The troubles of the mortgage lending bank, Northern Rock, has been rocking the Labour Government in England and financial markets across the world. As the run on the bank gathered pace, the Chancellor of the Exchequer, Alistair Darling, stepped in to guarantee the bank's customers their deposits worth over $50 bn, thereby effectively nationalizing the Bank. This is only the latest in a series of turbulences ravaging the global financial markets, sparked off by the sub-prime mortgage lending defaults in the US.
Nobody knows the exact extent and scope of this crisis, and when we are likley to get out of it. There is the usual debate about whether the Central Banks, notably the US Federal Reserve, should intervene and stabilise the markets. The Governor of the Bank of England, Mr Mervyn King, has come out openly arguing against any intervention by way of lowering interest rates since that would create a "moral hazard", by incentivizing reckless and greedy lenders. There is an excellent backgroud piece on this debate by Kenneth Rogoff in the Guardian, The Fed v the financiers.
The past two decades have seen too many instances of irresponsible lending by financial institutions, and every time a crisis occurs they are bailed out by Government with tax payer's money. The sub-prime mortgage crisis is only the latest in a long series of such reckless lending inspired financial fiascoes like the Savings and Loans scandal, the Latin American Tequila crisis, the collapse of LTCM, the dot com bubbles etc. The opponents of Central Bank intervention argue that such crisis will continue to occur, if suitably strong message is not sent across to ally all such "moral hazard" generating expectations. Further, such a shakeout is necessary to eliminate all the dubious investments made in the recent past. The proponents of bailouts, in turn argue that unless the crisis is contained before it spreads, it could paralyse the entire financial markets, with far reaching implications for the global economy itself.
Central Banking is, even at the best of times, a delicate balancing act. There are no clear algorithmic prescriptions that can be taken off the shelf and applied to set situations. Personal judgement and experience play a critical role in guiding us in choosing a particular alternative from a bouquet of options. Given the complex context, in the true spirit of scepticism, we need to ask all the possible questions, before venturing afar with the policy prescriptions.
Even if we accept the arguement of the proponents of intervention by Central Banks, it still leaves us with the question of how to recognize that a financial crisis has the potential to threaten the global economy? More importantly, can we confidently conclude as to which events are likely to destabilize the global financial markets and which not? Where do we draw the line between moral hazard and practical concerns of economic stability and growth? How do we recognize the symptoms of the arrival of a tipping point when the crisis threatens to spread out of control and drag the economy down? Should we leave the decision making on such an important issue to the discretion of a Central bank, or to the cold logic of certain financial and macroeconomic parameters and indices? If the later, what are those parameters which should be indicators of an impending economic crisis, that should trigger an intervention by the Central Banks?
The question is not just whether Central Banks should intervene or not. But, are Central Banks the right agencies to intervene in such situations? If they are and they ought to intervene, then under what circumstances? If not, should we leave the financial markets to find its own market solution? Is monetary policy the only instrument of such intervention? Or else, what other instruments of macroeconomic policy can be used to stablize the markets?
If we argue for Central Banks interventions, does it not presume that they are better positioned to understand the trends and consequences of movements in the global equity markets? Do Central Banks have any extra wisdom that helps them understand the global financial markets better than even the best of fund managers and investors, assisted as they are by rocket scientists and even Nobel laureates, crunching numbers on super computers?
Answers to these questions are also dependent on the objectives assigned to Central banks in each country. Is price stability and hence inflation targetting, to the exclusion of even short or even medium-term economic growth concerns, the primary objective of Central Banks? Or does even short and medium-term economic growth concerns take precedence?
There is an analysis of the role of Central Banks by Gary Becker, Should Central Banks Intervene During This Financial Crisis? and a description of the anatomy of the sub-prime bubble by Richard Posner, Against Bailouts, in two articles in their joint blog.