Stephen King: When reassuring words aren't enough

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The Independent Online

It's not often that you get to see a bank run. Left to their own devices, runs can be self-fulfilling. They always offer more than a whiff of fear.

The alarm over Northern Rock, though, is not confined to those who are keen to safeguard their deposits. Panic leaks out in other areas, too. Policymakers provide seemingly inconsistent signals. They want to reassure the rest of us that there is no reason to panic. Yet they provide emergency lifelines, thereby contributing to the panic they seek to forestall.

In the meantime, politicians and others are obliged to offer wise words of comfort. They pretend to bestraddle the world as omniscient titans of the financial scene, prepared to impart judgements beyond the wit of mere mortals. Here's a selection:

"The world economy is currently strong and is well-placed to weather the storm."

"Everyone should calm down and refrain from making simplistic comments in a very complex area which just cause unnecessary worry and concern."

"I see nothing in the present situation that is either menacing or warrants pessimism."

The first of these comments comes from Alistair Darling, the Chancellor of the Exchequer. The second comes from the British Bankers' Association, whose spokespeople apparently want all of us to stand in the naughty corner.

The third, I have to admit, is of a slightly earlier vintage. The comment comes from Andrew Mellon, the US Secretary of the Treasury, on 31 December 1929, just after the Wall Street Crash and ahead of the Great Depression.

I'm not suggesting for one minute that we're on the verge of a 1930s-style economic collapse. Mellon's unfortunate (in hindsight) remarks, however, serve to remind us that policymakers are mere mortals, prone to offering reassuring words either because they genuinely believe things will improve or, alternatively, because they think their words will somehow lift otherwise-depressed animal spirits (when you visit a sick relative in hospital, you're more likely to say "you're looking well" or "you're looking better" than to tell them they look as though they're at death's door, whatever the underlying reality may be).

Another example – a case of "tough love" – comes from William Poole, the president of the St Louis Federal Reserve, who said on 16 August that only a "calamity" would force the Federal Reserve to cut interest rates before the next scheduled policy meeting (which is taking place this week). His colleagues duly obliged with a reduction in the discount rate the very next day. Either they disagreed with Poole's views or, alternatively, a calamity is about to unfold.

Whatever the truth, troubled times lead to confused messages, giving the impression that policymakers, like the rest of us, are scrabbling around to find some sort of underlying reality.

Poole's attitude is interesting because it accords rather well with the views of the Bank of England. In both cases, there's a desire to minimise so-called "moral hazard", a situation where people take on too much risk in the expectation they'll be bailed out (a problem that's rife in the insurance industry, for obvious reasons). As Mervyn King, the Governor of the Bank of England, put it in his submission to the Treasury Select Committee last week, "the provision of ... liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behaviour".

If, though, the Bank of England agrees with William Poole, it loosely follows that the Bank disagrees with the Federal Reserve and, for that matter, the European Central Bank. Both institutions have been providing liquidity support for a number of weeks. Which central bank should we trust?

This issue is of more than academic interest, primarily because capital markets are so closely interlinked these days. After all, it's difficult to imagine that Northern Rock would have got itself into quite such trouble in the absence of the shenanigans associated with the US sub-prime crisis. In financial markets, what happens "over there" is increasingly important for what takes place "over here".

Against this background, the Bank of England's initially-principled stance now looks a touch confused. One day, there is no possibility of a bail-out. A couple of days later, the Bank is forced to step in to rescue an institution that, otherwise, would be in dire straits.

To be fair to Mervyn King, his Treasury Committee submission did spell out the conditions under which the Bank can lend "against collateral at a penalty rate" to an individual bank facing temporary liquidity problems, but it otherwise regarded as solvent, a message reconfirmed with the Bank's Northern Rock statement on Friday.

Nevertheless, some big issues stem from this.

First, the difference between "temporary liquidity problems" and insolvency is not so obvious in real time. If they persist for long enough, liquidity problems will become solvency problems. If the distinction is unclear, how can the Bank know when, and when not, to take a hard line on moral hazard?

Second, we don't yet know the terms of the Northern Rock "bail-out". Unless they are sufficiently draconian, there's a risk that the support operation will simply confirm the "too big to fail" doctrine (which, in turn, suggests that the Bank, despite its principled approach, cannot rid itself of political influence; after all, the lender of last resort intervention came with the blessing of the Treasury).

Third, even if the Bank wants to take a principled stance, it may be completely irrelevant should the Federal Reserve and European Central Bank choose a different approach. Arguably, the problems created within the British financial markets in recent weeks are a response to the Federal Reserve's past failures to manage moral hazard domestically. Whether rightly or wrongly, US investors believed the Federal Reserve would always step in to save the day, a view which encouraged excessive risk-taking, particularly within the housing market. If investors elsewhere in the world have become exposed to those risks through no fault of their own – either through the effects of mortgage debt securitisation or via the misguided efforts of the ratings agencies – is it right that they should suffer the consequences?

Fourth, what should be the approach of the authorities to financial market risk in the future? Can the Bank of England, Treasury and others insulate the UK from ineffective or poor regulatory environments elsewhere in the world? How tough should domestic regulations be? And will tougher regulations force financial capital to go elsewhere as a result? These are age-old questions and ultimately must reflect the political attitudes of the day. Too little regulation and too much risk-taking leads to a crisis and too little growth. Too much regulation and too little risk-taking leads to stagnation and, hmm, too little growth.

Whatever the eventual outcome to the current crisis, we live in a market-based system. Markets, though, are fickle and sometimes frail. Herd behaviour, whether in the form of excessive lending to sub-prime customers or through, for example, a bank run, is a sure sign of market failure. Failed markets, in turn, are often unstable, leading to outcomes outside the realms of normal experience. Policymakers are obliged to intervene and, sometimes, their policies will provide the necessary stabilisation. But not always. In December 1929, Herbert Hoover said: "I am convinced that through these measures we have re-established confidence." How wrong he was.

Not-so-wise sayings

* "No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time." Calvin Coolidge, US President, 4 December 1928

* "There is nothing in the situation to be disturbed about." Andrew Mellon, Secretary of the Treasury, February 1930

* "Gentlemen, you have come sixty days too late. The depression is over." Herbert Hoover, US President, June 1930

* "...how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions...?" Alan Greenspan, December 1996

* "...the fundamental underpinnings of the recent US economic performance are strong ... the new technologies and the optimism of consumers and investors are supporting asset prices and sustaining spending." Alan Greenspan, February 1999

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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