Market Overview

Is the Fed Jimmy Stewart? Is it the World's Central Banker?


You can already hear, in 'the mind's ear,' the chorus of indignation set to be heard doubtless from multiple locations along the political spectrum in coming days: It was bad enough, people will say, that the 'opaque' and 'unaccountable' Fed bailed out 'Wall Street.' But now our learning this week that it bailed out Belgian, British, French, German, Swiss and other concerns too, well, this is just the last straw.

Did it happen? Well, yes. Well then how? And how do we know?

Here is the story in brief. As many of our readers will recall, among the measures taken by Congress in the wake of our recent financial turmoil was an obscure provision of the Dodd-Frank financial reform bill requiring the Fed to report publicly the assistance that it provided during the worst of our recent financial crisis. That report finally came out this past Wednesday, and was in many ways startling.

Of the many transactions conducted by the Fed pursuant to its Term Auction Facility (TAF) in late 2007, for example, some of the largest cumulative totals were racked up with non-US counterparties.

Barclays Bank, for instance, was the largest cumulative borrower under TAF, availing itself of some $232 billion -- partly to assist it in salvaging bankrupt Lehman Brothers. (The second largest was Bank of America, which borrowed some $212 billion while salvaging Merrill Lynch.) Also among the top 10 users were the Bank of Scotland and RBS, like Barclays, of the UK; Dexia, of Belgium; Dresdner Bank and Bayerische Landesbank, of Germany; and Societe General, of France.

The story of the Fed's Commercial Paper Funding Facility (CPFF) is similar. Here the largest 'crisis' user was UBS of Switzerland, followed by insurer AIG of the US. Another four of the top ten firms that availed themselves of the CPFF were, like UBS, European concerns.

All in all, it looks as though somewhere near 10% of the Fed's total emergency lending during the crisis went to non-American financial institutions. Yet, we will of course hear, all of the risk that the Fed inevitably assumed in thus lending, it took with American taxpayers' money.

That risk, for its part, will be argued, moreover, to have been considerable. For the Fed accepted 'toxic' and (at least temporarily) illiquid assets among those it secured as collateral in these transactions. And notwithstanding that fact, the interest it charged on the loans fell far short of punitive.

Should we, then, be scandalized? In a word (well, two words), 'yes -- but ...'

We should not be scandalized that the Fed took these measures. We should be scandalized that it had to do so. For its having had to do so is the joint product of multiple dysfunctions that now afflict our integrated global financial system. Two in particular stand out and warrant attention here.

The first dysfunction to which I allude is that lending activity has increasingly come to take place, worldwide, in the so-called 'shadow banking' system, all while this system thus far remains free of those specialized forms of surveillance and regulation to which commercial banks -- whose activities they effectively replicate -- have now long been subject. Indeed, these markets have come to equal or surpass the commercial banking markets as sources of funds for commercial and investment borrowers, both within and across national boundaries.

The cardinal characteristic of 'shadow' banking -- the best known components of which probably are the commercial paper and repo markets -- is that persons and institutions borrow short in them in order to invest long. They issue, in other words, short-term debt, the proceeds of which they then employ to purchase assets with longer term maturities.

This practice of course (re)introduces the same, classic potential 'maturity mismatch'problems as used to subject commercial banks periodically to 'runs' -- at least prior to the reform legislation of the early 1930s. And a run of precisely that sort on these markets was just what we saw in the autumn of 2008.

Borrowers in the shadow banking sector found it easy to roll over their short term debts daily for as long as confidence remained high in those collateral assets whose market valuations rose so spectacularly during the bubble years that finally ended about 2007. Indeed, this very fact helped to fuel the bubble itself; it was half of that 'positive feedback loop' which WAS the bubble.

The moment the bubble reached its limiting point, however, these same short term credit markets 'froze.' Lenders would no longer agree to refinance on the strength of the now collapsed, perceivedly 'toxic' collateral. In other words they 'ran' on their borrowers, just as in many cases their own lenders -- e.g., money fund investors -- 'ran' on them. This was the bank run scene of the Frank Capra, Jimmy Stewart film simply transferred to a new venue.

In such circumstances, of course, investment firms no longer could roll over their debts; nor, more importantly, could anyone else tap these markets. That was the 'crunch.' And this was what somebody -- if not the Fed, who? -- had to address, lest all economic activity reliant upon credit -- and how much is not? -- grind to an absolute halt in the US and well beyond.

The second dysfunction the Fed's activity highlights is contained in that parenthetical question above -- if not the Fed, who? In effect, the Fed played what, at least since Bagehot's day, has been known as the classic 'lender of last resort' function. When credit markets freeze up, somebody has to replace them, at least for a while. And 'somebody' in these cases is nearly always a central bank.

It bears asking why someone must do this, and why those who do are called 'central' somethings. The reason is that a 'run,' like a bubble, is a classic collective action problem. The hallmark of these is that multiple acts of individual rationality aggregate into a collectively irrational -- or at any rate, calamitous and yet tragically avoidable -- outcome.

In what sense was the 2008 'run' on assets one of those? The answer is that it is in the same sense that any run on or 'bubble' in assets is. Each actor knows that she can do nothing to halt an unjustified rise or fall in the market valuation of an asset, even if she knows that the rise or fall is not 'fundamentally' warranted. So each acts on her own best strategy given that apparently unalterable backdrop, and everyone's doing so self-fulfillingly brings about the unjustified rise or fall itself.

Sound familiar? That's in effect what Jimmy Stewart was trying to tell all of those who sought to withdraw their savings from his bank. Those savings were in illiquid houses, and everyone's trying to withdraw them at once would simply bring on the very contingency that they now feared -- the bank's illiquidity-induced insolvency.

Consumer price inflations and widespread layoff activity on the part of firms during slowdowns, it bears noting, are possessed of the same structure. Each acting party might know that all parties' doing the same thing is what's causing the problem -- collectively speeding up purchases causing more price rises, for example, or massive layoffs worsening downturns -- but that doesn't change the best strategy for each party, who is powerless to change the dynamic. And so we all plunge ahead with 'irrational exuberance' or excessively morbid despair, wishing that someone could stop the whole sorry race that has captured us.

That 'someone,' in financial and monetary contexts, just is the central bank. Collective action problems require collective agents for their solution, someone able to act for all parties at once. And 'collective' in this sense is just what the 'central' in 'central bank' is about.

Consider in this connection what the Fed did from 2008 up to the recent past. Fed personnel surely knew that the massive undervaluation of assets that underwrote the freeze was no more warranted by fundamentals than had been the massive overvaluation that underwrote the antecedent bubble. Sure, there were 'toxic' assets among all those assets that had collateralized short term debt. But they were not ALL, or even MOST of them toxic.

Lenders' refusal to credit ANY of these assets reflected little if anything more than their uncertainties as to WHICH PARTICULAR ones would in fact prove nonperforming. They could not determine whether accepting, say, n% of the assets would expose them to no more than n% of the total toxicity, and so played it safe by accepting none at all. That's just the flip side of 'irrational exuberance.' You plan for the worst.

It is helpful to note that investors could rationally have calculated in this way even had they known that no more than n% of the pool was in fact 'toxic.' For none of them owned the whole pool, each of them only owned part. And in the face of uncertainty about which ones are toxic, it's not clearly silly to act on the assumption that you've a disproportionate share of them.

Under this sort of circumstance, the only 'investor' who can proceed with confidence is she who can purchase the entire pool or, at least, a very large part of it. For only that investor knows that she will then be exposed to no more than that n%. And this is precisely what properly functioning central banks, in their lender of last resort function, do in a crisis.

But why, then, the Fed? Well, that is the real dysfunction to which I referred. The fact is that no other central bank seems to have been up to the task -- either to supplant or, what would have been more reasonable to expect, to supplement it.

The European Central Bank (ECB) refused to lend on the strength of the perceivedly 'toxic' collateral, effectively ignoring the collective action problem part of the 'toxicity' story. But the ECB also is thus far still subject to much more political pressure than is the Fed. It lacks that degree of autonomy that effective central banks classically have had. And no other central bank was willing -- or probably yet able -- to step up to the plate either.

The Fed, both with more autonomy than its peers and with charge of what still is the world's only de facto reserve currency, was thus the sole collective agent fit for the task, and it knew it. Its action should accordingly be applauded as the act of financial statesmanship that it was, even as the necessity of that action is deplored. Its judgment has been vindicated by its having already recouped virtually all that it extended, and its action surely averted a full-bore global economic collapse.

All of this still leaves the question of where we're to go now from here. One answer seems to me plain, the other a bit more controversial.

The first answer is that the shadow banking sector -- indeed, any financial sector prone to maturity mismatch between the asset and liability sides of the balance sheets -- must be surveilled and prudentially regulated just as commercial banks are. The Dodd-Frank act does not explicitly address this need, but surely the new systemic risk organs it institutes, with the Fed playing a central coordinating role, will be possessed of sufficient authority to do so within their new mandates.

The second answer is that we are bound, before long, to move toward development of a true global central bank and attendant global reserve currency. I suggested as much in my previous column, and will of course say more on the matter in future. One nation's currency acting as global currency is not sustainable. It requires the nation in question to run persistent deficits in order to provide necessary global liquidity, and those deficits themselves soon become sources of global financial fragility.

But to move to a truly global currency, for its part, will require we establish a truly global central bank or its functional equivalent. The Fed, or any other national bank, can no more play this role indefinitely than can the national currency it manages serve as the world's currency indefinitely. Indeed, the Fed's having had to play this role this time around, both domestically and internationally, is itself part of the dollar's own long term problem.

Again, then, let us be scandalized, but let us be scandalized by the actual scandal. That is not that the Fed did what it did, but that the Fed had to do so.


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