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Thursday, April 03, 2008

"Market Maker of Last Resort"

I think Felix is right, the policy option described below is unlikely to be enacted. However, if things start to get a lot scarier than they already are, then that could change:

Should the Fed Buy Securities Outright?, by Felix Salmon: In a Q&A back in March, Mark Thoma proposed that the Fed should simply buy up distressed assets, rather than simply accept them as collateral:

If it were my choice, .. I'd do more. First, I'd trade for any financial assets at a price that fully reflects the risk of holding that asset. The Fed should trade non-risky assets, money or government bonds, for risky private sector assets at a risk adjusted price... Suppose the Fed takes a mortgage backed security off the hands of a bank that wants to reduce its risk profile, and pays the bank 80% of its value, the 20% "haircut" is to compensate for the risk of holding the asset.
What if the Fed loses money on these trades?
That could happen. But these assets could also increase in value as well, precisely because the Fed is holding them and reassuring markets. If the Fed makes a fair trade, ... it is as likely to make money as lose money. ...

Today, Willem Buiter says something very similar: that central banks can and should be a buyer of last resort when markets fail.

When markets are disorderly and illiquid, it is not just the prices of good or prime assets that fall below their fundamental values. The same holds for the prices of bad, impaired and sub-prime assets. Impaired assets too will have a fair or fundamental value. That fundamental value may well be far below the face value of the security, but it may also be well above the price the impaired asset would fetch in a fire-sale in an illiquid market.
If the central bank, or some other government agency, were to act as Market Maker of Last Resort and buy the impaired asset at a price no greater than its fair value but higher than what it would fetch in the free but unfair illiquid market, such a purchase would not be a bail-out. It would also be welfare-increasing...
This possibility of a capital loss and fiscalisation of this loss does not mean that the transaction ex-ante involved a subsidy by the central bank to the owner of the impaired asset, or a bail-out of the owner.

Both Thoma and Buiter stress that such activity must be combined with more stringent oversight of financial entities, including hedge funds and other leveraged weapons of potential mass destruction. Buiter even gets very specific about the mechanisms that a central bank could use to buy assets: apparently a well-designed reverse auctions "don't require the government buyer to know much or indeed anything at all about the fundamental value of what it is purchasing". Which sounds rather scary, until Paul Krugman comes along to remind us that the Hong Kong Monetary Authority went one step further in 1998, and started buying up not bonds but stocks. And made a fortune. Then again, Krugman is also comparing the idea of central banks buying securities outright to the idea of the US invading Canada, so it's not clear how on board he is.

My feeling is that it's not going to happen, mainly for political reasons. In this particular crisis, the distressed assets the Fed would end up buying would almost certainly be mortgage-backed bonds. But buying up mortgage-backed bonds looks very much like giving money to big banks and investors instead of giving it straight to struggling homeowners: the optics are simply terrible. If the collapse of Bear Stearns is seen as a bailout, this would be much worse. It might be a good idea, but its time has not yet come.

The independent Fed is not supposed to worry about the political implications of its decisions. But independence for the Fed is not unqualified, the degree of independence it has is due to legislative acts, not the constitution, and if the Fed oversteps its bounds then some or even all of its independence can be taken away by congress.

I don't think congress should underestimate the outcry that would occur if it tried to substantially reduce the Fed's independence, and I doubt that members of congress do underestimate that, at least for the most part. And members of congress with oversight responsibilities who disagree with the Fed's policy can use the hearings where the Fed chair testifies before congress to distance themselves from policies that are politically unpopular (posturing is not hard to detect when the chair testifies before congress, starting with the speeches in the form of questions politicians give when it's their turn to ask about monetary policy).

I would hope that if the Fed does not pursue the policy option described above, it is because it does not believe it is the optimal optimal policy, that the political consequences and the fear of losing independence do not play a large role in the Fed's decisions. Otherwise, what's the point of having an "independent" Fed if politics prevent it from pursuing the best possible strategy at the time when it's needed the most?

    Posted by on Thursday, April 3, 2008 at 01:25 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (47)


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