Monday, March 24, 2008

The Problem with Bailing out the Finance Sector

Moral hazard means that certain policies merely encourage more bad economic decisions.

A simple example is insurance. If our bike is ensured for the full amount, we have less incentive to look after it. Therefore, when we get insurance there is a greater chance it will get stolen. This is why insurance firms do not insure for full amount but make us pay the first £50 or £100.

Many, including Chairman of the Bank of England, Mervyn King, have argued the Fed's decision to cut interest rates will cause moral hazard in the US finance sector.

Why Cutting interest Rates could cause The Same Problems to Reoccur.

1. US finance companies made a lot of very poor decisions to lend to borrowers who were likely to default. These bad loans were made to people with poor credit histories or low incomes.

2. Because the banks made many poor decisions they suffered the consequence of record loan defaults. Banks and mortgage companies need to take responsibility for their poor decisions and lack of self regulation.

3. The loan defaults caused problems throughout the banking sector. The magnitude of loan defaults caused a freezing of money markets because the finance sector has swung to the other extreme and no longer wants to lend to anyone.

4. This credit crunch has caused a fall in stock markets and has endangered the future of the US economy.

5. To Avoid recession and restore confidence in the finance markets, the Fed have aggressively cut interest rates from 4.25% to 2.25% in a matter of months.

6. This is the main problem. The Banks have created a crisis and the authorities respond by trying to mitigate their bad decisions. Because Bear Sterns has been rescued, because interest rates have been drastically cut, the finance sector hopes to avoid the consequences of their previous bad decisions.

7. However, the problem is that if the authorities prevent the negative consequences of poor lending the finance sector may feel that it will be fine to do it in the future. Basically, if they make poor lending decisions it doesn't matter because the Monetary authorities have promised to bail out the finance sector. If poor lending decisions are punished then in the future, banks have a clear incentive to avoid making inappropriate loans.

8. The interest rate cuts which occured in the past months, maybe good from a short term perspective, but, in the long term it may merely create a future financial crisis

The Only Thing We Learn is that We learn Nothing.

Remember the dot com bubble? Financial investors got carried away speculating on dot com shares. The effect was that prices became divorced from reality before a spectacular crash.

This crash threatened a short term downturn, so the Fed aggressively cut interest rates to 1% to avoid a serious recession.

However, this rate cut to 1% created moral hazard. The finance sector was bailed out. - Create a bubble and it doesn't really matter because the monetary authorities will try and bail us out. In 2001 and 2002, these exceptionally low interest rates helped to create another bubble. This time in the housing market. Again this bubble burst in 2006 and now we see the monetary authorities responding by trying to mitigate the short term effects.

To be fair the Fed are between a Rock and a whirlpool. If they keep interest rates high a deep recession is inevitable. Cut interest rates and they risk causing moral hazard and a future bubble. It is easy to criticise the decision to rescue Bear Sterns and cut in interest rates. However, it would also be easy to criticise a decision not to rescue Bear Sterns and keep interest rates high. The Fed certainly face a difficult dilemma; unfortunately it is of their own making. In particular the decision to keep interest rates for so long during the early 2000s means they are now having to deal with the consequence of boom and bust

1 comment:

Carole G. said...

Some smart (not to mention common sense)ideas that the Fed could use!