Speech

Market Bailouts and the “Fed Put” CatoInstitute Washington,D.C. November30,2007 Federal Reserve policy actions starting policywouldhavesupportedthestockmarketto this past August to temper strains in somedegreein1930-32,woulditbeaccurateto financial markets have generated con- saythattheFedhad“bailedout”equityinvestors siderable commentary, some of which andcreatedmoralhazardbydoingso?Inotethat reflect concerns that policy action in such cir- amoreexpansionarymonetarypolicyin1930-32 cumstances creates moral hazard. The issue is would,presumably,havesupportednotonlythe extremely important, and, given that it is so stockmarketbutalsothebondandmortgage current, this is a good time to reflect in general marketsandthebankingsystem—byreducing on the Fed’s reactions to financial market devel- thenumberofdefaultscreatedbybusinessand opments. The concern over moral hazard is that householdbankruptciesinsubsequentyears. monetary policy action to alleviate financial Nowapplythesequestionstothecurrentsit- distress may complicate policy in the future, by uation.DidtheFed“bailout”themarketswith encouragingriskyinvestinginthesecuritiesmar- itspolicyadjustmentsstartinginAugustofthis kets.Therearesofewinstancesofmarketturmoil year?Haveweobservedanexampleofwhatsome similar to the current situation that I’ll broaden observershavecometocallthe“Fedput,”typi- the analysis to include significant stock market callynamedafterthechairmaninoffice,suchas declines. Doing so gives us a substantial sample the“Greenspanput”orthe“Bernankeput”?1 to discuss. Thus, my topic is whether Federal Whyhasnoone,atleastnotrecentlytomyknowl- Reserve policy responses to financial market edge,arguedthatamoreexpansionaryFedpolicy developmentsshouldberegardedas“bailingout” in1930-32wouldhave“bailedout”thestock market participants and creating moral hazard marketatthattimeand,byimplication,have by doing so. beenunwise? Tobegintoexplorethemoralhazardissue, Icanstatemyconclusioncompactly:There consideranextremecase,whichIofferasaprovo- isasenseinwhichaFedputdoesexist.However, cationtopromotecarefulanalysisandnotasan thosewhobelievethattheFedputreflectsunwise exampledirectlyrelevanttotoday’scircum- monetarypolicymisunderstandtheresponsibil- stances.Fact:TheU.S.stockmarketbetweenits itiesofacentralbank.Thebasicargumentisvery peakin1929anditstroughin1932declinedby simple:Amonetarypolicythatstabilizestheprice 85percent.Question1:IftheFedhadfolloweda levelandtherealeconomycannotcreatemoral moreexpansionarypolicyin1930-32,sufficient hazardbecausethereisnohazard,moralorother- toavoidtheGreatDepression,wouldthestock wise.Nordoesmonetarypolicyactiondesigned markethavedeclinedsomuch?Question2: topreventafinancialupsetfromcascadinginto Assumingthatamoreexpansionarymonetary financialcrisiscreatemoralhazard.Finally,the 1 Aputoptioncontractprovidesthatthebuyerofthecontractcansellanitem,suchas100sharesofcommonstockofaparticularcompany, foracertainprice—thestrikeprice—foracertainperiod.Thecontractprotectsthebuyerfromdeclinesinthestockpricebeyondthestrike price.The“Fedput”terminologyimpliesthatFedpolicyadjustments,byanalogywithaputoption,willpreventstockpricedeclinesbeyond somepoint. 1 MONETARYPOLICYANDINFLATION notionthattheFedrespondstostockmarket creatingapresumptionthatinthefuturethe declinesperse,independentoftherelationship governmentmayagainrescueafailingfirm.That ofsuchdeclinestoachievementoftheFed’sdual presumptionencouragesafirmanditsinvestors mandateintheFederalReserveAct,isnotsup- tobelesscarefulthantheyotherwisewouldbe portedbyevidencefromdecadesofmonetary abouttakingrisks.Ifafirmexpectsabailout,it history. believesthatgovernmenthelpwillcoverlosses Beforeproceeding,Iwanttoemphasizethat whilethefirm’sownerscanenjoythegains,ifany, theviewsIexpressherearemineanddonot fromriskystrategies.Whenthegovernmentis necessarilyreflectofficialpositionsoftheFederal expectedtoabsorblosses,bailoutsunavoidably ReserveSystem.Iappreciatecommentsand increaseinappropriaterisktaking,whichincreases researchassistanceprovidedbymycolleaguesat thelikelihoodoflossesinthefuture. theFederalReserveBankofSt.Louis.However, Astandardprobleminwritingandadminis- Iretainfullresponsibilityforerrors. teringinsurancecontractsisthatthebuyerof Myapproachwillbetostartbydiscussing insurancehaslessincentive,byvirtueofbeing bailoutsandmoralhazardingeneral.Iwillthen insured,tocontrolrisk.Almosteveryonehashad examinetherecordofstockmarketdeclinesand theexperience,farfromuplifting,oftalkingwith Fedpolicyadjustmentsandanalyzehowmone- someonewhosays,“don’tworry—it’sinsured.” tarypolicychangesthenatureofrisksinfinancial Theveryexistenceofinsurancemaychangethe andgoodsmarkets.Finally,Iwillarguethatthe behavioroftheinsuredperson.Insurancecom- waysinwhichmonetarypolicyaltersrisksin paniestrytodealwithmoralhazardinavariety themarketsyieldbenefitsfortheeconomyand ofways,suchasbywritingcontractswithsub- donotcreatemoralhazard. stantialdeductiblesorlosssharing.Suchcontract provisionsprovideanincentivefortheinsured tocontrolrisk. UNDERSTANDING BAILOUTS Governmentguaranteeprogramsalsogener- Atraditionalbailoutinvolvesgovernmental allyrequiresomelosssharing,buttherearemany assistancetoaparticularfirm,groupoffirms,or governmentprogramsandpracticesthatdonot groupofindividuals.Foreaseofexposition,I’ll adequatelycontrolmoralhazard.Perhapsthe concentrateonbailoutsoffirmsbutthesame mostdangerouspracticeistheexpostbailout, issuesapplytobailoutsofhouseholds.There whereafirmisrescuedoutsideofanyregularor maybeoccasionswhenagovernmentinfusion standingprogram.Suchabailoutcanchangethe ofcapitaltosaveafirmisjustified,suchasa rulesofthecompetitivegameinunpredictable bailoutofamajordefensecontractorduring ways.Noonecanknowwhetherabailoutwill wartime.However,mosteconomistsbelievethat berepeatedornot.Thosewhocontrolrisksand bailoutsarerarelyjustifiedandonlyincompelling actuallybearlosseswilljustifiablybelievethata circumstancesshouldthegovernmentbailout taxpayer-fundedbailoutofanotherfirmisunfair. individualsorfirms.2 TheFederalReservehasnofundsandno Animportantreasonforoppositiontobailouts authoritytoprovidecapitalorguaranteestofirms isthatitisessentiallyimpossibleforabailoutnot toprovideabailoutinthetraditionalsense.The tosetaprecedentforthefuture.Abailoutcreates Fedcannotevenbailoutbanks.TheFedcan whatisknownintheeconomicsandinsurance makeloanstobanks,butonlyloansthatarefully literatureas(aforementioned)“moralhazard”by securedbygoodcollateralandonlytobanksthat 2 Ofcourse,theFederalDepositInsuranceCorporation(FDIC)isobligatedtoprotectdepositorsfromlossoncovereddepositsanditissome- timestruethatthecheapestwaytohandleafailedbankistomergeitwithanotherbank,withtheFDICprovidingacapitalinfusion.Tothe extentthatthereisasafetynetforuninsureddepositors,abankbailoutdoesraisemoralhazardissues.Idonotmeantoimplythat“toobig tofail”isnotanimportantissueforfederalpolicy. 2 MarketBailoutsandthe“FedPut” arewellcapitalized.TheFedcanlendtoweak berofyearsandthediscountinfactencourages banksrequiringemergencyassistancetoprevent saferdriving,thenthateffectisnot“moralhaz- immediatecollapse,butagainonlytothosewith ard.”Fromtheperspectiveoftheinsurer,the adequatecollateral.TheFedworkscooperatively policychangesbehaviorinadesirableratherthan withtheFDICandotherbankregulatorstoclose aharmfulway.Thispointisacriticaloneinthe abankindistressortofindawillingbuyer. contextofmonetarypolicy,towhichInowturn. Creditorssometimesbailoutdebtorstoa degree,byrestructuringobligationstoextendthe repaymentperiodortoreducetheinterestrate. THE FED PUT Restructuringamortgageisoftenintheinterest The“Fedput”argumentisusuallystatedin oftheborrower,whomaybeabletoavoidfore- termsofmonetarypolicyreactionstostockmar- closure.Restructuringmaymakesenseforthe ketdeclines.ConsiderFigure1,whichplotsthe lendertoavoidthecostsofbankruptcyandto naturallogoftheS&P500indexandidentifies obtainthemaximumpossiblereturnfromafailing allstockmarketdeclinesof10percentormore loan.Nevertheless,lendersobviouslymustbe since1950.3Thefigurealsoshowsameasureof carefulnottomaketermstooeasyforaborrower theFederalReserve’spolicyrate.4Thepolicyrate lestotherborrowersaskforsimilartermsorfuture inthefigureisthediscountratebeforeOctober1, borrowersfailtoservicetheirobligations.Abail- 1982,andthefederalfundstargetratethereafter. outofthissortisfundamentallydifferentfroma Shadedareasshowrecessionsasdefinedbythe governmentbailoutbecausethelendersuffers NationalBureauofEconomicResearch. thelossandnotthetaxpayer.Lossesmotivate lenderstobemoredisciplinedintheirfuture Thefigureshows21stockmarketdeclinesof decisions. 10percentormore.Withinthreemonthsofthese Whydoweusetheterm“moralhazard”? stockmarketpeaks,theFedheldthepolicyrate Usingtheinsuranceexample,thehazardtothe constant,orincreasedit,on12occasions.There insurancecompanyarisesfrombehaviorinduced wasaFedratecutwithinthreemonthsonnine byinsurancethatmaybeadversetotheinterests occasions,5butforfiveofthesenineratecutsthe oftheinsurer.The“moral”in“moralhazard” Fedactedbeforethestockmarketpeak;itspolicy referstobehaviortheinsuredknowsisadverse actionscouldnothavebeenmotivatedbystock totheinsurer’sinterest—behaviortheinsured marketdeclines.Fedratecutsdidfollowthe wouldnotengageinwerehetosufferthefull stockmarketpeakinlateSeptember1976;the consequencesofthebehavior.Insurancecompa- firstratecutcamenineweekslater.6Anothercase niestrytomaintainpracticesdesignedtoencour- occurredafterthemarketpeakinJuly1998;a ageappropriatebehavior.Ifaninsurancecompany FedratecutinlateSeptemberwasaresponseto providesapremiumdiscountforadriverwho thesituationinthemoneymarketsfollowingthe submitsnoinsuranceclaimsoveracertainnum- nearcollapseofLong-TermCapitalManagement 3 TheS&P500seriesistheweeklyclose(FridaycloseunlessFridayisaholiday).Eachmarketpeakwasdefinedthisway:Undercriterion1, thepeakexceededthepreviouspeakandthemarketdeclinedby10percentormorefollowingthepeak.Undercriterion2,thepeak,followed byadeclineofatleast10percent,didnotexceedthepreviouspeakbutarecoveryofatleast10percenthadoccurredbetweenthetwopeaks. 4 ThepolicyrateinthefigureistheFed’sdiscountratebeforeOctober1982andtheFOMC’sfederalfundstargetratethereafter.Othermeas- uresareavailableforcertainpartsoftheperiodbefore1982,butusingthemwouldcreateseveraldiscontinuitiesinthepolicyrateseries. SeeRudebusch(1995,Table3a)forafederalfundstargetrateseriesfor1974-79. 5 OneoftheninewasthemarketpeakinNovember1968.Asthefiguremakesclear,theratecutprecedingthismarketpeakwassmalland temporary.Subsequently,theFedraisedratesandthecutsdidnotbeginuntiltheendofthe1969-70recession,atwhichpointstockprices startedtorise. 6 Rudebusch(1995,Table3a)identifiestwocutstotaling25basispointsintheFOMC’stargetfederalfundsrateinJuly1976andtwomore totalinganother25basispointsinOctober.Bythismeasure,therefore,FedratecutsbeganbeforetheSeptember1976stockmarketpeak. 3 MONETARYPOLICYANDINFLATION 8 7 6 5 4 3 2 (LTCM)andnotaresponsetothestockmarket Becausethe“put”languagebecamecurrent perse.7 duringtheGreenspanera,let’sexaminestock ThemarketpeakinMarch2000usheredin marketdeclinesof5percentormorethatdidnot thegreatbearmarketthatendedinOctober2002. reachthe10percentthreshold.Usingthe5percent Theinitialdeclinewassharp,butthemarket criterion,therewasamarketpeakinSeptember recoveredtoreachanotherpeakinearly 1989,andtheFeddidcutitspolicyratefollow- September2000thatwasonlyslightlylowerthan ingthatpeak.However,theFedhadstartedtocut theMarch2000peak.Duringthecourseofthe ratesinJune1989.Anothermarketpeakmeeting bearmarket,therewereseveralpeaks,each the5percentcriterionoccurredinlateJanuary lowerthantheonepreceding,followingsignifi- 1994,whenthepolicyratewas3percent.There cantrecoveries.Duringthisperiod,theFederal wasanothersuchpeakinAugust1994.TheFed OpenMarketCommittee(FOMC)cutthepolicy proceededtoraisethepolicyrateseveraltimes ratein10stepsfrom6.5percentto1.75percent in1994,startinginFebruary,anditreached6 inDecember2001andintwomorestepsto1 percentinJanuary1995. percentinJune2003.Thepolicyratecutswere Anothermarketpeakmeetingthe5percent notcloselyrelatedtothestockmarketdeclines criterionoccurredinJune1996.TheFOMChad afterthelocalpeaksanddeclinesthatcontinued cutthepolicyrateto5.25percentinJanuary1996, untilthemarkethitbottominOctober2002. andthepolicyrateremainedthereuntiltheFOMC 7 ThetranscriptsofFOMCmeetingsin1998provideexcellentinsightintotheCommittee’smotivationindealingwiththeLTCMsituation.Of course,motivationisnottheendofthematter;well-intentionedactionscanhaveunintendedadverseeffects.The1998and1999transcripts showthattheCommitteewaswellawareofthepotentialforinflationaryconsequencesofpolicyeasinginresponsetotheLTCMsituation. Transcriptsareavailableathttp://www.federalreserve.gov/fomc/transcripts/. 4 05-naJ 25-naJ 45-naJ 65-naJ 85-naJ 06-naJ 26-naJ 46-naJ 66-naJ 86-naJ 07-naJ 27-naJ 47-naJ 67-naJ 87-naJ 08-naJ 28-naJ 48-naJ 68-naJ 88-naJ 09-naJ 29-naJ 49-naJ 69-naJ 89-naJ 00-naJ 20-naJ 40-naJ 60-naJ Figure 1 Declines Greater Than 10 Percent in the S&P 500 and Fed Policy Rate LN (S&P 500) Fed Policy Rate 16 14 12 10 LN(S&P500) 8 (left axis) 6 4 PolicyRate 2 (rightaxis) 0 R MarketBailoutsandthe“FedPut” raiseditinMarch1997.Thisincreaseoccurred Therulethatasoundinvestmentmustbeable shortlyafteranotherstockmarketpeakmeeting towithstandadversityseemsself-evident the5percentcriterionearlierthesamemonth. enoughtobetermedatruism.Anybondor preferredstockcandowellwhenconditions Twomorepeaksmeetingthe5percentcriterion— arefavorable;itisonlyundertheacidtestof oneinAugust1997andoneinDecember1997— depressionthattheadvantagesofstrongover occurredwhiletheFOMCwasholdingthepolicy weakissuesbecomemanifestandvitally rateconstantat5.5percent. important.Forthisreasonprudentinvestors Thishistorymakesclearthatitjustisnottrue havealwaysfavoredtheobligationsofold- thattheFOMChaseasedpolicyinsystematic establishedenterpriseswhichhavedemon- fashionatthetimeofstockmarketdeclines,with stratedtheirabilitytocomethroughbadtimes theexceptionoftheperiodfollowingthe1987 aswellasgood.”(GrahamandDodd,1951, stockmarketcrash.Eventhisexperience,however, p.289) reinforcestheargumentthattheFOMC’sprimary Withregardtoinflationrisk,Grahamand concerniswithitsmacroeconomicobjectivesand Doddsaythat“[t]hesewidemovementsofthe notwiththestockmarketitself.Policyeasing generalpricelevel…seemtocarrythelessonthat occursattimesofrecession,althoughsometimes thelong-termtrendistowardinflation,punctu- isdelayedbecauseofconcernoverinflation.The atedbyequallytroublesomeperiodsofdeflation. Fedeasedpolicyaheadofthe1990-91recession Investmentpolicymustaccommodateitself,as andaheadofthe2001recession.TheFedhasalso farasitcan,tobothpossibilities”(Grahamand easedpolicyinresponsetoturmoilinthecredit Dodd,1951,p.8). markets,asinthefallof1998andstartingin Howmanyinvestorstodaymeasurethevalue Augustof2007.Clearly,though,onnumerous ofabondbythelikelihoodthatitwillcontinue occasionstheFedhashelditspolicyratecon- topayinterest“undertheacidtestofdepression”? stant,orraisedit,asstockpricesdeclined. Howmanyinvestorstodaymaintainportfolios robustagainstthepossibilityofinflationofthe magnitudeexperiencedinthe1970sordeflation EFFECTS OF FED STABILIZATION ofthemagnitudeexperiencedintheearly1930s? Theanswer,Ibelieve,is“notmany.” POLICY ON FINANCIAL MARKETS Thefactthatfewinvestorsworryabout AlthoughthereisnoevidencethattheFed extremeeconomicinstabilityisabenefitof respondstothestockmarketperse,thereisan soundmonetarypolicyandnotacost;changes elementoftruthtotheargumentthatFedpolicy ininvestorpracticeareconducivetohigherpro- canlimitdownsideriskinthestockmarket.The ductivitygrowth.Thesameistrueforchangesin sameFedpolicythatsucceedsinstabilizingthe householdandfirmbehaviorreflectingthegreatly pricelevelandtherealeconomyshouldtendto reducedriskofeconomicdepressionoreven stabilizefinancialmarketsaswell.Thus,theele- severerecessionofthemagnitudeof1981-82.If mentoftruthinthe“Fedput”viewreflects wedidnotbelievethateconomicstabilityisgood expectedanddesirableoutcomesfromsuccessful fortheeconomyandforsociety,whywoulda monetarypolicy.Generaleconomicstability,by stablepricelevelandhighemploymentbemon- whichImeanbothstabilityofthepriceleveland etarypolicygoals?Justasadeductiblechanges oftherealeconomy,doeschangethenatureof behaviorofinsurancepolicyholders,soalsodoes risksinthefinancialmarketsand,therefore, economicstabilitychangeinvestorbehavior. changesinvestorstrategies. Economistshavelongarguedthatpricestabil- ConsiderthesecondofGrahamandDodd’s ityimproveseconomicefficiency,inpartbecause “FourPrinciplesfortheSelectionofIssuesof businessesandindividualscanmakedecisions theFixed-IncomeType”: undertheassumptionthattheydonotneedto 5 MONETARYPOLICYANDINFLATION pursuestrategiesdesignedtocopewithachang- todestabilizetherealeconomy.Thosewhostill ingpricelevel.Inflationanddeflationdistort believethatthereisatrade-offbetweeninflation relativeprices;suchdistortionleadstomisallo- andunemploymentshouldreflectonthefacts cationsofresources.Withgreatlyreducedriskof thattheGreatDepressionwasaconsequenceof pricelevelinstability,investorsconcentrateon deflationandtherecessionsof1969,1973-75, risksrelatingtochangesindemands,technology, 1980,and1981-82wereconsequencesofthe andrelativeprices.Betterevaluationofthese GreatInflation. riskspromotesmoreefficientallocationofcapital Withrespecttofinancialinstability,thecen- andfostershighereconomicgrowth. tralbankhastheresponsibilitytodowhatitcan Monetarypolicysuccessinstabilizingthe toalleviatemarketturmoil.Whenthereisawide- generallevelofpricesdoesnoteliminaterisks spreadincreaseinriskaversionandaflightto fortheeconomy.Therealeffectsofinflationor safeassets,thecentralbankoughttoprovide deflation,shouldeitheroccurinthefuture,will extraliquiditytopreventbankrunsfrombringing bemagnifiedpreciselybecausetheeconomy downthebankingsystem.Provisionofextra todayhasadjustedrelativelycompletelytoan centralbankliquiditydoes“bailout”firmsthat environmentofpricestability.Oneofthereasons hadnotmaintainedsufficientliquiditythem- theGreatInflationwassocostlywasthateco- selves.Hereagain,though,theterm“bailout,” nomicagentsin1965didnotanticipatetheinfla- withitspejorativeconnotations,iscompletely tion.Decisionsandinstitutionsthathadbeen inappropriate.Inafractionalreservebanking sensibleandefficientinanenvironmentofprice system,itissimplyimpossibleforownersof stabilitybecameunprofitableasinflationrose bankliabilitiestoconvertalltheirliquidclaims after1965. tocash,buttheefforttodosowilldrivedown Wheneventsthreatentocreateinflationor aggregatedemand.Thesameargumentapplies deflation,theFedoughttoacttomaintainprice toliquidclaimsissuedbynon-bankfinancial stability.ItistruethatFedactionsinsuchcircum- firms.Widespreadbankfailureswilldestroythe stances“bailout”investorswhowouldloselarge claimsofprudentinvestors,aswellasofthe sumsshouldinflationordeflationtakehold.But imprudent. “bailout”isacompletelyinappropriatetermto Forafractionalreservebankingsystemto useinthiscontext,foritimpliescostsofthesort work,acentralbankmuststandreadytobethe discussedearlierwhenthegovernmentprovides ultimatesourceofliquidityforsolventbanks,and capitaltosupportfirmsthatwouldotherwisego banksinturntakethecreditriskofproviding bankrupt.Thecentralbankissupposedtostabi- liquiditytosolventnon-bankfirms.By“solvent,” lizethepricelevel;theeconomyisbetteroffwhen whatImeaninthiscontextisthatafirm’sassets peopleactonajustifiedbeliefthatthecentral valuedatanormallevelofeconomicactivity bankwillbesuccessful. coverthefirm’sliabilities,leavingareasonable Exactlythesameargumentappliestocentral levelofnetworth.Thefirm’scapitalcanabsorb bankactionsinresponsetoeventsorshocksthat lossesoccasionedbynormalbusinessrisks.We mightdrivetheeconomyintorecession,orinto canargueaboutwhat“normalbusinessrisks” anunsustainableboom.Providedthatthecentral shouldbecovered;but,inmyview,economic bankdoesnotsacrificelong-runpricestability,it depression,hyperinflation,andfinancialimplo- canandshouldrespondtonewinformation sionarenotincluded. indicatinganincreasedriskofrecession.There Thestockmarketrespondstochangingexpec- isnoconflictbetweenthegoalsofpricestability tationsconcerningcorporateprofits,which andhighemployment.Pricestabilityandexpec- dependinpartonthestateoftherealeconomy. tationsofpricestabilitypermitthecentralbank Sloweconomicgrowthoroutrightrecessiontends torespondconstructivelytoshocksthatthreaten toreduceprofitsandthelevelofstockprices.It 6 MarketBailoutsandthe“FedPut” isdesirablethatinvestors’expectationsofprofits DOES FED POLICY SUCCESS reflectknowledgethatthecentralbankwill BREED FINANCIAL MARKET respondconstructivelytonewinformationabout INSTABILITY? thelikelycourseoftherealeconomy.AndIuse theword“knowledge”deliberatelyandnotjust Somehaveargued,HymanMinskymost theword“expectation”toemphasizetheimpor- prominently,8thatmonetarypolicysuccess tanceofahighdegreeofmarketconfidenceinthe breedsgreaterfinancialinstabilitybyencourag- centralbank.Whenthereisahighdegreeofcon- inginvestorstoassumemorerisk,especially fidenceinthecentralbank,everyoneshould throughgreaterleverage.Perhapsthiscontention believethatthecentralbankwillrespondto isattheheartoftheargumentthatrecentFed eventsthatmightotherwisedrivetheeconomy policyactionsinresponsetothesubprimemort- intorecession.Inthissense,a“Fedput”should gagemesswillonlyincreasefinancialrisksin exist.Acentralbankissupposedtodowhatit thefuture. cantomaintainemploymentatahighlevel. ItishardtofigureouthowtotesttheMinsky Ofcourse,atthecurrentstateofknowledge, proposition,butmyinstinctisthatitisnotcor- thecentralbankcannotpreventallrecessions. rect.Asvexingasthecurrentmarketsituationis, Acentralbankmaybeunabletopreventsome itisimportanttorememberthatintheearly1980s recessionsbecauseithasincompleteknowledge theunwindingoftheGreatInflationledtofailure ofhowbusinesses,households,andmarkets ofmanyindustrialfirms,farmers,banks,and behave.Inothercases,acentralbankhasnoway eventuallyalargepartofthesavingsandloan offorecastingcertaineventsthatmaydrivethe industry.Thefinancialturmoilof1998seems economyintorecession. mildbycomparisonwiththeearly1980s;of Acentralbankcandoitsbesttorespond course,wedonotyetknowthefullextentofthe appropriatelytoeventslikethestockmarket currentturmoilinhousingandhousingfinance. crashof1987andtheterroristattacksof9/11. Ifanempiricaltestwouldbeinconclusive, Whensuchashockoccurs,marketparticipants whichIthinkitprobablywouldbe,ouronly maybeunsureabouttheappropriateresponse, recourseistoarguefromasomewhatabstract andthecentralbankmayalsobeunsure.Never- perspective.Wedohavegoodreasontobelieve, theless,marketparticipantshavegoodreasonto bothfromtheoryandexperience,thatpricelevel believethatthecentralbankwillrespondasthe instabilityincreasesfinancialinstability.Large appropriateresponsebecomesclear.Confidence changesintheinflationrate,upordown,are inthecentralbankinthissensehelpstostabilize alwaysunanticipated.Thus,inflationcreates markets. unanticipatedchangesintherealvalueofbonds IhaveemphasizedtheimportanceofFed stabilizationpolicyforthefinancialmarkets.The andothercontractsstatedinnominalterms.The sameargumentsholdwithequalforceformarkets gainsandlossestendtobecapricious,andlosses forgoodsandforproductiveinputs.Decisions canbelargeenoughtobankruptthoseonthe ontheallocationsofcapitalandlaboraremore wrongsideoftheunanticipatedchangeininfla- efficientinanenvironmentofgeneraleconomic tion.Thesameproblemariseswheneconomic stability.Long-livedcapitalprojectsrequirecon- activitychangesinanunanticipatedfashion— fidenceinmonetarystability.Ofcourse,other bankruptciesriseduringrecessions. aspectsofgovernmentpolicyareequallyimpor- Whenthepricelevelisreasonablystable tant,suchastheruleoflawandthetaxandreg- andeconomicactivityisgrowingreasonably ulatoryenvironments. smoothly,macroeconomicrisksarereduced. 8 AconvenientbibliographyofMinsky’sworkandofworkabouthisideascanbefoundathttp://cepa.newschool.edu/het/profiles/minsky.htm. 7 MONETARYPOLICYANDINFLATION However,microeconomicrisksdonotdisappear. CONCLUDING COMMENTS Thehedgefundisagoodexampleofafirm IntheEmploymentActof1946,Congress designedtoexploitmicroeconomicrisks.The chargedtheFedwithpromoting“maximum basicideaofthehedgefundistotakepositions employment,production,andpurchasingpower.” basedonrelativecalculationsofvarioussorts.In NotthatlongbeforetheEmploymentActadif- aparticularindustry,ahedgefundmighttakea ferentviewprevailed.DavidCannadine,inhis longpositioninwhatitbelievestobestronger Mellon:AnAmericanLife,wroterecentlyabout firmsandashortpositioninweakerfirms.Con- AndrewMellon’sattitudesduringtheearlypart centrationonmicroeconomicissuesisexactly oftheGreatDepression: whatissupposedtohappenwithreductionof Mellonconstantlylecturedthepresidenton macroeconomicrisks.Highleveragedoesincrease theimportanceoflettingthingsbe.Thesecre- risk,butdoessointhecontextofbothmacroeco- tarybelonged(asHooverwouldrecall)tothe nomicandmicroeconomicuncertainty. “leaveitalone,liquidationistschool,”andhis SincetheendoftheGreatInflation,most formulawas“liquidatelabor,liquidatestocks, boutsoffinancialinstabilityhavebeenassociated liquidatethefarmers,liquidaterealestate.” withinnovationandnotwithexcessescreated (Cannadine,2006,p.445) byeconomicstability.Innovationsofallsorts Thatviewislonggone.Macroeconomists encourageexperimentation;someoftheexperi- todaydonotbelievethatpoliciestostabilizethe mentsturnoutbadlyuntilengineeringandman- pricelevelandaggregateeconomicactivitycreate agementpracticesadapttotheinnovations.As ahazard.FederalReservepolicythatyields theuseofsteamenginesspreadinmanydifferent greaterstabilityhasnotandwillnotprotectfrom applicationsinthenineteenthcentury,boiler lossthosewhoinvestinfailedstrategies,finan- explosionswerecommon.Railroadbridgesfell cialorotherwise.Investorsandentrepreneurs down.ThenewtechnologyoftheInternetled haveasmuchincentiveastheyeverhadtoman- tothedot-combubble.Wehaveseenthesame ageriskappropriately.Whattheydonothaveto processwithfinancialinnovation—portfolio dealwithismacroeconomicriskofthemagnitude experiencedalltooofteninthepast. insurancefailedinthestockmarketcrashof Inthepresentsituation,manyinvestorsin 1987andhighlymathematicaltradingstrategies subprimepaperwilltakeheavylossesandthere failedLTCM.Certainunderwritingandsecuriti- isnomonetarypolicythatcouldavoidthose zationstrategiesforsubprimemortgagesarein losses.Clearly,recentFedpolicyactionshave theprocessoffailingtoday,atenormouscostnot notprotectedinvestorsinsubprimepaper.The onlytoinvestorsbutalsotohomeownersfacing policyobjectiveisnottopreventlossesbutto foreclosure.Idonotbelievethatthefailureof restorenormalmarketprocesses.Theissueisnot anyofthesefinancialinnovationswasrelatedto whethersubprimepaperwilltradeat70cents themorestablepricelevelandmorestableecon- onthedollar,or30cents,butthatthepaperin omyofthepastquartercenturycomparedwith factcantradeatsomemarketpricedetermined thepreviousquartercentury. byusualmarketprocesses.SinceAugust,such Somefinancialstrategieswillgothewayof paperhastradedhardlyatall.Anactivefinancial thesteamautomobile;otherswillberefinedand marketiscentraltotheprocessofeconomic becomeascommonandroutinelysuccessfulas growth,anditisthatgrowth,notpricesinfinan- thepersonalcomputer.Whotodaydoesnot cialmarketsperse,thattheFedcaresabout. acceptthebasicideaofportfolioanalysis,in Oneofthemostreliableandpredictablefea- whichindividualsecuritiesarenotstudiedin turesoftheFed’smonetarypolicyisactionto isolationbutinthecontextoftheircovariances preventsystemicfinancialcollapse.Ifthisregu- withothersecurities? larityofpolicyiswhatismeantbythe“Fedput,” 8 MarketBailoutsandthe“FedPut” thensobeit,butthetermseemstometobe monetarypolicy.Ihaveobservednoevidenceto extremelymisleading.TheFeddoesnothave suggestthattheFedhaspursuedsuchacourse. thedesireortoolstopreventwidespreadlosses Thatfinancialmarketsaremorestablebecause inaparticularsectorbutshouldnotsitbywhile marketparticipantsexpecttheFedtobesuccess- afinancialupsetbecomesafinancialcalamity fulinachievingitspolicyobjectivesisadesirable affectingtheentireeconomy.Whetherfurthercuts andexpectedoutcomeofgoodmonetarypolicy. inthefederalfundsratetargetwillalleviate Thereisnomoralhazardwhenlargelypredictable financialturmoil,orriskaddingtoit,isalways policyresponsestonewinformationhaveeffects anappropriatetopicfortheFOMCtodiscuss. onfinancialmarkets. Butonethingshouldbeclear:TheFeddoesnot ThatthemonetarypolicyprinciplesIhave havethepowertokeepthestockmarketatthe discussedhereareuncleartomanyinthefinan- “proper”level,bothbecausewhatisproperis cialmarketsisunfortunate.Macroeconomicsta- neverclearandbecausetheFeddoesnothave bilizationdoesnotraisemoralhazardissues policyinstrumentsitcanadjusttohavepredict- becauseastableeconomyprovidesnoguarantee ableeffectsonstockprices. thatindividualfirmsandhouseholdswillbe Fromtimetotime,tobesure,Fedactionto protectedfromfailure.Improvedpublicunder- stabilizetheeconomy—tocushionrecessionor standingofthispointwillnotonlyhelptheFed dealwithasystemicfinancialcrisis—willhave todoitsjobmoreeffectivelybutalsowillhelp theeffectofpushingupstockprices.Thateffect privatesectorfirmstounderstandbetterhowto ispartofthetransmissionmechanismthrough managerisk. whichmonetarypolicyaffectstheeconomy. However,itisafundamentalmisreadingofmon- etarypolicytobelievethatthestockmarketper REFERENCES seisanobjectiveofpolicy.Itisalsoamistaketo Cannadine,David.Mellon:AnAmericanLife.New believethatapolicyactionthatisdesirableto York:AlfredA.Knopf,2006. helpstabilizetheeconomyshouldnotbetaken becauseitwillalsotendtoincreasestockprices. Graham,BenjaminandDodd,DavidL.Security Itmakesnosensetolettheeconomysufferfrom Analysis.ThirdEdition.NewYork:McGraw-Hill, continuingdeclinesinstockpricesforthepurpose 1951. of“teachingstockmarketspeculatorsalesson.” “Teachingalesson”iseerilyreminiscentof Rudebusch,GlennD.“FederalReserveInterestRate Mellon’sliquidationistview.Norshouldthecen- Targeting,RationalExpectations,andtheTerm tralbankattempttoprotectinvestorsfromtheir Structure.”JournalofMonetaryEconomics,April unwisedecisions.Doingsowouldonlydivert 1995,35(2),pp.245-74. policyfromitscentralresponsibilitytomaintain pricestabilityandhighemployment. Thornton,DanielL.“WhenDidtheFOMCBegin TheFedwouldcreatemoralhazardifitwere TargetingtheFederalFundsRate?Whatthe toattempttopumpupthestockmarketwhenever VerbatimTranscriptsTellUs.”JournalofMoney, itfell,regardlessofwhetherornotsuchpolicy Credit,andBanking,December2006,38(8), actionsservedthefundamentalobjectivesof pp.2039-71. 9

William Poole (2007, November 29). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20071130_poole

@misc{wtfs_speech_20071130_poole,
  author = {William Poole},
  title = {Speech},
  year = {2007},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20071130_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}