamin and David L. Dodd (1951), Security Analysis, 3rd ed. (New York: McGraw-Hill Book Co. Inc.).
Rudebusch, Glenn D. (1995), “Federal Reserve interest rate targeting, rational expectations, and the term structure,” Journal of Monetary Economics 35, 245-74.
Thornton, Daniel L. (2006), "When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcripts Tell Us," Journal of Money, Credit, and Banking, December 38, 2039-71.