Insider Joins Critics of the Fed,
Faulting Credit-Crisis Programs
Moral Hazard Fears
By GREG IP
June 6, 2008; Page A3
In a striking insider's
critique, a Federal Reserve policy maker said lending programs the
central bank has created to combat the credit crisis distort private
markets, encourage risky behavior and could endanger the Fed's
Federal Reserve Bank of
Richmond President Jeffrey Lacker's remarks, made Thursday in a speech
in London and amplified in an interview, show that concerns that
outsiders, including former Fed Chairman Paul Volcker, have raised about
the Fed's actions -- in particular its rescue of the investment bank
Bear Stearns Cos. -- are shared by some inside the Fed.
Those people, including
presidents of some of the 12 regional Fed banks, remain a minority.
Nonetheless, their views will matter in the months ahead as the Fed, the
Bush administration and Congress grapple with the implications of the
Fed's unprecedented actions.
"The danger is that the
effect of recent credit extension on the incentives of financial-market
participants might induce greater risk taking," a phenomenon called
moral hazard, "which in turn could give rise to more frequent crises, in
which case it might be difficult to resist further expanding the scope
of central-bank lending," Mr. Lacker said, according to a text of his
the full speech.1)
In an interview, Mr.
Lacker said that "before this recent episode, there [were]
well-understood and well-articulated boundaries around when we would
lend": to manage short-term interest rates, to help banks deal with
temporary shortages of cash, or to facilitate the closure of a bank
taken over by regulators.
"The innovative credit
programs and other things we've done have gone beyond previously
accepted boundaries. We'll be wrestling with the consequences." The new
program could put the Fed's independence at risk, he said. "It crosses a
line into what is essentially fiscal policy to direct credit to
particular sectors, creating expectations of similar treatment."
Fed officials are debating
how quickly, if at all, they should withdraw some of the lending
programs they have created to stabilize markets. If some of those
programs become permanent, they might entail the Fed expanding its
oversight of the financial system. Federal Reserve Bank of New York
President Timothy Geithner, who helped arrange the Bear Stearns rescue,
is to address its implications for the country's regulatory structure in
a speech Monday.
Since August, the Fed has
taken numerous unconventional steps to improve conditions in credit
markets, including vastly expanding loans to banks. Separately, it has
temporarily lent safe Treasurys from its own portfolio to investment
banks in exchange for their riskier securities. Most controversially, it
lent $29 billion to Bear Stearns and opened its discount window to
investment banks for the first time.
In a separate Thursday
speech, Charles Plosser, president of the Federal Reserve Bank of
Philadelphia, made points similar to Mr. Lacker's, highlighting to the
possibility that a central bank's actions can distort markets and prices
and "effectively subsidize risk-taking by systemically important
"Policy interventions in
financial markets run the risks of increasing moral hazard and
inhibiting efficient price discovery," he told the Society for Financial
Econometrics in New York. "Moreover, interventions intended to quell
instability can, by creating moral hazard, actually make instability
more severe in the long run." Mr. Plosser suggested policymakers outline
in advance conditions under which they would lend to financial
institutions and commit "to act in a systematic way" consistent with
those guidelines. Mr. Plosser, former dean of the William E. Simon
Graduate School of Business Administration at the University of
Rochester, became president of the Philadelphia Fed in August.
In a speech scheduled for
delivery to the European Economics and Financial Center in London, Mr.
Lacker said the Fed should lend more when a sudden demand for, or
shortfall of, cash drives short-term rates higher. But he said the past
year's credit crisis results from something different: Investors are
fundamentally reassessing the creditworthiness and appeal of many types
of securities and institutions.
When a central bank makes
loans to such institutions or accepts their debt as collateral, it
"distorts economic allocations by artificially supporting the prices of
some assets and the liabilities of some market participants."
Mr. Bernanke considers
concerns raised by Mr. Lacker to be valid, but he has argued that the
problems involved in the Bear Stearns loan were preferable to the chaos
and disorder that would have resulted from the firm's bankruptcy.
As for the Fed's other
steps, officials have argued that they represent a more effective use of
the Fed's existing authority rather than an expansion of that authority
and that they are similar to tools in use by the European Central Bank.
Asked if he approved of
the Bear Stearns deal, Mr. Lacker said: "It was an excruciating choice.
I wasn't close to all the data they had...so I'm not going to
Still, he said that
because of the Fed's $29 billion loan to Bear, it is "going to be
natural for firms to ask for what they view as similar accommodation."
Mr. Lacker said the Fed
has already "gotten questions from firms saying, 'I'd like to take over
this other firm. Can you help like you helped with Bear?'" He declined
to name or describe the firms, adding, "We've turned them down" because
helping them "wasn't appropriate."
To convince the markets
that it won't routinely prop up troubled firms, the Fed eventually will
have to let fail some institutions that lie beyond its stated boundaries
for intervention, Mr. Lacker said.
Those boundaries "are
going to be more credible if we take actions, and those actions are
going to be more credible the more costly they are" in terms of
disruptions to the market.
Mr. Lacker, who holds a
doctorate in economics from the University of Wisconsin, joined the
staff of the Richmond Fed in 1989 and has been its president since
August 2004. He regularly dissented in votes on interest-rate decisions
in 2006, favoring higher rates. He isn't currently one of the five
regional Fed bank presidents with a vote on rates.
Write to Greg Ip at