Questions raised by the Fed’s role in the crisis

The commentary on the crisis information recently released by the Fed has devolved into a dispute about the “correct” way to interpret the data.  But this dispute obfuscates the important questions raised by the Fed’s actions.  A good analogy for understanding what took place is to think of the Fed as the provider of shelter in a storm:

There was hurricane going on outside and the banks needed shelter.  The Fed provided the shelter.  But it turns out the shelter wasn’t just for one night and it wasn’t just for one bank.  The Fed provided shelter to all the banks for months on end.  Some banks were sheltered at the Fed for more than a year.

It is this long-term aspect of the Fed’s “emergency” lending that forces one to question whether this was emergency lending at all.  And raises the following questions:

Did the banks have a duty to construct their own shelters to weather the hurricane?
Or is the Fed their liege lord with a duty to protect them?  If the Fed has a duty to protect the banks in a hurricane, then what is the likelihood that the existence of that duty is the reason the hurricane lasted so long?  (These storms are clearly not acts of God, but entirely endogenous to the actions of the banks.)
By providing such extensive shelter, does the Fed discourage the banks from building their own storm-worthy shelters?

Did the banks pay a fair rate for the shelter?  Did they just do the dishes every night or did they pay a “normal times” market rent of say 5% of the market value of the shelter per annum or did they pay a rate closer to the value to them of the shelter?  Aren’t liege lords entitled to something like a third of their clients’ gross revenue annually in good times and in bad?

What about the decision the Fed makes about who gets shelter?  Does the Fed provide shelter to all the banks, or only to a select few banks?  Should consumers — or non-financial firms — have access to this shelter?  If not, why not?

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Failure is the only sure path to a safer financial system

There is a truly egregious error — that reflects the modern anti-capitalist view of financial markets — in an otherwise informative article on the shadow banking system by Kelly Evans of the WSJ.  She writes:

There are two basic ways to make a financial system safer: insurance and regulation.

There is undoubtedly a third way to make the financial system safer:  regular failure of financial institutions.  This is the only proven way to make a financial system safe, since its the one that existed from the 13th century and was the foundation on which the modern financial system was built over more than half a millenium.

Minsky is regularly discussed, but his ideas don’t seem to have actually penetrated the discourse:  stability is destabilizing.  The most stable financial system it is possible to achieve is one with regular bank failures.  The analogy is to the management of forest fires which when allowed to occur regularly have the beneficial effect of clearing the undergrowth, revitalizing the forest, and reducing the likelihood of a truly destructive conflagration.

The problem in our financial system is not an insufficient supply of safe assets, but the concept that there is such a thing as a safe asset.  Keynes’ clear explanation of the ephemeral nature of liquidity debunked this view generations ago. (See Ch 12 of the General Theory, well discussed here).

Regular failures of financial institutions are the best way to ensure that the risks inherent in every financial asset are constantly being taken into account.  It is far more likely to be successful than insurance, which given the political muscle of the financial industry is guaranteed to be underpriced (see the experience of the FDIC, from 1996 to 2006 most banks paid nothing in FDIC premia) or regulation, as the regulators are unlikely to ever have a deep enough understanding of the current structure of the industry (which is always morphing in light of new regulations) to keep banks from making short-term profits while putting the losses to the taxpayer.

The only long-term solution to this problem is financial institution failure, regular, repeated and built into the very structure of the market.