Business Times - 06 Dec 2007
Does the 'Bernanke put' matter any more?
Critics argue that financial bailout policies encourage risky lending in the future
By LEON HADAR
IS IT fair to suggest that the US central bank is predisposed to 'bail out' the financial markets? That is what critics of the Fed have charged, pointing out to predictable expansionary policy adjustments in response to pressures from investors worried about the diminishing value of their assets. And these measures have been named after the chairmen of the US Federal Reserve - thus the 'Greenspan put' or the 'Bernanke put'. The critics have argued that such policies have amounted to a 'moral hazard'; the argument being that financial bailouts encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.
William Poole, president of the Federal Reserve Bank of St Louis, in an address he made at the Cato Institute last week, denied that such a 'Fed put', exists, at least in the way that critics depict it. More specifically, he rejected the notion that the Fed has been trying to 'bail out' the financial markets with its policy adjustments starting in August this year.
But then Mr Poole went on to explain that 'there is a sense in which a Fed put does exist'. However, those who believe that this Fed put 'reflects unwise monetary policy misunderstand the responsibilities of a central bank', he insisted. 'The basic argument is very simple: A monetary policy that stabilises the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise,' he said. 'Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard,' he added. '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.'
Referring specifically to the charge that the Fed put amounts to a moral hazard, Mr Poole had this to say: 'Macroeconomic stabilisation does not raise moral hazard issues because a stable economy provides no guarantee that individual firms and households will be protected from failure.'
It's difficult to quarrel with Mr Poole's contention about the reasons behind the Fed's monetary policy, that it is a response to the threat of financial crisis and not to 'stock market declines per se.' But the same logic can be applied to financial assistance programmes the US had provided to many Third World leaders during the Cold War. The rationale behind those aid packages was the need to strengthen pro-American regimes in the context of the fight against Communism. In fact, these programmes did produce a moral hazard, creating incentives for dictators, like Zaire's Mobutu for instance, to refrain from reforming their stagnant and corrupt economic systems.
Similarly, there is growing evidence that the current problems facing the credit and mortgage markets had resulted from risky behaviour by lenders who were encouraged by the policy of the Fed under Alan Greenspan - the 'Greenspan put', to provide liquidity through the lowering of interest rates - in response to perceived shocks in the economy - including the recession that began in March 2001, followed by the terrorist attacks in September, corporate accounting scandals, and a slow recovery.
In fact, the Fed kept the funds target rate unchanged at one per cent from July 2003 to June 2004, certainly unjustified in view of the economy's growth rate.
Moreover, while the Fed may have never embraced a specific policy aimed at bailing out certain companies, its approach seemed to imply that large financial services companies - the crisis at Long Term Capital Management (LTCM) comes to mind - would not be permitted to fail.
We can assume that we can expect similar non-bailouts through a put if and when Citigroup or other financial behemoths face similar problems.
Hence it's not surprising that investors in Wall Street have reacted to each interest rate cut under Ben Bernanke's Fed with a sense of euphoria and big rallies. There is a perception of a 'Bernanke put' - including to the hints that the Fed's policy committee would repeat this performance in the Dec 11 meeting.
Mr Poole stressed in his presentation, that inevitably, 'Fed action to stabilise the economy - to cushion recession or deal with a systemic financial crisis - will have the effect of pushing up stock prices'. But the Fed should not avoid taking action to protect the economy because it might raise stock prices.
Nor, Mr Poole argued, does it make any sense 'to let the economy suffer from continuing declines in stock prices for the purpose of teaching stock market speculators a lesson'. Mr Poole suggested that his decision on whether or not to support another rate cut would depend very much on economic fundamentals, hinting that a better-than-expected employment report could change for the better the perception about the health of the economy.
Other Fed officials like San Francisco Fed president Janet Yellen and vice-chairman Donald Kohn indicated that developments since the last rate policy meeting in October suggested a bigger slowdown than they expected, which could persuade them to cut rates again.
This time, however, it is not inconceivable that investors will gradually come to accept the reality that not even the Fed put could deliver the cure to the current credit squeeze and the housing troubles reflected in the continuing fall in house prices.
There is a rising sentiment that the current property collapse affecting a multi-trillion-dollar market could be devastating to the US economy. There seems to be a sense of a crisis and major doubts about the long-term health of American financial system.
There is a sense that these problems could be beyond the control of the Fed and that not even a Bernanke put could change the perception.
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