When the Lender of Last Resort Fails

Charlie only had one life jacket on his pontoon boat. Pete fell overboard and Charlie thought about throwing it to him but then realized that if he did, he would no longer have one for himself.  Being a true friend he threw it to him but unfortunately Pete went over the falls anyway – life jacket and all. Then Charlie noticed the leak in the boat.

I studied a lot of macro but I never got to the chapter that says what happens when the lender of last resort fails.  It is a widely shared view that the Fed has the right and the privilege to be the lender of last resort. So if the US economy is sinking and sinking badly, the Fed is supposed to use monetary policy to keep us all from drowning. We saw the lender of last resort activity in the last couple of years. Now the Fed has announced that it will be the lender of last resort for French and other European banks.

It all sounds pretty rational. Economic systems are prone to boom and bust cycles. We think we learned from the Great Depression and from other financial crises that monetary policy should play a stabilizing role. But one thing we didn’t learn is what happens when the central bank plays the role of lender of last resort and they fail. That is, Pete goes over the waterfall and there are no life jackets left. What now?

If there will be a lesson to be learned from the present global financial crisis it will be that central banks really did play their lender as last resort roles. Europeans often bemoan the fact that the European Central Bank did not bail out Greece and other countries fast enough or with enough gusto, but even the ECB has come forth with plenty of cash. Now the FED, ECB, and a few other central banks are printing money to help key European banks get enough dollars. There is enough money out there to sink a very large boat.

What is reassuring to some folks and frightening to others is that the lender of last resort role has no finite amount of ammunition. Unlike Charlie’s life jacket, the Fed has plenty of bullets. Why? Because modern central banks can print money whenever they want.  It is virtually costless to pump out another $100 billion. The problem is not so much the number of bullets – it is their impact. Maybe we should be using pharma as our example. Mike has a headache. Give him a couple of aspirins. Mike still has a headache. Give him a few more aspirins. The truth is that Mike has a headache because is wearing the wrong size undershorts. Aspirin isn’t going to help. Mike needs a bigger thong.

When the Fed was doling out all that dough last year did it ever wonder what would be left for them to do in a double dip? I don’t know what goes on behind those gold laden walls, but I didn’t hear much on this topic. And their seeming unflagging duty to pour in even more money recently suggests that the thought has not even entered their minds.  If one tranche wasn’t enough try two. If two wasn’t enough try three. It’s just math. It’s math at least until you realize that more and more aspirin in going to give Mike a bad stomach problem to complicate his undershorts issue. 

So there are two points to cover. First, why didn’t the earlier money expansions work? Second, why are they creating even worst problems as a result of the monetary addiction? The first part is easy. Monetary stimulus (and fiscal stimulus) do not address the most pressing problems. The causes of the Wall and Main Street problems were financial – too much leverage on top of two much leverage.  Very little has been done to solve those problems because politicians don’t have the guts to tell people there is no easy way out of that dilemma. So they prefer to drag us through a decade of horrible economic malaise instead. Don’t rip off the band-aid. Pull it off a little at a time. Only a politician would do this. Doctors don’t get paid for being popular. They rip off band-aids with fervor and sometimes glee. Our politicians use money as a drug to counter some of the negative side-effects of the slow band-aid pull.

So the answer to question 1 is simple – politicians give us money instead of real solutions. The second question is more interesting. Okay – so we slowly bleed for a while. Isn’t that better than the intense pain of a quick solution? I think the answer is no. Here are five why.

Reason #1. Weakening the economy for a long time makes it very sensitive to every economic virus that goes around. A strong patient bounces back from the flu quickly. The weak one may not survive. What economic shocks are around the corner? Clearly whether it is a jolt in energy prices or a spike in food prices after flooding, the economy will adjust more slowly and with less elasticity. This is very risky behavior!

Reason #2. Keynes was very specific in his book the General Theory that when credit markets lack confidence, the impact of monetary policy on output and employment all but disappears. There may still be a few people around who trust Bernanke, but as more and more money seems to work less and less, we are getting closer and closer to Keynes’ liquidity trap wherein money is totally useless to stimulate the economy.

Reason #3. The low interest rate environment just compounds our problems. So long as people cannot get decent returns on assets they will pressure financial institutions to innovate and create ways for them to take higher risk and get high returns. Banks would rather facilitate this madness than loan money to entrepreneurs. Isn’t it interesting that the Fed says they are saving us yet what they are really doing is engineering a repeat of the past financial crisis! Why does the Fed want to perpetuate leverage and risky investments? This could mean more downgrades and another financial crisis

Reason #4. All this focus on monetary policy diverts our attention away from reforms that would regulate the most egregious factors in the housing and financial markets. It is true that the positive effects of these kinds of policies will be slow in coming. But the longer you wait, the more the problems fester. The more the problem festers the more we raise the probability that a new shock will throw us for a loop.  

Reason# 5.The Fed has discounted an increase in inflation despite the fact that most indicators and expectations measures show it is bubbling below the surface. Despite all this economic sluggishness and large and persistent excess capacity, the psychological link between money and inflation remains as strong as ever. Inflation will not simply rise gradually. At some point it will explode. When it does it will be too late for the Fed to reverse engines. Bernanke stares at the cameras and solemnly says for us to trust him. The Fed is a very modern and scientific institution. When the economy recovers and inflation begins to be a larger threat, the Fed with utmost precision will remove money in the perfect amounts that will guarantee growth in output with stable inflation. Woowee. And if you believe that have I got a bridge to sell you!

In short, the Fed is entering uncharted waters. They seem to see no end and no risk to their policy of lender of last resort. They REALLY need to think about this some more. It is a very dangerous game they are playing with our jobs and welfare.