Shielding the inefficeint: Financial Express: 19th December 2007

The lowering of the US Federal Reserve’s benchmark interest rate by a further 25 basis points, juxtaposed with similar action taken by the Bank of England and European Central Bank’s infusion of liquidity, brings to fore the evolving role of central banks. Textbooks talk of monetary policy in the context of growth and inflation targets. However, the monetary authority has progressively become more responsible for the integrity of the system, which has a bearing on policy formulation. The question is how far it should go to protect the inefficient or failed elements of the system.
The official line taken by the US Fed when it lowered interest rates by 50 basis points earlier was that both GDP growth and inflation are quite satisfactory, but its own proclivity is towards growth. This time, it has said no such thing. But one could guess subprime concerns. The losses to be suffered by the financial system are estimated in a range of $200-400 billion. Estimates of both the OECD as well as The Economist indicate that while growth may be hit, an outright recession is ruled out. In fact, given that commodity prices are rising, inflation is the bigger concern today. Clearly, due to the present liquidity problem, the Fed has been lowering its rate and has held out $24 billion towards liquidity supply. Nothing really wrong in this, but it does provoke a debate on whether or not the central bank should come to the rescue of financial players in times of such crises.
To go back a bit into economic theory, Joseph Schumpeter had espoused “creative destruction”, wherein he emphasised that it is a natural law that as economies move along, crises are but natural and should be allowed to run their course. This will help eliminate inefficient players, and in turn, lead to catharsis that would leave the system better off. Note that the subprime case’s origins can be traced to banks and other mortgage houses lending recklessly to individuals and then securitising the loans. Such institutions that operate on flaky grounds, according to Schumpeter, must not be allowed to survive, and their failure will come to cleanse the system and set an example for others. The Asian crisis, for example, was mainly due to crony capitalism, and had lessons on credit assessment that makes Basle 2 norms all the more relevant. Prudential banking, everyone agrees, is important to economic stability.
Also, by helping save the situation, the Fed (and the Bank of England and European Central Bank) sets a precedent of standing by any financial organisation which bungles, especially so in case there is systemic risk posed to the Economy. In fact, Henry Paulson of the US Treasury has also spoken of repricing subprime mortgage loans, which benefits those who are less likely to comply, thus creating a perverse incentive not to worry about compliance. This results in a moral hazard, which is quite scary because if banks in India, for example, know that the Reserve Bank of India (RBI) will eventually cover them, then they would be that much more reckless in lending.
From the point of view of the protagonists of rescue missions by central banks, there are two compelling reasons for affirmative action. The first is that the financial system today is a very important part of the Economy and has deep implications for the real sector (and overall growth). The Asian economies took over five years to recover, and the other affected countries such as Brazil and Russia took even longer to recover from the slump. Lower US growth is serious business that the Fed cannot ignore.
The other reason is that in the world of globalisation, it is hard to escape the contagion effect. Indian stock Markets were hit when the subprime crisis erupted. It affected not just our banks but also the RBI’s policy stance. Funds were withdrawn from bank stocks across the world, causing market turbulence. Further, various countries’ monetary policies are getting aligned with one another, and given that the “decoupling” of the rest of the world from the US is still not a proven phenomenon, a recession in the US can affect others too. Recall that the Fed took the blame for the Great Depression of the 1930s, which explains why it must be proactive in such situations.
The result is that central banks have taken on a new inadvertent role of protecting inefficient entities—ironically, to protect the Economy. Further, as was the case with Northern Rock, the interests of deposit holders had to be protected. The UK’s regulator, the Financial Services Authority (FSA), was in charge, but the Bank of England had to come to the bank’s rescue to protect deposit holders.
This certainly calls for greater and more stringent financial supervision, either with a separate arm of the central bank or an independent authority which will in turn have to ensure that the rules are obeyed and be responsible for a bailout in times of crisis.