When should you protect the innocent even though you may, in the process, let off the guilty? A pacifist would presumably say "always" because war, by its very nature, leads to the slaughter of innocents (or, in our world of media spin, gives rise to "collateral damage"). Those in favour of zero tolerance for all forms of crime might have to say "never" because no judicial system is ever going to weed out those who truly are guilty from those who are wrongfully accused. And then, to make things more complicated, there are those occasions when saving the life of one innocent person requires the loss of another (think human shields or life-threatening child-birth).
When policymakers consider such issues, they junk their natural moral absolutism and turn to the ethics of Utilitarianism, typically defined as the "greatest happiness of the greatest number". Utilitarianism is, of course, far from perfect, a point made forcibly by Aldous Huxley in Brave New World, but, for those who govern, it has the advantage of allowing decisions by numbers. Policymakers can think in terms of costs and benefits and reach a conclusion which offers the illusion of objectivity.
Policymakers' responses to the sub-prime crisis and the possibility of a credit crunch will, ultimately, depend on their views about the protection of the innocent and the punishment of the guilty. Admittedly, the choices won't be quite as wrenching as those faced in other spheres of public life but it's already becoming apparent that the Utilitarian calculations shaping policy decisions are beginning to shift. At first, the attitude towards the sub-prime problems was one of zero tolerance. There would be no bail-out because both lenders and borrowers should have known better. In a matter of days, though, policymakers' attitudes began to evolve.
When things first started to go wrong, the crisis was lodged firmly within the banking system. Many banks and other financial institutions owned collateralised debt obligations (one of a variety of structured products). The values of some of these structures were underpinned by sub-prime debt. These underpinnings clearly weren't terribly strong. It wasn't long before faith in asset-backed collateralised debt obligations was gone and, with it, liquidity dried up. No one wanted to lend to anyone else, because no one knew what exposures others had to CDOs and, indirectly, to the riskier end of the US housing market.
Liquidity crises, though, do not discriminate well between those who deserve to go bust and those who don't. Although, at first, the attitude from central bankers was from the Dirty Harry school of thought ("You gotta ask yourself one question – "Do I feel lucky?" – well, do you, bank?"), this approach quickly mellowed as the dangers of a liquidity crunch became all too clear. Central banks injected liquidity, the Federal Reserve cut its penalty discount rate and the liquidity crisis began to ease.
The debate has since moved on. The big fear now is the onset of a credit crunch. In simple terms, a credit crunch can be regarded as a tightening of monetary conditions for a given level of policy rates. In other words, lending standards in the financial system tighten independently of any decisions made by the central bank. For the man or woman on the street, this may imply higher borrowing costs, bigger required down-payments for the purchase of a property, a lowering of maximum income multiples for mortgages, tougher foreclosure conditions and so on. Put another way, even if interest rates aren't particularly high by historic standards, the ability to borrow (and to renegotiate terms on a favourable basis) is reduced.
This, in turn, may have a series of negative effects on the broader economy. If people cannot borrow so easily, demand for the new car or the loft conversion may begin to decline. Tighter mortgage terms may mean people have to spend more of their income repaying their mortgage, leaving less available for the trip to the local restaurant or ball game. In time, these downward multiplier effects may lead to rising unemployment and, eventually, the onset of recession.
It's for this reason that President Bush chose to step in last week. His proposals to expand the role of the Federal Housing Administration in order to help with the refinancing of sub-prime mortgages and his call for lenders to show greater flexibility towards some of their more distressed customers are recognition of the potential severity of a possible crunch (and its associated loss of votes): "I've made this a top priority to help our homeowners navigate these financial challenges so that as many families as possible can stay in their homes."
Soothing words, perhaps, but they don't quite deal with the underlying policy problem. Central bankers (more so in Europe than in the US) have been worrying for a number of years about the degree of excessive risk-taking within the financial system, whether reflected in rapid money supply growth, incredibly high correlations of returns across both asset classes and geographies, the innovation of structured products or the emergence of private equity (which, supposedly, turns base metal into gold). We may now have the makings of a credit crunch but, arguably, its foundations were laid during the earlier credit "bubble" – when financial conditions were unusually lax for a given level of official interest rates. Perhaps central bankers were also in the wrong, refusing to raise interest rates quickly in the light of the US housing bubble (and similar housing bubbles elsewhere), all too happy to argue publicly that the gains in house prices were simply a reflection of welcome financial innovation rather than of lax lending standards.
If a credit crunch develops, it will ultimately reflect a revised view of the risks associated with the various products that sprang up in the earlier credit boom and which did so much to secure a healthy growth rate and a high level of employment in the US. At the moment, there is no desire to provide any bail-outs for the institutions (or, indeed, the reckless borrowers) which now are seen to be at the epicentre of additional risk-taking. As Ben Bernanke, the chairman of the Federal Reserve, put it, "It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions."
Fine words and, for the most part, entirely understandable. A bail-out of the reckless, the gullible and the unscrupulous should not really be part of public policy. It creates the classic moral hazard problem, allowing people to believe that the public purse will always be opened to "reward" bad behaviour (the financial market version of this is the "Greenspan put", the idea that interest rates will always be cut to ward off financial distress, thereby encouraging people to take stupid risks). At the end of the day, though, people know that the economy, or the banking system, is "too big to fail". After all, the Savings and Loans industry was bailed out from 1989 onwards, even though its problems resulted, once again, from the behaviour of the reckless, gullible and unscrupulous.
In wartime, policymakers have to accept the death of innocents. In peacetime, society demands the protection of the innocent. Sometimes, though, it's not possible to provide that protection without bailing out the guilty. The moral hazard problem won't easily go away. After all, there will always be those asking themselves Dirty Harry's question – "Am I feeling lucky?"
Stephen King is managing director of economics at HSBC: firstname.lastname@example.orgReuse content