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Fed will likely avoid ‘moral hazard’

Marketplace Staff Aug 13, 2007
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Fed will likely avoid ‘moral hazard’

Marketplace Staff Aug 13, 2007
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TEXT OF COMMENTARY

Kai Ryssdal: There are a couple of phrases that keep showing up as journalists try to figure out how best to describe what’s happening in the financial markets. Credit squeeze is one. There’s liquidity crunch.

Another we’ve seen a lot of since late last week is something called moral hazard. The idea that people who are too well-protected if they should do something stupid, might go ahead and do something stupid. It’s an insurance term that’s been hijacked by economists.

And another way to think of it, given the news, is this. Should the Federal Reserve be pumping money into the system to help out the likes of Goldman Sachs — institutional players that took big risks when times were good and money was cheap. Commentator Krishna Guha maintains that’s looking at it the wrong way.


Krishna Guha: Now, the Fed has to be very careful not to promote moral hazard.

If it were to bail out investors who took a punt on subprime mortgages, or bought into fancy derivatives they did not understand, it would only encourage reckless risk-taking in the future.

But nothing the Fed has done so far amounts to bailing out recklessinvestors. What it has done is to provide liquidity to creditworthy institutions. It’s lending against good-quality securities, such as loans guaranteed by Fannie Mae or Freddie Mac.

This is central banking 101. The Fed always acts as a lender of last resort when private markets are too spooked to lend at normal rates even to borrowers holding sound assets.

The Fed is not trying to stop the repricing of risky assets by helping to ensure that the markets have enough liquidity to work. Quite the opposite — it is allowing the repricing process to continue, while trying to prevent any unnecessary fallout.

What would promote moral hazard would be any move to cut interest rates that was not obviously justified by collateral damage from the market turmoil to the real economy. There are plenty of people who would like the Fed to do that, but Idoubt that Mr. Bernanke and his colleagues would be willing to oblige.

And that is why it is way too soon to conclude that the Fed will becutting interest rates in September or even sooner. If dislocations in the markets last long enough and run deep enough to threaten the supply of credit to home-buyers or to businesses, then the Fed might cut interest rates.

But what the Fed will not do is cut rates simply in order to help out badly burned hedge-fund managers and hapless foreign investors left holding the subprime bag. That would indeed be a case of risking moral hazard.

Ryssdal: Krishna Guha covers the Federal Reserve for The Financial Times.

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