Who says finance isn’t highly entertaining?
The question is how [central banks like the Federal Reserve should] help the system without encouraging even more bad behaviour. This is such an important question because the system has been so crisis-prone…
I think of the underlying game as “seek the sucker”: sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer [that’s you!] who rescues the players who became rich from lending to sucker number one and selling to sucker number two.
[B]uyers believe sellers know more about the quality of what they are selling than they themselves do… [P]recisely what has now happened to trading in certain classes of security. The crisis is focused in markets in structured credits and associated derivatives [in other words, all kinds of securities that contain debt of various forms]. The cause seems to be rampant uncertainty.
Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties [people to whom they have lent money]…
Yet the difficulty is not a lack of general liquidity. Central banks have provided it freely… Nor is this a general crisis in lending. Credit spreads have not exploded for corporate or emerging market debt. They have merely become less unreasonable…
This then is a crisis in the market for financial lemons. So what should the authorities do about that? My answer is “nothing”… they should not promote the survival of a market in lemons.
This is why I disagree with the suggestion… that central banks should now become market-makers of last resort [accept these various kinds of financial instruments as collateral for loans].
Central banks could do this only if someone regulated not just the soundness of financial institutions (as now) but also the properties of all the products these institutions invent.
Otherwise, the central banks might be forced to buy what they do not understand. They would, instead, be offering a commitment to be buyers of last resort in a market for lemons, thereby subsidising the creation of a market in junk. [That would be a bad idea.]
If central banks were to regulate products, however, they would be running the financial institutions. Ours would become a quasi-nationalised financial system. [That would also be a bad idea.]
Now suppose central banks did, instead, refuse to intervene in the afflicted markets. What would happen? Sellers must turn lemons into apples, pears, strawberries and all the rest. In other words, they must demonstrate the precise properties of what they are trying to offload. Where they cannot do this, they may have to hold securities to maturity. [Gasp!]
Meanwhile, vulture funds would invest in obtaining requisite knowledge. Losses will also have to be written off. How much of the market in securitised lending would survive this shake-out, I have no idea. But I do not care either. That is for the players to decide, after they realise the consequences of getting it wrong.
Burned children fear the fire. If some of the biggest and most powerful institutions in the world have been playing with fire, they need to feel the burns. It is not the central banks’ job to rescue them by creating a market in the incomprehensible. It is their job to preserve the banking system and the health of the economy. Neither seems now to be in grave danger.
Decisions made in panic are almost always bad ones. Stick to principles and let the masters of the financial system sort themselves out. They are paid enough to do so, after all.
From the Financial Times.