Fed Treads Moral Hazard

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Fed Treads Moral Hazard

Step In and Cut Rates

Or Stand By and Watch:

Whither Helicopter Ben?
By [b]E.S. BROWNING
August 13, 2007; Page C1

[/b]



Wall Street has a dream: that the Federal Reserve will rescue financial markets with a sharp cut in interest rates.

Behind that dream lurks a problem, something financial people call moral hazard.

Moral hazard is an old economic concept with its roots
in the insurance business. The idea goes like this: If you protect
someone too well against an unwanted outcome, that person may behave
recklessly. Someone who buys extensive liability insurance for his car
may drive too fast because he feels financially protected.

These days, investors and economists use the term to
refer to the market's longing for Federal Reserve interest-rate cuts.
If investors believe the Fed will rescue them from their excesses,
people will take greater risks and, ultimately, suffer greater
consequences. Some grumble that the Fed created problems this way in
1998, 1999 and 2003.

If the Fed were to cut rates now, it certainly could
help with the current market crisis. The cheaper money would reduce
pressure on stock and bond markets by making it easier to buy
beaten-down stocks, bonds and other securities world-wide. Wall Street
is a powerful lobby in Washington, and its bleating for help can be
hard to resist for politicians, whose campaigns often depend on
financial contributions from Wall Street figures.

But if the Fed were to ride to the rescue, the
skeptics worry, it would encourage people to speculate even more,
creating an even bigger bubble later.

"You don't want to see the Fed bail out these guys who
have made a lot of money. They have made their bed and you want to see
them lie in it," says a veteran trader at a New York brokerage house.
"Then again, you don't want to see the economy go into recession."

That, in a nutshell, is the choice the Fed's policy makers face today.

Earlier in his term as Fed chairman, Ben Bernanke was
seen by a lot of investors as possibly too inclined to bail people out.
Mr. Bernanke was dubbed "Helicopter Ben" because of a reference he once
made to an economic theory that, if deflation threatens, the Fed's role
is to dump money into the economy as if dropping it from a helicopter.

Mr. Bernanke wasn't advocating such a posture, and
many felt the nickname was unfair. It has taken him months of steady
insistence that he wasn't about to cut rates and fuel inflation for the
gadflies to stop calling him that.

Now, it is the other side that is upset, worrying that
his refusal to cut rates will hurt growth and enable the credit crisis
to fester. Last week, Fed policy makers issued a statement reiterating
their determination to fight inflation, and the worriers grumbled the
Fed was being too tough.

But Mr. Bernanke's old critics -- those who formerly
called him Helicopter Ben -- cheered. Articles were written announcing
that the "Bernanke put" was dead. The "Bernanke put" was another arcane
reference, in this case to an option known as a put option that permits
investors to sell stock at a preset price, limiting potential losses.
Critics had complained that, as long as people could count on the Fed
to intervene in case of trouble, Mr. Bernanke was putting a floor under
the market -- offering a put. In earlier years, people called it the
"Greenspan put," a reference to then-Fed Chairman Alan Greenspan.

With people screaming from both sides, the Fed's
response has been to seek out the middle ground. Instead of cutting
rates, the Fed has offered additional loans to banks, to ensure there
is plenty of money in the financial system, and it has offered to buy
bonds from banks that feel they are holding too many bonds in the midst
of a bond crisis.

Economists generally feel the proper solution to such
problems is to start small and use the least intervention possible. The
Fed seems to be saying that, if it can right the ship without cutting
rates, it will do so, and it won't cut rates unless things get worse.

Debates of this sort, featuring quaint expressions
such as moral hazard, have gone on for decades, and they flare up
whenever crises do. Some of the issues date back to the government's
failed efforts to save the economy from the Great Depression, a subject
on which Mr. Bernanke has written extensively. Some go back even
farther.

Some still complain that the Fed, then led by Mr.
Greenspan, contributed to the stock bubble of the late 1990s. In 1998,
the Fed cut interest rates to support the bond market after it was
swamped by a Russian debt default and the near-collapse of a huge hedge
fund that specialized in bonds, Long-Term Capital Management. The Fed
also encouraged banks to rescue that hedge fund. Stocks, the riskiest
of which were down more than 20% at that point, quickly recovered.


Late in 1999, the Fed slowed its campaign of rate
increases and used other means to pump money into the system to avoid
trouble as bank computers switched to 2000 from 1999. That dose of easy
money may have helped prolong a stock surge that didn't end until early
2000.

Starting in January 2001, the Fed gradually cut its
target rate for overnight bank lending to 1% in 2003 from 6.5% in 2000.
That kept the economy out of a deep recession, but some complain that
the Fed kept rates too low for too long, laying the groundwork for
today's troubles, which were fueled by cheap money. The Fed began
raising rates at the end of June 2004, and the target rate today is
5.25%.

The complaint that the Fed was too slow to raise rates
"leaves me scratching my head: There is simply no hard evidence to
support it," wrote Mark Gertler, an economics professor at New York
University who has co-written several academic papers with Mr.
Bernanke, and who submitted this comment to The Wall Street Journal's
Real Time Economics blog. "By keeping interest rates low in the absence
of inflationary pressures, the Fed prudently insured against a
Japan-style stagnation," Mr. Gertler wrote.

Just to show how hard it is to please critics, some
complain the Fed has been too tough -- not too lenient. They say the
Fed raised rates too much in the early 1990s, causing bond prices to
collapse, and again in 2000, throwing the economy into recession -- and
should have been cutting them months ago to prevent recession today.

In general, Fed officials say, they intervene to
support the economy and the financial system, not to bail out foolish
investors. Unfortunately, one can lead to the other.

An example: If your neighbor smokes in bed, you may
hope he burns his hand and learns a lesson. But if his house is burning
down due to his careless smoking, you probably would prefer that the
fire department come to extinguish the fire. In this example, the fire
department can send the careless homeowner a bill. In financial
markets, that is harder to do.