Central banks are not the world’s most glamorous institutions. The word “grey” seems tailor-made to describe these lenders of last resort.
But as financial markets reel from the recent credit crunch, unprecedented attention has been given to the world’s central bankers’ Delphic-like utterances, as they work to unplug the blocked pipes choking credit from Wall Street to Shanghai. Witness the frenzied attention given to the Federal Reserve’s half-point interest rate cut on September 18.
Central bankers are normally circumspect individuals, cautious about what they say and don’t say. Occasionally, however, central bankers can be decidedly un-Delphic in their comments. This was recently true of David Dodge, governor of the Bank of Canada, and Mervyn King, governor of the Bank of England.
By mid-September, both had made it clear they were skeptical of the wisdom of central banks seeking to resolve the credit crisis by, among other things, offering three-month loans to commercial banks.
The point of such loans – so the argument goes – is to reduce the high interest rates in the money market for certain types of debts, thereby giving banks the space they need to prepare themselves for the full impact of the American subprime mortgage implosion. Thus by September 14, the European Central Bank (ECB) had made 75 billion euros in three-month loans available to commercial banks.
According to Mr. King and Mr. Dodge, this is bad monetary policy. In Mr. Dodge’s view, it is “certainly not our job to somehow bail out people who have made losses.”
Likewise, Mr. King observed that measures such as those adopted by the ECB assist more reckless investors to the detriment of those who have been prudent. He also suggested such decisions actually incentivize irresponsible investors to pursue similar strategies in the future. As Mr. King stated in mid-August: “Interest rates aren’t a policy instrument to protect unwise lenders from the consequences of their unwise decisions”.
Plainly, what Mr. Dodge and Mr. King have in mind is the phenomenon known as moral hazard. In financial terms, moral hazard can occur if lenders make high-risk loans (normally the loans offering the highest returns), because they know they will be bailed out by a third party if the loan fails.
In these circumstances, lenders have a high incentive to offer loans that carry extremely-high failure risks: that is, loans they might not otherwise make.
Likewise, if a borrower thinks they are a big enough financial player, they may risk taking on huge debt at high-interest rates in the belief that no one – including central banks conscious of bad loans’ unpredictable chain-effects – will let them go bankrupt.
It is not coincidental that Mr. King has warned against IMF bailouts of debt-ridden developing nations. The same principles are equally applicable to countries – a point often missed (or ignored) by some international debt relief advocates, ranging from economists who should know better, to secular and religious activists susceptible to simplistic solutions.
Curiously, however, the voluminous literature on moral hazard contains little reflection on why the adjective “moral” is attached to the word “hazard.” Why not simply call these situations instances of “loan hazard”?
The word “moral” reflects some realization that people or institutions who enable such behavior or who act on the basis of such assumptions are behaving in an ethically questionable manner.
Moral hazard is analogous to giving alcohol to someone with an alcohol addiction, hoping to calm them for the moment. Another analogy is the student who runs up huge debts, secure in the knowledge that his indulgent parents will bail him out. Both the alcoholic and the student are ultimately responsible for their choices. But those enabling their damaging behavior also bear some responsibility. The enabler’s benevolent nature is itself a source of powerful temptation for others.
Which brings us back to central banking. Is the practice of central banking itself an exercise in moral hazard?
In his recent book Money, Bank Credit, and Economic Cycles (2006), the Spanish economist Jesús Huerta de Soto argues that the very existence of a lender of last resort inevitably encourages financial irresponsibility on the part of some financial players.
Some economists would disagree with this analysis, arguing that central banks usually do distinguish between illiquidity (a temporary shortage of funds) and insolvency (an irrecoverable financial collapse) – even if the distinction is often a fine one.
It is hard, however, to dispute that a degree of moral hazard seems implicit to the very logic of central banking, inasmuch as it inescapably seems to involve protecting some financial institutions from the consequences of their choices.
Not even Mr. King’s criticisms of moral hazard prevented him from executing an abrupt volte-face on September 19 by stating that the Bank of England would extend emergency lending to all banks in the wake of the Northern Rock bank’s crisis.
Ultimately, one difference between various central banks’ operations over the past two months may be the varying degrees of moral hazard they are willing to countenance. Not exactly a ringing endorsement of central banking.
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