The rest of us should hope that even in the current fervid atmosphere, reasoned argument can win out over impassioned ideology.

TO BE NOTED: From the FT:

Treasury rewards waiting

March 24, 2009 11:56am

by FT

By Christopher D. Carroll

Maybe it was worth the wait.

Judging from preliminary details, the US Treasury’s plan to rescue the financial system is a lot savvier about the relationship between financial markets and the macroeconomy than are the usual-suspects: critics from both left and right who are already pouncing on the Geithner plan.

Unlike the critics, the Treasury has absorbed the main lesson from the past 30 years of academic finance research: asset price movements mainly reflect changes in investors’ collective attitude toward risk.

Perhaps the reason this insight has not penetrated, even among academic economists, much beyond the researchers responsible for documenting it, is that it has not been expressed in layman’s terms. Here’s a try: in the Wall Street contest between “fear” and “greed,” fear fluctuates much more than greed (in academic terms, movements in “risk tolerance” explain the bulk of movements in asset prices).

Such extravagant movements in investors’ average degree of risk tolerance have proven impossible to reconcile with economists’ usual benchmark ways of understanding peoples’ attitudes toward risk. One response has been to try to reverse-engineer a “representative consumer” who would choose to behave in a way that matches the data, under the assumption that market prices are always a perfect and optimal representation of rational choice.

Unfortunately, the reverse-engineered preferences look nothing like what we know of household behaviour from a vast literature that observes the choices households make in their daily lives (as documented in a variety of microeconomic datasets).

The second response to the market’s remarkable fluctuations in risk attitudes is more in tune with Warren Buffett’s view, following his mentor Benjamin Graham, that market prices move much more than can be
justified by the sober judgment of someone with a long horizon and stable preferences. Buffett has arrived at his current perch more by skepticism about the market than by unblinking faith in its wisdom. As Mr. Buffett has shown, patient investors who buy low and wait for underpriced assets to recover can do very well indeed.

Which brings us back to the Treasury’s plan. The details flow from an overarching view that the markets for the “toxic assets” that are corroding banks’ balance sheets have shut down in part because in those markets the degree of risk aversion has become not just problematic but pathological. The different parts of the plan reflect different approaches to trying to coax private investors back into the market by reducing their perceived degree of risk to levels that even a skittish risk-shy hedge fund manager might find tempting.

The government and the private investor would be partners in a Buffett-like arrangement in which the assets would be held long enough that the investors can expect to receive payments that have justified the waiting.

This motivation sounds suspiciously like some of the arguments for the ill-fated Paulson TARP plan from last autumn; but the problem with the Paulson plan was never fundamentally with the idea that there were
problems in the market for toxic assets, but with the idea that the right way to fix that problem (and everything else wrong with the economy!) was simply to have the government drastically overpay to buy
up the toxic assets from whoever was foolish enough to have ended up holding them. (Maybe this is not really what Secretary Paulson had in mind, but it seems the most sensible interpretation). Instead, the new
plan from the Treasury gives private investors (who know more than Treasury about the likely payoffs of these securities) the pivotal role in competing to set the prices of the securities, via a competitive auction process.

The private investors currently on the sidelines are not fools and have no incentive to lose money on the deal. In addition, there is no pretense now (as there was last autumn) that the resolution of the toxic assets problem is the sole remedy for our economic woes; it is part of a carefully conceived plan including the
stimulus bill, the housing foreclosure mitigation plan, the TALF plan for reviving the market for securitised assets, the bank “stress tests” designed to triage the good banks, the salvageable banks, and the zombie banks; and a host of other measures designed to address other aspects of the crisis.

Finally, the new plan’s principal goal, fostered in numerous ways, is to induce private investors to come off the sidelines and reengage with the markets, while the Paulson plan’s mechanisms for accomplishing that goal were either murky or nonexistent.

When fuller details emerge, it would be useful if the economics profession and the financial community could have a mature conversation about whether the plan could be improved before it goes
into operation. For example, it may be necessary to make any bank that participates agree to the sale of all their toxic assets, to prevent the kind of cherry picking that has contributed to the shutdown of
these markets so far. And there is good reason to be very careful to minimize the possibility of “heads-I-win, tails-the-government-loses” kinds of bets.

But broad-brush denunciations are unhelpful, whether they derive from preconceived prejudices of the left (which needs to recognise the important distinction between the greedy people who got us here and the wise captains of finance who can help us get out), or the right (which espouses a destructive ideology according to which all government action of any kind is a mistake).

The rest of us should hope that even in the current fervid atmosphere, reasoned argument can win out over impassioned ideology.

Christopher D. Carroll is professor of economics at the Johns Hopkins University"

by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets

TO BE NOTED: From Vox:

"Punter of last resort

Debate: Financial rescue and regulation, a Global Crisis Debate Posted by: Christopher D. Carroll (Department of Economics, Johns Hopkins University), 18 March 2009

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The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”

The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) ‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson’s comment that “utility maximization is a metaphysical concept of impregnable circularity,” and Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the ‘puzzle’ does not seem to have weakened participants’ belief in the soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the “lender of last resort” role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today’s terminology, ‘an increase in the price of risk’).¹

Some economists, of course, view narrative history in the deLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the ‘risk-free’ rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.² Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as ‘risk-free’ is that the Fed takes away the risk.³

Figure 1a

Figure 1b

Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn’t change that now.

But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,⁴ shows that over the “Taylor Rule” era of systematic monetary policy (roughly since 1984), the Federal Reserve’s choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

Let’s put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.⁵ The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences. ( NB DON )

As the Economist magazine might put it, the problem is that the ‘punters’ (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the ‘lender of last resort’ to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed’s appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.

Christopher D. Carroll

Department of Economics, Johns Hopkins University

References

Barbera, Robert J., and Charles L. Weise (2008): “Minsky Meets Wicksell: Using the Wicksellian Model to Understand the 21st Century Business Cycle,” Manuscript, Gettysburg College, Available at http://www.gettysburg.edu/dotAsset/2104335.pdf.

DeLong, J. Bradford (2008): “Republic of the Central Banker,” The American Prospect, Available at http://www.prospect.org/cs/articles?article=republic_of_the_central_banker.

Holland, A. Steven, and Mark Toma (1991): “The Role of the Federal Reserve as “Lender of Last Resort” and the Seasonal Fluctuation of Interest Rates,” Journal of Money, Credit and Banking, 23(4), 659–676, Stable: http://www.jstor.org/stable/1992702.

Kindleberger, Charles P. (2005): Manias, Panics, and Crashes: A History of Financial Crises. Wiley, 5th Edition.

Macaulay, Frederick R. (1938): The Movements of Interest Rates, Bond Yields and Stock Prices in the United States Since 1856. National Bureau of Economic Research, New York.

Mehra, Rajnish, and Edward C. Prescott (1985): “The Equity Premium: A Puzzle,” Journal of Monetary Economics, 15, 145–61, Available at http://ideas.repec.org/a/eee/moneco/v15y1985i2p145-161.html.

Weise, Charles L., and David Krisch (2009): “The Monetary Response to Changes in Credit Spreads,” Paper Presented at the Eastern Economic Meetings, March 1 2009, Corresponding Author: Charles Weise, weise@gettysburg.edu."