Perhaps it’s true what George Bernard Shaw said – that if you laid down every economist in a line, they still wouldn’t reach a conclusion. Things are decidedly inconclusive at Jackson Hole in Wyoming, where central bankers are meeting for their annual symposium.
Powerful voices in the Fed are angling for a rate cut to help house prices and buoy markets, but they’re being met by those who see cuts as a dangerous moral hazard in a classic bank-run.
According to Axel Weber, the German Bundesbank chief, the current financial crisis bears all the hallmarks of a bank-run. You know the kind of thing – frustrated savers scrambling to cash in their flimflam paper at the Western Union for its value in gold. Something like that anyway. Weber told an audience at Jackson Hole:
What we are seeing is basically what we see underlying all banking crises
In his analysis, markets, just as in the 19th century, are currently prey to a spiralling liquidity crisis created as investor confidence drops and everyone rushes to get their chips off the table.
The difference is that this time, it’s not a run on the banks. Instead, noted Weber, the current liquidity storm is being weathered by unregulated financial institutions – hedge funds, banking conduits, SIVs and such like. It is what Paul McCulley, managing director of Pimco, has termed a “run on the shadow banking system”.
This is problematic then, for regulators like the Fed, which were created in the 19th century to deal with liquidity crises in the actual banking sector. Whereas banking crises in the past could be cooled by – in Ben Bernanke’s subtly crafted words – “a helicopter load of money”, that avenue is closed, because central banks are prohibited from lending to the unregulated institutions behind the current storm. The liquidity central bankers have injected into the system so far has been poorly targeted and hasn’t run to where it’s actually needed.
In Weber’s analysis, the problem is that regulators have only their bluntest tool left to calm the markets – loosening their monetary policy. But we all know the arguments against that one.
Also speaking at Jackson Hole on Saturday, James Hamilton, the distinguished professor of economics at the University of California, agreed with Weber. The problem, said Hamilton, is the parlous state of lending and debt in the modern market at large – something a rate cut would spur rather than spurn.
The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run…. The problem arises when the losses on the institution’s assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavourable terms, causing an otherwise solvent institution to become insolvent….
But, it would seem there is a significant diversion of opinion among the central banking community of the world. For while the ECB is likely to keep rates on an even keel next week, it’s looking ever likelier that the Fed will loosen the spigot.
Weber and Hamilton’s analyses run counter to powerful voices in the Fed who are arguing for a cut. The imprimatur of the “Greenspan put” – the notion that markets should be supported by low rates and high house prices – is still obvious in Ben Bernanke’s administration. Markets need to be stimulated by a load of cash – and a rate cut would do just that.
Frederic Mishkin, a governor of the Fed set out the most powerful case for rate-cutting yet on Saturday. The “optimal response” to a decline in house prices, said Mr Mishkin, would involve “quicker, more aggressive interest rate cuts”. To most Jackson Hole observers , Mishkin’s remarks make a rate cut on September 18 seem like a fait accompli.
So why would a rate cut be unadvisable? Well, say Hamilton and Weber, if it’s a bank run, then the problem is with the state of lending and debt in the first place. A rate-cut would do nothing but offer short term relief. One final word from Hamilton’s Jackson Hole speech:
Governor Mishkin discusses the potential role of real estate prices in the monetary transmission mechanism. I am seeing that not as an issue in its own right, but instead as a symptom and a propagation mechanism of the broader problem. It is a symptom in the sense that, if loans were extended to people who shouldn’t have received them, real estate prices would have been bid up higher than they should have been. And it is a propagation mechanism in the sense that, as long as house prices continued to rise, all sins were forgiven.
Forgive and forget, says Hamilton, just won’t wash.