Tuesday, September 25, 2007

Containing "moral hazard"

Much has been written about "moral hazard" created by central bank intervention in times of financial crises- the danger that such intervention encourages market players to take undue risks in the knowledge that the central bank is always there to help them out.

In my posts on the subject, I have been sceptical of this line of reasoning. When you are faced with a financial crisis that threatens to impact the real economy- note, not just a crisis that is confined to the financial sector- you don't sit around twiddling your thumbs. You don't use the possibility of "moral hazard" to justify inaction. That is because the costs of systemic failure can be huge where banks are involved- in the East Asian crisis, the countries there were set back by years when it came to economic growth.

I also believe that another criterion is valid: has intervention by central banks or governments actually led to increased moral hazard? Are banks more prone to failure today than before? Impressionistic evidence suggests this is not the case. In the US, banks are better capitalised than before, their risk management practices have improved hugely and they are better placed to present a crisis than before.

Larry Summers' article in Business Standard today makes clear why moral hazard cannot be allowed to come in the way of timely intervention. Summers provides three good reasons for this.

First, ......... the prospect that people may smoke in bed is not usually taken as an argument against the existence of fire departments. Moreover, if there is “contagion” as fires can spread from one building to the next, the argument for not leaving things to the free market is greatly strengthened.

Second, ......moral hazard and confidence are opposite sides of the same coin. Financial institutions can fail because they become insolvent, as misguided lending or borrowing causes their liabilities to exceed their assets. But solvent institutions can also fail because of illiquidity simply because creditors rush to withdraw their funds and assets cannot be liquidated fast enough. In this latter case the availability of external support averts needless panic and contagion.

Third,.....much of what financial authorities do in response to crises does not impose any costs on taxpayers and may actually make them better off. In the much criticised LTCM case no taxpayer money, except perhaps the cost of a lunch, was spent. ....Monetary policies that prevent deflation of the kind that cost Japan a decade of growth in the 1990s are another example of how a policy can respond to stress without imposing costs on taxpayers or the economy.

Summers goes on to spell out the conditions under which central bank intervention would be worthwhile:

First, are there substantial contagion effects? Second, is the problem a liquidity problem where a contribution to stability can be provided with high probability or does it involve problems of solvency? Third, is it reasonable to expect that the action in question will not impose costs on taxpayers? If the answers to all three questions are affirmative, there is a strong case for public action.

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