Real and pseudo crises

The distinction made by Schwartz ( 1986) between real and pseudo financial crises and its extension by Bordo, Mizrach and Schwartz ( 1995) to systemic risk has resonance for the recent crisis events. Schwartz argued that a real financial crisis involves a scramble for high powered money by the public fearful for the safety of their bank deposits, ie a banking panic or a threat to the payments system. Pseudo crises encompass “ a decline in asset prices of equity stocks, real estate, commodities;depreciation of the exchange value of a national currency;financial distress of a large non-financial firm, a large municipality, a financial industry, or sovereign debtors…” Schwartz ( 1986 page 12). In the case of a real crisis, the monetary authority should act as a lender of last resort and provide whatever liquidity is required to allay the public’s fears. In the case of a pseudo crisis there is no need for action.

In this framework , the recent events of a collapse in the US housing market and its consequences for wealth holders directly or indirectly exposed by derivatives represents a pseudo crisis which should not be the object of central bank intervention. However the spillovers of the subprime crisis into the interbank loan market and the freezing up of liquidity to the banking system in Europe and America did pose the threat of a real financial crisis and should have been dealt with by following the strictures of Thornton ( 1802) and Bagehot (1873) to lend freely but at a penalty rate. Bagehot placed primary emphasis on the Bank of England lending without hesitation on the basis of collateral that would be sound in the absence of a crisis. The penalty rate was to prevent moral hazard.

The actions of the ECB of flooding the money market with liquidity and the Fed of following similar actions and also reducing the discount rate by 50 basis points in August 2007 suggests that they heeded the first part of Bagehot’s lesson to lend freely on the basis of proffered collateral but not quite on the second part of lending at a penalty rate.

Finally we speculate on whether the recent financial crisis could have been avoided if the Fed had not provided as much liquidity as it did from 2001 to 2004. After Y2K when no financial crisis occurred, it promptly withdrew the massive infusion of liquidity it had provided. By contrast thereafter,it foresaw a series of shocks to the economy that might lead to financial crisis, eg the tech bust of 2001 and 9/11. In each case it injected liquidity, but when no financial crisis occurred , it permitted the additional funds it had provided to remain in the money market. In addition, it overreacted to the threat of deflation in 2003-2004 which may have been of the good ( productivity driven) variety rather than of the bad ( recessionary) variety ( Bordo and Filardo 2005).

Source: ‘The Crisis of 2007 :The Same Old Story, Only the Players Have Changed’ (Michael D. Bordo) – remarks prepared for the Federal Reserve Bank of Chicago and International Monetary Fund conference; Globalization and Systemic Risk. Chicago, Illinois September 28, 2007

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