Wednesday, September 19, 2007

Bernanke vs Greenspan

The Fed cut its benchmark rates by 50 basis points yesterday. Those who liked the move called in 'bold'. Those who didn't like it called it 'risky'.

Earlier, when Bernanke had held out against a large cut in interest rate, people had called him 'bold' and compared him favourably with the supposedly trigger-happy Greenspan. Greenspan, they said, was Wall Street's central banker, only too happy to cut rates in order to appease the financial markets. Bernanke was the academics' central banker, guided by larger theoretical considerations.

Greenspan's interest rate cuts, the critics said, had fostered moral hazard in the financial markets, they had caused firms to take up excessive risk. Now, we were all paying the price for those excesses. Bernanke was diferent, they said. He was out to make a point to market players: if you take excessive risk, be prepared to pay the price for it.

Much of this gets blown away by yesterday's interest rate cuts. A trigger point, perhaps, was the collapse of Northern Rock, a mortgage lender, in the UK, with the Bank of England rushing to its rescue. No regulator anywhere wants crowds queueing up outside banks and the prospect of a similar run on banks in the US, caused by protracted uncertainty in the markets and a sharper downturn in the US economy, no doubt helped focus minds in the US Fed.

So where does that leave us in terms of policy? Is Bernanke going the Greenspan way? Is the 'Greenspan put' , the floor on asset prices caused by interest rate cuts, now a 'Bernanke put'? Are central bankers obliged to take steps to prevent steep falls in asset prices that impact on financial institutions and especially banks? The answer to the last question at least does appear to be in the affirmative. The consequences of not responding are just too fearful for central bankers to contemplate.

Does this mean that Greenspan and Bernanke are abetting 'moral hazard' and we are bound to be swept by excesses of the kind that led to the present crisis? That would be too sweeping a judgement. There is a difference between some of the earlier financial crises and the present one.

In the present crisis, it is non-bank financial institutions that are primarily involved. Banks are involved indirectly either through lines of credit they have extended to troubled institutions or because they are holding securitised assets. Banks are much better capitalised today than before (especially US banks) and they are well placed the absorb the losses to which they are exposed.

The markets are jittery because it's hard to put a precise figure on the losses, given the accounting and valuation issues involved. The resolution of the crisis will take time and markets will remain jittery. But the financial system is better equipped to absorb the shock than on many earlier occasions. You can't argue that central banks have caused moral hazard to worsen through their actions.

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