Monday, March 17, 2008

Why the Fed must act in unfamiliar ways

(Mohamed El-Erian in the FT) It is déjà vu for those who remember previous emerging market crises: imploding balance sheets, a bank run, disorderly falls in the currency and emergency policy responses (including on a Sunday evening). Yet there is a huge difference: this is happening in the US and not in an emerging economy.

In spite of significant – and previously unthinkable – measures, the US still faces the risk of further reductions in financial leverage in both the economy as a whole and at the level of individual companies. Sudden stops in the availability of liquidity remain possible, especially for hedge funds; and “price gapping” – where asset prices rise or fall suddenly – will remain the norm. As they consider what to do next, the US authorities would be well advised to study the experience of emerging economies. If they do, they will focus on three main findings.

First, incremental steps using traditional policy instruments are inef­fective. As Sunday’s announcements from Washington indicate – including the creation of a lending facility for primary dealers – crisis management is about imaginative policies in the context of high uncertainty. Second, it is no longer a matter of designing a perfect policy response. It is about finding the one with the least collateral damage and backing it with meaningful international support. Third, the earlier the authorities move with their policy response and stay ahead of the process of reducing levels of leverage, the less severe will be the clean-up that needs to be done once the financial crisis abates.

Where do US policymakers stand relative to these findings; and what are the implications? Over the past few weeks, the policy stance has evolved away from reliance on traditional instruments. Part of this – such as the Federal Reserve’s bold attempt on Friday to contain the sjtuation at Bear Stearns, the investment bank, and Sunday’s follow-up announcements – is the result of forced events. Part is more deliberative, reflecting the need to target housing, which lies at the centre of the turmoil.

There is now recognition that the incremental approach did not succeed in getting ahead of the reductions in leverage. Instead, markets looked for a floor for asset prices using a disrupted mechanism of price discovery in the context of illiquidity. To stop this from pulling the rug from underneath the domestic economy, policymakers now face the unpleasant reality of having to cross at least one of two lines in the sand: altering contracts so that stressed mortgage holders can avoid default and foreclosures; and/or explicitly using the government’s balance sheet to support the housing market. The aim must be both to complement Fed financing and to shift the policy focus from institutions to assets.

Breaching either line involves long-term damage to the US economy – most notably through moral hazard. In intervening to stabilise the system as a whole, the authorities end up protecting certain people and institutions from the consequences of their ill-advised actions, thereby undermining the discipline that is crucial to market efficiency. As unpleasant as this is, the moral hazard risk is inevitable at this advanced stage of the crisis. Indeed, the question is not just what happens to irresponsible lenders and imprudent borrowers. It is also about the damage that is being inflicted on others as the financial system freezes.

There are other components of collateral damage. Crossing the first line critically undermines the sanctity of contracts and, at the very minimum, leads to a persistent increase in the risk premiums that lenders impose on all borrowers. In addition, there may be unintended consequences that erode the integrity of the market system.

The other line, which involves the authorities’ balance sheet, amplifies inflationary pressures and weakens public finances. Yet these costs are less persistent and, as such, lower than those associated with the alternatives. Indeed, the real cost of the second regime shift is more nuanced. It relates to forcing institutions to operate outside their comfort zones and, perhaps, beyond their core competencies.

This is what the Fed faces today. Its traditional instruments are too blunt to get to the root of the problem. They must be supported by fiscal measures that target housing directly. Yet there are inevitable operational problems in using the Federal Housing Administration, creating a new institution or approving a new fiscal package. As such, a Fed that is anchored by a dual (growth and inflation) mandate may be forced to go beyond financing institutions and engage in fiscal action through the use of its balance sheet.

How about the international dimension? The past few weeks have been characterised by a deafening silence on the part of the European and Japanese policymakers when it comes to the US situation. This has contributed to currency market instability.

All this suggests that are no easy answers for policymakers; but there is a right answer that consists of at least two additional components.

First, supplement monetary policy by getting the Fed to fill the void left by slowing moving fiscal agencies – through outright purchases of high-quality mortgage securities or by extending financing terms to one year. And, second, there should be co-ordinated central bank intervention to counter disorderly exchange rates that exacerbate the credit turmoil.

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