Solutions to Subprime Crisis

Let’s go back to basics. Public interventions are a bad thing, unless there is a
well-identified market failure. Since early August, we have witnessed a massive market
failure due to acute information asymmetry. Each financial institution knows, or should
know, its situation, not just on but also off its balance sheet. There are reasons to believe
that this is not fully the case, but let’s overlook this first failure. What each financial
institution does not know, and should not know, is what is on the books of the other
financial institutions with which it trades daily. The old result, which goes under the
colourful name of lemon’s markets, is that, suspecting the worst, no financial institution
wants to lend to the others. The consequence is that liquidity is plentiful inside most
financial institutions, but not available on the interbank market. Extreme scarcity in the
midst of plenty is a big failure. In practice, it means that those institutions that need cash
to carry out normal daily business can’t find it, and therefore cannot operate normally.
Credit is vanishing. Since a modern economy cannot function without credit, the market
failure has potentially catastrophic implications. Intervention is fully justified.
Of course, this is not a call for just any intervention. Basic principles also say
that the intervention must directly address the failure. Ideally, it means full transparency
whereby each financial institution’s situation is public knowledge. Unfortunately, even
assuming that each institution knows what is on its books, this first-best solution is
impossible for it would mean revealing too many commercial secrets. So we must go to
the second-best solution: provide the needy financial institutions with the liquidity that
they need to operate as normally as possible. This is what the Fed and the ECB have done
for a month now.
The problem with second-best solutions is… that they are not first-best. By providing
liquidity to the market, the central banks are not just helping out financial institutions that
only need cash, they also bail out other institutions that have taken excessive risk and
only deserve to be folded. This is what some critics have complained about, and they are
right. Well almost. For they have to consider the opposite risk, that innocent institutions
and their customers stand to be badly hurt if the liquidity squeeze is allowed to continue.
This is unfortunate, but it could be an even better second-best solution than full scale
liquidity injections. The case is hard to make but let’s try.
The first argument is that there are no innocent bystanders. All financial
institutions are guilty of excessive risk taking. Their customers too are to be blamed for
having continued to do business with reckless banks. The first argument is uncomfortably
close to a value judgment. Who can decide what is ex ante excessive risk taking? Did the
bank supervisors issue warnings? If they did not, which we do not know yet, the risks are
found ex post to have been excessive. But in a world where zero probability is
incompatible with risk-taking, any risk-taking stands to be found misguided ex post. As
for customers, yes, theory says that they should monitor their banks. But information
asymmetry and plain common sense tells us that they can’t.
A second argument will accept that the first one does not hold water, but
would, reminds us that risk-takers must face the consequences of their actions when they
do not pan out as expected. If they do not, they will be even more reckless the next time
around. True, but the question here is one of timing. Should the punishment be imposed
now or later? Imposing it now implies accepting all the consequences of an interbank
market meltdown. These consequences are too frightful to contemplate. They are also
unnecessary. Once the dust settles, the time of punishment will come. Inquiries should be
conducted and those who violated the law must be brought to account. The problem is
that reckless risk-taking is not unlawful, and rightly so. But then, what are they to be
punished for? Bad judgment.
This brings us to the third argument. Bad judgment in this case is the source of a
serious externality, another market failure that calls for public intervention. The problem
is that deciding on bad judgment is a value judgment. Currently, dealing with the
externality is entrusted to supervising agencies. Obviously, something has gone amiss
here and the market failure has been compounded by a policy failure. The ball is logically
thrown back in the government’s court, which seriously weakens the case for punishing
the markets.
Finally, comes Bagehot and the recommendation that emergency lending be
carried out at penalty rates. The ECB is lending at the normal rate and the Fed even
lowered the discount rate, seriously contradicting the Bagehot principle. The problem is
that Bagehot is about isolated events of illiquid individual institutions, not about a
systemic drying-out of markets where most institutions are awash with cash. Most
institutions that currently absorb the liquidity are illiquid not primarily because they made
mistakes but because they have no way to break the information asymmetry problem.
In the end, not providing the liquidity amounts to taking an excessive risk, that of
punishing millions of citizens if a credit squeeze were to create a serious recession. We
are reminded of the 1929 crash. Countless studies have blamed the monetary authorities
for having stood by as the world economy slid into the Great Depression. Back then,
many voices argued that the markets should clean themselves and that excessive risk
takers should face the consequences.