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Solutions to Subprime Crisis

Lets go back to basics. Public interventions are a bad thing, unless there is a

well-identified market failure. Since early August, we have witnessed a massive marketfailure due to acute information asymmetry. Each financial institution knows, or should

know, its situation, not just on but also off its balance sheet. There are reasons to believe

that this is not fully the case, but lets overlook this first failure. What each financialinstitution does not know, and should not know, is what is on the books of the other

financial institutions with which it trades daily. The old result, which goes under the

colourful name of lemons markets, is that, suspecting the worst, no financial institution

wants to lend to the others. The consequence is that liquidity is plentiful inside mostfinancial institutions, but not available on the interbank market. Extreme scarcity in the

midst of plenty is a big failure. In practice, it means that those institutions that need cash

to carry out normal daily business cant find it, and therefore cannot operate normally.

Credit is vanishing. Since a modern economy cannot function without credit, the marketfailure has potentially catastrophic implications. Intervention is fully justified.

Of course, this is not a call for just any intervention. Basic principles also saythat the intervention must directly address the failure. Ideally, it means full transparency

whereby each financial institutions situation is public knowledge. Unfortunately, even

assuming that each institution knows what is on its books, this first-best solution is

impossible for it would mean revealing too many commercial secrets. So we must go tothe second-best solution: provide the needy financial institutions with the liquidity that

they need to operate as normally as possible. This is what the Fed and the ECB have done

for a month now.The problem with second-best solutions is that they are not first-best. By providing

liquidity to the market, the central banks are not just helping out financial institutions thatonly need cash, they also bail out other institutions that have taken excessive risk andonly deserve to be folded. This is what some critics have complained about, and they are

right. Well almost. For they have to consider the opposite risk, that innocent institutions

and their customers stand to be badly hurt if the liquidity squeeze is allowed to continue.This is unfortunate, but it could be an even better second-best solution than full scale

liquidity injections. The case is hard to make but lets try.

The first argument is that there are no innocent bystanders. All financial

institutions are guilty of excessive risk taking. Their customers too are to be blamed forhaving continued to do business with reckless banks. The first argument is uncomfortably

close to a value judgment. Who can decide what is ex ante excessive risk taking? Did the

bank supervisors issue warnings? If they did not, which we do not know yet, the risks arefound ex post to have been excessive. But in a world where zero probability is

incompatible with risk-taking, any risk-taking stands to be found misguided ex post. As

for customers, yes, theory says that they should monitor their banks. But informationasymmetry and plain common sense tells us that they cant.

A second argument will accept that the first one does not hold water, but

would, reminds us that risk-takers must face the consequences of their actions when they

do not pan out as expected. If they do not, they will be even more reckless the next time

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around. True, but the question here is one of timing. Should the punishment be imposed

now or later? Imposing it now implies accepting all the consequences of an interbank

market meltdown. These consequences are too frightful to contemplate. They are alsounnecessary. Once the dust settles, the time of punishment will come. Inquiries should be

conducted and those who violated the law must be brought to account. The problem is

that reckless risk-taking is not unlawful, and rightly so. But then, what are they to bepunished for? Bad judgment.

This brings us to the third argument. Bad judgment in this case is the source of a

serious externality, another market failure that calls for public intervention. The problemis that deciding on bad judgment is a value judgment. Currently, dealing with the

externality is entrusted to supervising agencies. Obviously, something has gone amiss

here and the market failure has been compounded by a policy failure. The ball is logically

thrown back in the governments court, which seriously weakens the case for punishingthe markets.

Finally, comes Bagehot and the recommendation that emergency lending be

carried out at penalty rates. The ECB is lending at the normal rate and the Fed even

lowered the discount rate, seriously contradicting the Bagehot principle. The problem isthat Bagehot is about isolated events of illiquid individual institutions, not about a

systemic drying-out of markets where most institutions are awash with cash. Mostinstitutions that currently absorb the liquidity are illiquid not primarily because they made

mistakes but because they have no way to break the information asymmetry problem.

In the end, not providing the liquidity amounts to taking an excessive risk, that of

punishing millions of citizens if a credit squeeze were to create a serious recession. Weare reminded of the 1929 crash. Countless studies have blamed the monetary authorities

for having stood by as the world economy slid into the Great Depression. Back then,

many voices argued that the markets should clean themselves and that excessive risktakers should face the consequences.