With the collapse of Bear Stearns,
financial markets are moving closer to a crash
that risks grave harm to the economy and the lives
of working people. The Federal Reserve's recently
created Term Auction Facility (TAF) and Term
Securities Lending Facility (TSLF) move policy in
the right direction. However, more needs to be
done if a crash is to be prevented.
One
way of thinking about Fed policy is in terms of
the institutions the Fed deals with, the assets
the Fed deals in, and the collateral the Fed
accepts. The TAF and TSLF both expand the Fed's
transactions menu, but the Fed has resisted
expanding the set of institutions it deals with.
Thus, initially only depository institutions were
given access to the TAF, and only primary
government securities dealers
have access to the TSLF.
That is not
adequate. Had Bear Stearns had access to the TAF
its collapse might have been avoided. Now, the Fed
has decided to give liquidity access to securities
dealers like Bear Stearns, which is welcome but
still belated.
The Fed's failure to expand
the set of institutions it deals with reflects
failure to adapt to the new world of financial
intermediation. Previously, lending was dominated
by banks, which meant the Fed could address
liquidity shortages threatening the supply of
credit by providing liquidity directly to banks.
Today, lending is increasingly separated from
banks. First, banks sell many of the loans they
originate so that the ultimate lender is not a
bank. Second, many originating lenders are
non-bank firms. That means the credit supply is
vulnerable to disruptions among these other
lenders.
The current problem is that asset
prices are falling owing to lack of confidence,
triggering margin calls on these non-bank lenders.
That has compelled them to sell assets, further
driving down prices and triggering further calls.
Some lenders have been unable to meet these calls,
threatening bankruptcy even though their
underlying loans are still performing. That
threatens a cascade of asset price collapse.
The Fed's new facilities are a good move
that broadens capacity to protect against
liquidity disruptions. However, the Fed should
further widen the set of institutions it deals
with. Limiting dealings to depository institutions
and primary government securities dealers protects
banks and Wall Street's major brokerage houses,
but leaves too much of the system unprotected and
creates inefficiencies.
Firms outside the
Fed's ring of protection must set up complex
transactions with firms inside the ring to access
emergency liquidity. That is good for insiders'
fee income, but it raises the cost of distributing
liquidity and creates unnecessary transactions
that can be disrupted. Meanwhile, restricting
access to the Fed's liquidity auction facility
fails to discover the true price of liquidity that
would be paid if all had auction access, which is
tantamount to not getting liquidity to those who
need it most. That is inefficient, and it also
provides a subsidy to institutions inside the ring
of protection.
In addition to expanding
the institutions the Fed deals with, the Fed
should consider further judicious expansion of the
categories of securities it accepts as collateral
under its auction (TAF) and securities lending
(TSLF) facilities. Any additional collateral
categories should be assessed at deeply discounted
values as they will be more risky. That will
protect taxpayers from bearing losses if the
collateral under-performs.
Even equities
could potentially be accepted, but this would
involve crossing a bright line as they are a
different form of legal obligation. By accepting
equity collateral, the Fed could acquire an
ownership stake in firms, which would move it
beyond its current role of setting interest rates
and providing liquidity to the financial system.
Among economic commentators there has been
much misleading chatter about limits imposed by
the size of the Fed's balance sheet. The reality
is the Fed has no practical limit to its balance
sheet as it can always directly purchase financial
assets. There is no need for that now, but in the
meantime the Fed might further increase the size
of its auction facility and should definitely
widen the set of auction participants.
Critics will inevitably claim such changes
are inflationary. That has been the history of
every innovation in central banking. However, the
reality is innovations are only inflationary if
used in an inflationary way. With regard to the
current crisis, that means the Fed will have to
withdraw liquidity convincingly once the crisis
has abated.
Finally, stopping a financial
crash does not get the US economy out of the
woods. There remains the underlying residential
mortgage debt crisis, and many risky mortgages
will go bad as will the mortgage backed securities
in which they are embedded. There is also the
problem of recession, which calls for reviving
aggregate demand and getting the economy growing
again. Both the mortgage debt crisis and the
recession need their own tailored policy
responses. However, if the Fed fails to prevent a
crash, the mortgage crisis will be deeper and a
recession far more severe.
Thomas I Palley is the
founder of the Economics for Democratic and Open
Societies Project.
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