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 Moral Hazard on Wall Street and Main Street

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Number of posts : 440
Registration date : 2007-07-01

PostSubject: Moral Hazard on Wall Street and Main Street   Sat Aug 18, 2007 11:41 pm

Moral Hazard on Wall Street and Main Street

By Marc Chandler Contributor

8/17/2007 5:22 PM EDT

Click here for more stories by Marc Chandler

The Federal Reserve has taken several
steps up a policy-escalation ladder to address the turmoil in the
capital markets. It has allowed the fed funds rate to deviate sharply
from its target and has created conditions that have allowed an
approximately fivefold increase in excess reserves of the banking
system.The Federal Reserve took additional steps earlier
today. First, it liberalized the so-called discount window borrowings,
which are neither at a discount nor take place at a window. The Fed cut
the punitive rate from 100 bps more than the fed funds target to only
50 bps and lengthened the period that the funds can be borrowed.
Yet, discount window borrowings are minor ($265 million total in
the week ending Aug. 15), and the discount rate is still above the fed
funds target and well above the recent average effective fed funds rate
(weighted by size). As such, these moves are largely symbolic. Second, and arguably more importantly, the Fed changed its
bias by saying "Financial market conditions have deteriorated, and
tighter credit conditions and increased uncertainty have potential to
restrain economic growth going forward." This was the first sentence of
their statement with the announcement of the changes in the discount
This is important because it represents a stronger recognition
of the potential for the macroeconomy to suffer from the capital-market
turmoil than was expressed in the Fed's statement after the Aug. 7 FOMC
Over the last couple of weeks, we have argued that the bar for
a Fed cut was high and that a material impact on the real economy would
be necessary. With today's statement, the Fed, in effect, indicates
that it is a bit closer to the bar than it was previously. This means that the odds of a September rate cut have
increased. However, it is not a done deal. First, the Fed explicitly
stated that the discount moves were temporary and indicated that "these
changes will remain in place until the Federal Reserve determines that
market has improved materially."
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Number of posts : 440
Registration date : 2007-07-01

PostSubject: Re: Moral Hazard on Wall Street and Main Street   Sat Aug 18, 2007 11:42 pm

Second, the Federal Reserve seems reluctant to
cut its fed funds target, even though some pundits have suggested that
the Fed under Alan Greenspan would have.
The Greenspan Put

At the heart of this debate is the status of what has
euphemistically been called the Greenspan put. This refers to the
concept articulated by the then-chairman of the Federal Reserve in late
2002. There were three components to what he said.
First, Greenspan said that asset bubbles cannot be detected with a high degree of certainty.

Second, he said that monetary policy should not try to offset asset bubbles.

Third, he said that the collapse of the asset bubbles can be
detected, and that the economic fallout can be mitigated by timely use
of monetary policy.
In effect, policy should not be used to curb "irrational
exuberance," but should be used to clean up the mess created when the
asset bubbles pop. This asymmetrical policy role should therefore not
deter excessive price appreciation of asset markets, but should limit
the knock-on effects of asset price depreciation. In early 2003,
current Fed chief Bernanke seemed to concur. This asymmetry creates a moral hazard as surely as any social
welfare program does. The pendulum of market sentiment swings,
sometimes violently so, on its own between fear and greed, but the
asymmetry of the Greenspan/Bernanke doctrine encourages unhealthy greed
by socializing the costs of the shift toward fear. It rewards imprudent
economic actors and punishes the prudence of others. Turmoil Presents Difficulty

Part of the confusion in the markets presently, which may be adding
to the turmoil, is that the market is not sure that Bernanke still
adheres to what Greenspan and he previously articulated. I suspect
Bernanke does in fact want to distance himself from it, but the turmoil
in the markets is making it difficult to jettison it completely at this
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PostSubject: Re: Moral Hazard on Wall Street and Main Street   Sat Aug 18, 2007 11:42 pm

Officials have intimated that the market was
mispricing risk for some time. As credit spreads widened, the Fed was
more than willing to stay on the sidelines. When the stress moved to
the short-end of the curve and morphed into a liquidity issue, the Fed
-- like the European Central Bank (ECB), the Bank of Japan, Bank of
Canada and the Reserve Bank of Australia -- provided extra liquidity
into their respective banking systems. However, it was clear from the continued turmoil in the markets
that the liquidity provisions, while sufficient to keep overnight rates
low, failed to arrest the fear that seemed to be paralyzing the two
main channels of capital distribution: the banks and the markets.
The Effect is Unknown

It is too early to tell whether the Fed's moves will be sufficient
to stabilize the situation. On the one hand, if these moves are
successful, there seems to be little reason for the Fed to take
additional policy steps.
On the other hand, if it fails, then it is also less clear that
a 25-bp or even a 50-bp rate cut would rekindle the animal spirits. And
it is not clear that that is truly desirable from a policy making point
of view. In the process of ameliorating the fallout from the end of the
equity and technology bubble, the Federal Reserve, so the argument
goes, helped foster the real estate bubble. A rate cut now would
potentially risk a new bubble and thereby keep the Fed and the markets
in this perverse cycle. Unlike in 1998 and 2000, the U.S. and the world economy appear
strong enough to absorb the current dislocations. What happens on Wall
Street does not always impact Main Street.
U.S. growth in the second quarter is likely to be revised
sharply higher to a 4% handle, and the early signs suggest the economy
enjoyed reasonably good momentum as the financial crisis deepened.
Growth in the third quarter is likely to be slower than the second, but
not nearly as weak as the first quarter. If the situation does get worse in the coming days, the
Federal Reserve and Treasury still have a number of policy tools in
their arsenal before climbing the escalation ladder to an inter-meeting
cut. Bernanke is likely to resist a rate cut as long as possible. The
real economy does not merit such a move, and core inflation readings
have begun creeping up. Nor does he appear anxious to soften or
socialize the discipline of the market place.
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