Are Central Banks Out of Their Minds?

More central banks around the world are using public money to bail out private companies. Are central banks out of their minds? Are they running out of options?

Back in March, the Federal Reserve announced that would be lending banks as much as $200 billion in US Treasuries in exchange for mortgage backed securities. In doing so, the Fed immediately increased the risk on their books and caused an uproar on whether or not it is smart to use public money to financial institutions from their own overly aggressive risk appetite.

For a long time, the Bank of England refused to follow in the Fed’s footsteps because they did not want to foster an environment where banks and financial institutions would start relying on central bank bailouts. Their laissez-faire attitude received significant criticism even though in my opinion, it is the right attitude for the long run. Unfortunately the Bank of England has finally buckled under the weight on political and economic pressure.

With mortgage lenders becoming more stringent, the Bank of England was forced to take a page out of the Fed’s book. Today, they unveiled a GBP50 billion package that would allow banks to swap their mortgage backed securities for UK bonds in the hope that this would encourage mortgage lenders to extend new loans.

Meanwhile the Reserve Bank of Australia also announced today that they bought A$780 million worth of mortgage backed securities to help add liquidity to the mortgage market.

Are these Central Bank’s Out of their Minds?

Desperate, Yes.

Crazy, No.

The Fed’s action last month has helped to stabilize the equity markets and restore some risk appetite. Although lower house prices and losses in mortgage backed securities cannot be avoided, these measures by central banks has and will continue to temper the decline. They are working aggressively to prevent a collapse in the financial markets and even though the public bailouts increases the risk”moral hazard,” with the US and UK economies headed for more trouble, the central banks have no choice but to address the problems now and deal with the consequences later.

Comments

[growthvalue]

I hope they keep doing it. They are crazy and going to pay.
One word: Inflation

They will blow it up if they keep going

[whidbey]

Deal with the consequences later? When and With what? Looks like the boys are "all in"; they have even put their stash on the pot. If this hand does not come their way, they will be wiped out.

Now who is out of their minds? We are. You missed the point.

[icandoitdon]

i don't think central banks are out of their mind. i think the writer is out of her mind.

let me give you a brief lesson in capitalism 101, which the writer and central banks around the world have either forgotten or ignored.

THE BUSINESS CYCLE IS A NATURAL CONSEQUENCE OF CAPITALISM AND IT CANNOT BE REPEALED.

central banks, particularly under the tutelage of an ignorant alan greespan before and ben bernake now, have tried to repeal the business cycle through extension of easy credit at prices that do not reflect the risk of lending. all players in the financial system fell prey to easy and cheap money without regard to credit risk. why fear credit risk with a federal reserve ready, willing to do anything to avoid an economic downturn? through it's actions in respose to current economic conditions which their own policies fostered,the federal reserve does what? it throws more cheap money in the system and stands ready to contaminate it's own balance sheet to prevent an even more severe economic downturn. and our congress wants to give the federal reserve more authority....go figure.

our financial system teeters on the edge of collapse and it was pushed there by a federal reserve whose actions have more in common with socialism than capitalism. it is a disgrace and it should be legislated out of existence.

[SecondThoughts]

I say "yikes" when I read the writings of "icandoitdon"... Its almost a waste of time to respond; he is so "out there" that he may be out of reach. But, I have a moment so I'll try to help him. First and most significantly, starting with the 1980s, "business cycles", also known as recessions, have been generally shorter in duration and, shallower. Maybe an exception is the prolonged slowdown of 2001 through 2003. But, even though that episode was longer, it was still billed by the NBER as comparatively short compared to recessions of the pre-1980s variety. Accepting, as he must, this thesis, one then asks why? Why have recessions become shorter/shallower? I think economic historians will look back on 1982 - 2000 as having been "good years" for two reasons: (1) significant technological advancement and (2) sounder monetary and fiscal policy. (Unfortunately, the second doesn't apply well to the current Bush administration.) To say that Greenspan and Bernanke have tried to "repeal" the business cycle is ridiculous; tame it yes. But, let's be clear what "icandoitdon"... said at the outset: He doesn't "think central banks are out of their mind." But, then, he goes on to explain a point of view that is exactly the opposite??!!

[icandoitdon]

second thoughts:

let me return the favor and try to help you. take your blinders off first...

1. where is it written that economic expansions or contractions must conform to a norm? some are short..some are long. that's the nature of capitalism. if this recession is longer than normal let me pose this question to you...short recessions, in your belief, confirm that we have had "sounder monetary and fiscal policy." if this recession proves to be longer and deeper than usual, would you then argue that it is because of "unsound fiscal and monetary policy? i doubt it. believe what you choose, but don't base your arguent on false logic.

2. your belief that we have more sound fiscal and monetary policy today than in the past is simply unsupported by the facts. i can point to many things that support the opposite...a declining dollar, a speculative run in all commodities prices partly because of loss of faith in the dollar, decimated money-center bank stocks, huge increases in commercial and residential lending loss reserves, declining retail sales, institutionalized and spiking budget deficits, declining real incomes.....want more? let me know...

3. thanks for explaining that greenspan and bernake are trying to "tame the business cycle" but not repeal it. that makes me feel a whole lot better...

4. my comment that the central banks are not out of their mind was facetious. let me be more clear just for you: i think they're absolutely nuts.

[01GTvert]

The business cycle is a load of BS. What causes the cycle is the fed offering easy credit for years on end and then retracting that very same credit even more aggresively...nothing more nothing less. All of the major depressions/booms are created by the Fed.

[icandoitdon]

01GTvert:

my belief doesn't quite mirror yours but it's close. the fed exacerbates moves in the business cycle...booms are boomier and busts are bustier (heh heh). this is why i believe that we are better off without a federal reserve. alternatively its power should be curtailed...not enhanced as hank paulson wants to do. (no surprise there...what would expect from the former head of goldman sachs but more socialism during busts and more good ole "free market capitalism" during booms.)

[dieuwer]

Does it really matter what the FED does or doesn't? As long as you know what the FED is up to, you can profit from it.

[BriceTimmons]

I'm in with the real capitalists on this one, but it's hard to sort out who here is one. Miss Lien has an excellent point regarding the aims of the Fed, however, the idea that it isn't futile (and thus somewhat insane) to attempt to moderate such a large and complex economic collapse. (I use the term "collapse" somewhat loosely as "recession" simply doesn't capture the nature of the multiple and interwoven market meltdowns that we're experiencing now.) Icandoitdon's point regarding the effects of running the tap to keep the leaky tub full is on point. You end up with more water on the floor. Whether central banks create the "business cycle" or merely exacerbate a natural ebb and flow within the market is largely irrelevant. The necessity of dealing in information-based currencies in the modern world has the effect of rendering any commodity currency untenable. Some entity must govern money (whether pegged to a commodity or created by fiat), and that entity or group of entities will, even if not created by the government, become governmental in nature. We must learn, however, not to rely on that entity to stabilize markets when the finance sector becomes gluttonous and overexposes itself. There correction will occur, and staving it off until tomorrow with cheap money and risk-assumption merely creates new problem areas in the market and mortgages tomorrow for the sake of today. To me it invokes the image of an adjustable-rate home equity loan on our entire system. Good luck, everybody!

[BriceTimmons]

Correction from line 4:

...and complex economic collapse [is overly generous to our central banker friends.]

[Coelacanth]

I believe Central Bankers are slightly out of their minds at the moment and that may not be the worst thing in the world. If indeed the financial calamity we face is unprecedented.....then out-of-the box thinking would seem to be in order.

The Europeans and Asians can say whatever they want about us but our central bankers have been very proactive and creative. By comparison, the befuddled Mervyn King appears to have only recently awoken from the comedy-of-errors called Northern Rock.

I have slightly less contempt for Trichet because at least he'll have the cojones to stand up to a clown like Burlesconi when he starts to chime in about monetary policy. I do tire hearing Trichet drone and on about inflation. In case you haven't noticed Mr. Trichet the slow burn of lenders not lending has a nasty recoil. In the wake of Libor rising to 2.9% (Mommy!) I'll be interested to see if his language starts becoming a little more dovish.

[Dude59]

"Although lower house prices and losses in mortgage backed securities cannot be avoided, these measures by central banks has and will continue to temper the decline. "
Unfortunately, you are correct that the decline in house prices must continue until the average house in a region costs 3 to 4 time the average income. The second part of your thesis is flawed, as delaying the recognition of this will not improve the situation. You only have to look to Japan for an example of what happens when losses are not taken, and bailouts prevent the removal of bankrupt institutions.

We are facing a situation where we will see limited or negative global economic growth going forward. With Production (of all types) limited by energy and productivity gains, and less energy per dollar being available, and the cost increasing faster than productivity gains, the net returns will decrease.

With cost inflation increasing globally, and net returns decreasing, we cannot accept the artificial support of institutions that deserve to fail. Doing so will prevent the emergence of those institutions that might thrive in this new millennium.

[Hugh]

The business cycle is NOT a feature of pure capitalism, but a feature of government mixing with capitalism. In pure capitalism, millions of decisions are constantly being made that self correct markets. In a central bank situation, (government controlled "capitalism"... a hand full of people make big decisions, some wrong, that impact millions.

Read Ludwig von Mises's Human Action

[icandoitdon]

hugh...

your point about the business cycle being a result of a mixed economic system, i.e. government and capitalism, is an interesting one if true, which i don't think it is. was the tulip mania and subsequent crash of 1636-1637 holland caused by the government of holland? i don't think so...it had more to do with mob behavior and it has been studied for that purpose. while capitlism worked...the system cleansed itself with the fall in tulip prices... those holding tulips at peak prices were wiped out. the notion that free, unfettered capitalism always works smoothly is an academic myth. having said that, i do believe it is preferable to any other economic system as long as you are not among the feeble-minded or feeble-bodied.

even if unfettered capitalism were free from a business cycle, i don't think it's especially relevant since unfettered capitalism exists only in textbooks. if governments even tax goods, services or people they are involved....they don't need a federal reserve.

i do agree that government meddling is too often damaging because governments typically overreact and inhibit the natural cleansing process of capitalism, which is necessarily painful to some participants. if it weren't painful there would be no lesson to learn. hence my belief that the power of the federal reserve should be curtailed.

[SecondThoughts]

This is really silly. "...ignorant Alan Greenspan before and Ben Bernanke now"; "...edge of collapse"; "socialism"; the Fed as the sole cause of the business cycle; "we are better off without a federal reserve"; "real capitalists"; "pure capitalism"; "unfettered capitalism". These are some of the words and phrases that have been used in this thread that have very little usefulness in a fruitful discussion of what the Fed has been doing.

But, my major issues lie with "icandoitdon"... He replied by saying that there is no "norm" to expansions and contractions indicating that "some are short..some are long" not realizing that he had just defined a "norm". What I said earlier, though, about cycles (recessions) being shorter was only partly due to improved macro management with the other "cause" related to the tremendous contribution of information technology during the late 80s and throughout the 90s. In addition, if icandoitdon had taken the time to read my comment, he would have seen that I carefully excluded the current Bush era from any association with sound fiscal management. And, I don't hold Greenspan's Fed blameless either--I believe he held rates too low for an excess period of time.

There is much that is being said about the Fed today. I do know this: the Fed and, specifically, the FOMC, has very knowledgeable and dedicated people who are very cognizant of their reputations. They are not out of control and not, as seemingly most writers in this thread seem to believe, "stupid". A little control on the use of language would be in order, gang.

Regarding the dynamics of what has become a very dominant financial sector (FIRE), clearly, greed in a viral form has infected motivations. Its not without parallel with the tulip-mania where you could buy tulip "options." Leverage has been used excessively; new complex derivative instruments invented seemingly on the fly; all this at a much faster rate than regulators have been able to keep up with much less act in the capacity of regulators. The finance sector has created a "parallel" non-banking credit creating business model that has heretofore escaped any serious regulation. And, it is this toward which Paulson has directed his attention in making recommendations for increased regulation. I think he's right.

Let's step back a little and look at "academic capitalism" compared to reality. Let's look at Adam Smith and all the classical and neoclassical followers. Basically, they created a theoretical construct that rests on, among others, the twin assumptions that people (consumers and businesses) are fully rational AND have complete information upon which to make decisions. In such a world, no mistakes are possible. But, we know that neither of these assumptions is true and, I argue, that their inadequacy is the portal through which informed government regulation must necessarily pass. Such "regulations"... should restrict certain behaviors (zoning laws, building codes, fraud, etc.) and promote others (tax incentives, etc.).

I've run out of time. Sorry.

[iThinkBig]

If I were to start a business today, I see most being good candidates for a Board of Directors. A couple people here do not have the understanding of human nature which drives capatalism. What drives profits is the law of nature, survival of the fittest. Any attempt by governments to implement socialism in it's stead has failed over the last 6,000 years it has been attempted.

[icandoitdon]

second thoughts:

yes, I understand that by averaging the length/severity of every recession in the last 100 years we can find a norm. but what's the point? there is a world of difference between a severe recession, a mild recession and a depression. i just don't think recession "norms" are partiularly meaningful as a measure of how well the federal reserve has performed. tell it to the homeowner who is deep underwater on a house he can't afford that banks let him buy that regulators ignored.

i also agree that i shouldn't have referred to alan greenspan and ben bernake as ignorant. i could have used more diplomatic language to describe what i feel is their lack of competence. but my tview isn't exactly heretical. plenty of heavyweight economists have voiced objection to the way they have handled the economy. given the enormous influence these unelected officials exert over the economy they deserve to be called on the carpet for their mistakes, which in many cases were glaring. a 1% federal funds rate? what in the hell was greenspan thinking?.

we also agree on more than you realize...

we agree that the bush/cheny administration had nothing but contempt for "sound fiscal management."

we agree that the greenspan's fed "isn't blameless" for the current economic problems we face.

we agree that fear and greed have become increasingly significant drivers of capital markets and that the use of complex financial instruments and leverage have played a major role in reaching the the state of disarray that we're in today.

we agree that adequate regulation is an important part of any solution. i take issue with the notion that more regulation is needed because the regulation that was in force should have been adequate to police many of the issues that led to the current dysfunction in the financial markets. while regulators are clearly not equipped in certain cases, too many regulators were either asleep at the switch or incompetent.

as for the fed, the single most influential regulator of our financial system, it does seem to me that it has lost control. it has clearly overstepped it's charter in underwriting the purchase of bear stearns by guaranteeing 29 billion of their paper, never mind their good intentions. neither do they seem to appreciate their role as a regulator bound to protect the financial system...not individual firms, which has become a pattern in recent years. had they done their job as a regulator as readily as they focused on elimininating every little economic hiccup along the road, which capitalism can handle just fine without their help, thank you, we wouldn't be in the fix we're in today.

greenspan ran the fed for over 20 years during which the seeds of today's problems were sowed. he ignored them, lurching from one bubble to the next, which he helped create that he claims he couldn't see. whether bernake can improve on his record remains to be seen, but i'm not encouraged. they don't call him helicoper ben for nothing.

[swaps]

There are business cycles. I have somewhere a book called Cycles, written 50 or more years ago that shows all the interacting cycles. It clearly shows an expanding cycle until about the year 2000, followed by a long down cycle/

The Kondratiet or however you spell it long wave.

But the Fed - and the global forces behind it and parallel control freaks like the CFR - artificially create the cycles now. They expand business with low rates, then contract the business momentum with high rates.

I have seen this for more than four decades. Around 1990 I wrote a column saying that the then current Fed induced contraction was like a foreign enemy overflying the country and pin=point bombing businesses to take them oot.

The Fed clearly knew what would happen when it began ratcheting up interest rates even as the pundits and observers began to wail and shriek and rend their garments.

The enormous danger now posed by the interlocked out of control bubble had to be known by The Fed, for these are the smartest people in economics.

The Fed should be taken over. The greedy, egocentric investment bankers should evanesce into oblivion. And the government should temporarily start a mortgage enterprise that will issue mortgages to borrowers who are in compliance with the requirements to buy properties that are accurately appraised.

[JimHawthorne]

"Our" economic system has morphed into one in which, provided you're big enough, you will not be allowed to fail.
I'm not quite sure what you call a system where we have the privatization profits and the socialization of losses...
Capitalism it ain't!

[jcrash]

If you guys would get back to your jobs instead of posting useless prattle, we might get a bump in US productivity.

[icandoitdon]

this is my job. i am retired :D