Speech

Balancing Financial Stability, Price Stability, and Macroeconomic Stability: How Important Is Moral Hazard? U.S.MonetaryPolicyForum NewYork,NewYork February29,2008 There are two ways to view the question Theconceptofmoralhazardismosteasily that comprises the title for this panel explainedinthecontextofinsurance.Thevery discussion. One concerns the potential existenceofinsurancemaychangethebehavior for moral hazard issues to decrease oftheinsuredperson,whobecomeslesscareful stability. The other is the extent to which, cur- intakingcareofinsuredpropertythanheother- rently, the issue in actuality has decreased sta- wisewouldifthepropertywereuninsured.Being bility or raised a problem for the Federal lesscarefulwithothers’propertythanyourown Reserve. The potentialisclearlyenormous. isnotmoralbehaviorandisahazardtotheinsur- However,Ibelieve that in the macroeconomic ancecompany. policy sphere, actual moralhazardproblems SomeclaimthatFederalReservepolicy todayarerelativelyminor with the exception of responsestofinancialmarketdevelopments a small number of large financial institutions shouldberegardedas“bailingout”marketpar- whose managements and investors believe they ticipantsandcreatingmoralhazardbydoingso. can count on government assistance should Inmyview,thisargumentisincorrectbecause these firms find themselves in deep trouble. thereisabenefitratherthanahazardtosound Beforecontinuing,andalthoughIhave monetarypolicythatstabilizestheeconomy. attendedmylastFOMCmeeting,Ineedtoempha- Consideramonetarypolicythatmaintains sizethattheviewsIexpressherearemineand lowandstableinflation.Ifmarketparticipants donotnecessarilyreflectofficialpositionsofthe haveconfidenceinthecontinuedsuccessofthat FederalReserveSystem.Ithankmycolleagues policy,thentheyneednotstructuretheiractivities attheFederalReserveBankofSt.Louisfortheir toberobustagainstaseriousoutbreakofinflation. comments,butIretainfullresponsibilityfor Monetarypolicydoeschangebehavior,butitis errors. notahazardtotheeconomythatfirmsandhouse- holdsmaketheirplansontheassumptionof continuingpricestability.Indeed,oneofthe MORAL HAZARD IN MONETARY argumentsforpricelevelstabilityisprecisely POLICY thatmarketswillworkbetterandprivatedeci- Iaddressedmoralhazardinmonetarypolicy sionswillbemoreefficientthaninanenviron- inaspeechattheCatoInstitutelastNovember, mentofpricelevelinstability.Outcomesaremore “MarketBailoutsandthe‘FedPut.’”1Letme efficientbecausebehaviorchangesinresponse repeatthegistofthatargument. totheenvironmentofpricelevelstability. 1 1http://www.stlouisfed.org/news/speeches/2007/11_30_07.html. 1 FINANCIALMARKETS Thesameargumentholdsformonetarypolicy outinvestorswhomadeloanstheyshouldnot actionsthatservetostabilizefinancialmarkets havemade.Thereisalsoawidespreadbelief inthefaceofmarketturmoilofthesortthatbroke amonghomeownerswhoaremeetingtheirfinan- outlastAugust.Amonetarypolicyresponseto cialobligationsthatitwouldbeunfairforthe marketturmoilisanapplicationtomodernfinan- governmenttobailout“irresponsible”borrowers cialmarketsofthetraditionalfunctionofthe whenresponsibleones,perhapswithconsider- centralbankasalenderoflastresorttothebank- ablestruggle,aremeetingtheirobligations. ingsystem.AbeliefthatFederalReservepolicy Asanaside,itseemstomethatmostofthose actionswillservetostabilizethefinancialsystem advocatingsomesortofgovernmentactionare willaffectbehavior,butnotonthewholeina supportingrelativelynarrowlydrawnproposals hazardousway.Thisvalidityofthisassertionis thatdonotapplytoinvestor-ownedhousesand lessobviousthanthecaseforpricelevelstability; topropertiesalreadyinforeclosure.Whetheror Iwillarguethecase. notasoundproposalcanbeenactedthatavoids Whenfinancialmarketsaregenerallystable, creatingmoralhazardremainstobeseen,but manyfirmswilldecidethattheycangetalong currentpublicdebateissensitivetotheissue. withlesscapital.Allelseequal,higherleverage obviouslyincreasesrisk.Shouldtherebeashock, afirmwithlesscapitalismorelikelytohavedif- TOO BIG TO FAIL ficulty.However,inthemorestablefinancial Inthecontextofmacroeconomicstability, environment,shocksarelesscommonandless themainmoralhazardissuearisesinthecontext severewhentheydooccur.Ifthatwerenotthe of“toobigtofail.”IbelievethatitwasAlan case,wewouldnotdescribethesituationasbeing Greenspanwhoputtheissuethisway:Nofirm “amorestablefinancialenvironment.” shouldbetoobigtofailbutsomemaybetoobig However,whateverthedegreeoffinancial stability,nothingprotectsanindividualfirmfrom toliquidatequickly.Supposealargefirmgets itsmistakes.TheFed’sactionsinrecentmonths intotroubleandthepotentialadverseconse- havenotpreventedmanyfinancialfirmsfrom quencesforstabilityaresogreatthatintervention havingtowritedownthevalueofbillionsof isunavoidable.Inthatsituation,anyintervention dollars’worthofassets.Fedactionshavebeen oughttotakeaformsuchthatthecoststoshare- successfulinhelpingtoprotectthefinancial holdersandmanagementaresolargethatnofirm systemwithoutprotectinganyparticularfirm. inthefuturewillwanttoallowitselftofallinto Anumberofhedgefundsandmortgagebrokers suchasituation.LestIberegardedasasofttouch havegoneunderwithoutafingerofpublicsupport whenIsaythatasituationcouldarisethatcould beingliftedtosavethem.Thatisasitshouldbe. makeintervention“inevitable,”Iwouldseta Lendershaveforeclosedonthousandsof veryhighbartoanyintervention.HereiswhatI homeownersindefaultontheirmortgagesand thinkissoundadvice:“Experiencesuggeststhat haveforcedtheformerownerstoleavetheir thepathofwisdomistousemonetarypolicy homes.Sofar,wehavenotseensignificantgovern- explicitlytooffsetotherdisturbancesonlywhen mentfundsbeingsuppliedtopreventforeclosures, theyoffera‘clearandpresentdanger.’”Somemay althoughproposalsforsuchsupportarecommon. besurprisedtolearnthattheauthorofthissen- Thepublicdebateonthisissueseemspretty tencewasMiltonFriedmaninhispresidential healthytome.Peopleunderstandtheanguishof addresstotheAmericanEconomicAssociation foreclosurebutalsothepotentialmoralhazard in1967.2 frombailingouthomeownerswhotookout Inrecentmonths,someboardsofdirectors mortgagestheycouldnotaffordorfrombailing haveforcedouttheirCEOsandcompanieshave 2 TheAmericanEconomicReview,March1968,58,p.14. 2 BalancingFinancialStability,PriceStability,andMacroeconomicStability:HowImportantIsMoralHazard? raisednewcapital,dilutingtheownershipposi- average.Idonothaveanewmessagehere;we tionofexistingshareholders.Iamsurethatthese haveknownforalongtimethatadvanceprepa- costswillnotbelostonfuturemanagements,but rationandastrongbalancesheetarethekeysto itremainstobeseenhowlongrecentpainremains ridingoutafinancialstorm.AsIhaveempha- inmanagers’memories.Inanyevent,wearefor- sizedbefore,theFederalReservecandealwith tunatethatinthecurrentepisode,sofaranyway, liquiditypressuresbutcannotdealwithsolvency nolargefinancialfirmshavebeensoweakened issues.IdonothaveanyinformationontheGSEs bylargelossesthattheywereunabletoraisenew thatthemarketdoesnotalsohave.Nevertheless, capital. inassessingtheriskoffurthercreditdisruptions Wehaveknownformanyyearsthatmoral thisyear,IwouldputtheGSEsatthetopofmy hazardisapotentiallyseriousissue.Ifafirm listofsourcesofpotentiallyseriousproblems.If believesthatitwillbebailedoutifitgetsinto thoseproblemswererealized,theywouldbea trouble,thatexpectationencouragesexcessive directresultofmoralhazardinherentinthecur- risk-takingandincreasestheprobabilityoftrouble. rentstructureoftheGSEs. Therearetwocomplementarywaystodealwith moralhazard.First,firmsintroubleoughtnotto bebailedout,unlessthebailouttakesaformthat MORAL HAZARD RISKS TO imposesheavycostsonmanagersandshare- ECONOMIC STABILITY holders.Second,firmssubjecttogovernment regulationoughttobecompelledtomaintain Thetitleofthissessionstartswiththeword adequatecapitaltoreducetheprobabilityoffail- “balancing.”Monetarypolicyisabalancingact, ure.U.S.banksenteredtheperiodofturmoillast withdangersofrecessionandinflationbothvery yearprettywellcapitalizedandhavebeenable real.Myview,oftstated,isthattheFOMCshould towithstandlargelosses. giveprimacytotheinflationobjective,because, Iammoreskepticalofthefinancialstrength ifinflationdevelopswhiletheFOMCisconcen- oftheGSEs,andbelievethatwecouldseesub- tratingonavoidingrecession,theconsequence stantialproblemsinthatsector.Accordingtothe willbetodelayrecessionbutnottoavoidit.And, S&PCase-Shillerhomevaluedatareleasedearlier mostlikely,thedelayedrecessioninanenviron- thisweek,asofDecember2007averageprices mentofrisinginflationandrisinginflationexpec- haddeclinedby15percentormoreoverthepast tationswillbeworsethanthemildrecession 12monthsinPhoenix,SanDiego,Miamiand avoidedintheimmediatefuture. LasVegas.WecanaddDetroittothedangerlist TheFOMC’s“primeconcern,”though,must asthehomepriceindexforthatcityisdownby notbeconfusedwith“exclusiveconcern.”The almost19percentoverthe24monthsending FOMChasgoodreasontorespondtoemployment December2007.Withhousepricesfallingsignifi- problemsanddoingsoneednotbeinconsistent cantlyinanumberoflargemarkets,manyprime withmaintaininganenvironmentofpricestabil- mortgagesissuedafewyearsagowithaloan-to- ity.Ofcourse,differentobservershavedifferent valueratioof80percentmaynowhaverelatively viewsastowhethertheFOMCisstrikingthe littlehomeownerequity,whichincreasesthe rightbalance,buttheneedtostrikethebalance probabilityofdefaultandamountoflossinevent oughtnottobeatissue. ofdefault. Thetraditionalmonetarypolicyproblemof AsIemphasizedsometimeago,GSElosses balancinginflationandemploymentrisksis willdependonthevarianceaswellasthemean seriouslycomplicatedwhenaneventraisinga ofchangesinnationalhomeprices.Lossesin moralhazardproblemintervenes.Whenanevent marketswithhomepricesfallingmorethanthe occursriskingextremefinancialinstability,the nationalaveragewillnotbeoffsetbygainsin bestcourseofactionisprobablyforpolicymakers marketswithpricechangesabovethenational tokeeptheshipafloatandworryaboutthecom- 3 FINANCIALMARKETS passcourselater.However,whenbailingouta Althoughtherehavebeenanumberofinter- firmtokeeptheshipafloat,theaimshouldbeto estingefforts,noonehascomeupwithareally allowasmuchpainaspossibletoflowthrough convincingmodelofwhyfluctuationsinnominal tomanagementandinvestorstodiscourage magnitudesshouldcausefluctuationsinreal futureriskybehavior.Toavoidafutureinflation magnitudes.Acontraryview,alsowithanexten- problem,monetarypolicyaccommodation,which siveliterature,flowsfromworkonrealbusiness maybeapartofthepolicyresponse,shouldbe cycles.Fromthisperspective,thebusinesscycle reversedpromptlywhenthemarketssettledown. isarealphenomenonandnominalmagnitudes SinceWorldWarII,thenumberoffinancial arealongfortheride.Intherealbusinesscycle upsetsissofewthatwedonothavealargesam- model,causationrunsfromthebusinesscycleto plefromwhichwecandrawlessonsastobetter nominalfinancialmagnitudes. andworsewaysofhandlingtheaftermathof MyownworkhasbeenwithintheFriedman- financialturmoil.Withthebenefitofhindsight— Schwartztradition.Idonothaveanydoubtthat andtheimportanceoftheword“hindsight” monetarypolicymistakescancreaterecession. shouldbeemphasized—itisnothardtoargue Intryingtosortoutthecausalitybetweenmoney thattheFOMCwastooslowtoraisethefederal andoutput,Friedmanemphasizedtheimportance fundstargetaftertakingthetargetdownto1per- ofevidencefromnaturalexperiments.Ithinkit centin2003.Ialsobelievethat,withhindsight, usefultothinkaboutthatsameapproachinana- theFOMCwastooslowtostartraisingthefed lyzingthecurrentsituationinthecreditmarkets. fundstargetin1999afterdroppingitby75basis Wearedealingwithsomethingclosetoanatural pointstodealwiththeturmoilcreatedbyLong experimentbecausetheturmoilspreadingfrom TermCapitalManagement.Theprobleminthese thesubprimemortgagemarketwasclearlyunan- episodes,however,wasnotrelatedtomoralhaz- ticipatedand,fortheeconomyoutsidehousing, ardbuttopolicyjudgmentsoftheusualsortof basicallyexogenousandnotcloselyrelatedto tryingtostriketherightbalancebetweeninflation changesinmonetarypolicy.Wearelivingthrough andunemploymentconcerns. anepisodethatisascloseaswehaveseentoa purecreditdisturbancewithoutanaccompanying monetarydisturbance. THE CURRENT EPISODE OF Letmedevelopthisthemeabitmorecare- FINANCIAL TURMOIL fully.TheFOMCdid,ofcourse,raisethetarget federalfundsratefrom1percentinmid-2004to Wearecurrentlylivingthroughanepisode 5.25percentinmid-2006.Theeffectofrising thatwillprovideconsiderableevidenceonsev- interestratesinslowingmortgagefinancewas eralimportantquestions.Infiveyearsorso,we notasurprise;norwasaslowinginhomeprice willseewhethertheFOMCwithdrewcutsinthe appreciationasurprise.Inthequartersbefore fedfundsratetargetonanappropriateschedule. August2007,wedidnotobserveamarkeddecline Thecurrentepisodewillalsoprovideevi- denceonavexingissueofcausation.AsGreenlaw inmoneygrowthoranyoftheotherusualsymp- etal.emphasizeintheirveryinterestingpaper, tomsofamonetarydisturbance. therelationoffinancetotherealeconomyhas Thegrowingscaleofdefaultsofsubprime longbeenapuzzlebecauseofthedifficultyof mortgagesinthespringandsummerof2007was sortingoutcauseandeffect.Thereisalargelitera- asurprise.Ithinkitreasonabletoregardthe tureonthisissue.Onetraditionflowsfrom effectsofthesedefaultsoncreditmarketsbeyond Friedman-Schwartz,and,beforethem,thework themortgagemarketasanexogenouscreditdis- ofIrvingFisher,relatingfluctuationsinmoney turbance—perhapsasexogenousaswegetinour growthtothebusinesscycle.Greenlawetal.report discipline.Theissueathandiswhetherthisdis- evidenceontherelationofgrowthindomestic turbancewillcauseasignificantcontractionin non-financialdebttogrowthinrealGDP. economicactivityoutsidehousing. 4 BalancingFinancialStability,PriceStability,andMacroeconomicStability:HowImportantIsMoralHazard? Ifocusonactivityoutsidehousingbecauseit insuranceonhomeowners.Floodinsurancewill isobviousthatthisparticularsectorisoverbuilt. compensatethehomeowner,period.Amonetary TheU.S.economyhasexperiencedproblemsin policyresponsemayormaynotoccuratatime particularsectorsbefore,suchassteelandagri- whenafinancialfirmgetsintotroubleandmay cultureinearly1980s.Thoseproblemslingered ormaynotbeadequatetopreventafirmfrom afterrecoveryfromthe1981-82recessionbegan failing. butdidnotpreventtherecovery. Moreover,afinancialfirmcannotexpecttar- Weaknessininvestmentinresidentialstruc- getedaidforjustthefirmsintrouble.Anexception tureshasbeenholdingdownGDPgrowthina tothisgeneralstatementisthat,unfortunately, significantmannersincethesecondquarterof theGSEsprobablycanexpecttargetedaid.Thus, 2006but,throughthelastquarterof2007,was puttingtheGSEsasidebecausetheymightget notsufficienttopushgrowthofGDPexcluding assistancedirectlyfromCongress,expectationof housingbelow1.5percent.Theissueiswhether amonetarypolicyresponsetofinancialturmoil thecreditmarketproblemswillhaveasignifi- iscompletelyunlikethesituationfacedbythe cantadverseimpactoutsidehousing.Bywayof homeownerwithunderpricedfloodinsurance. comparison,theshockof9/11hadaquickand Manyhomeownersdobuildhousesinareas largeimpact;firmsshedonemillionjobsin wheretheywouldnotbuildiftheyweretotally October,NovemberandDecemberof2001.We responsibleforlosses,orhadtobuyinsurancein havenotyetseenaneffectofcreditturmoilon acompetitivemarket.Financialfirms,ontheother realactivityofthismagnitude. hand,cannotexpectaidiftheybuildonthe financialfloodplain.Andthatisasitshouldbe. CONCLUDING REMARKS NOTE Isuspectthattheoriginofthispaneltopic wastheviewthatacentralbankresponseto Becausethisisapaneldiscussion,thistext marketturmoilcreatesmoralhazard.Ageneral- shouldberegardedaspreliminary;Imayadd izedmonetarypolicyresponse,intheformof somecommentsreflectingearlierdiscussionat theFOMCcuttingthetargetfederalfundsrate,is theforum. completelyunliketheeffectsofgovernmentflood 5

William Poole (2008, February 28). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20080229_poole

@misc{wtfs_speech_20080229_poole,
  author = {William Poole},
  title = {Speech},
  year = {2008},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20080229_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}