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Thursday, November 29, 2007 2:06 AM


Moral Hazards And Fed Actions


I just finished reading the complete speech by Fed Vice Chairman Donald L. Kohn on Financial Markets and Central Banking.

Supposedly this ignited a rip-roaring rally on Wednesday but the reality is everyone knew a rate cut was coming anyway so there is no way this could have caused a rally. For more on this idea please see Non-Voting Plosser Sets Hawkish Tone.

The market rallied steeply because that is what bear market rallies do when they get as oversold as this market was.

More interesting to me was Kohn's discussion on Moral Hazards.

Moral Hazard

Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised. At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost.

To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.

To minimize moral hazard, central banks should operate as much as possible through general instruments not aimed at individual institutions. Open market operations fit this description, but so, too, can the discount window when it is structured to make credit available only to clearly solvent institutions in support of market functioning.

The Federal Reserve's reduction of the discount rate penalty by 50 basis points in August followed this model. It was intended not to help particular institutions but rather to open up a source of liquidity to the financial system to complement open market operations, which deal with a more limited set of counterparties and collateral.
Asymmetric Response Create A Moral Hazard

Kohn is disingenuous at best and a blatant liar at worst with that speech.

The Fed claims to seek "price stability" but idly stands by ant lets bubbles expand to amazing proportions. Then after the bubble pops, all of a sudden the Fed claims to be concerned about "innocent bystanders".

For starters, the only innocent bystanders are those who sat the bubble out. Everyone else was greedy, perhaps even willing participants to fraud.

The truly innocent were hurt many ways: They were robbed by the Fed's inflationary policies, they received inadequate interest for their cash savings, and property taxes soared while incomes did not. Those on fixed incomes suffered the most. On the other hand, the enormously wealthy benefited the most.

So let's be honest here. The Fed does really not care about those who were hurt. If it did, it would not have let the conditions that fostered this bubble brew as long as it did. The Fed is only concerned about a credit crunch that is affecting bank profits and bank's ability to lend.

That unfortunately is the harsh reality. Even if you choose not to believe that, the Fed's asymmetric actions are a moral hazard in and of themselves. By acting only after bubbles break rather than taking aim at the conditions that foster bubbles (loose credit standards fostered by setting interest rates too low), the Fed has an active policy that is guaranteed to bail out reckless lending institutions whenever they make mistakes.

And when market participants think they are going to be bailed out by the Fed, all kinds of ridiculous risks are taken. Now in a so called effort to protect the "innocent bystanders", those innocent bystanders are about to be punished a second time.

The only way to stop this cycle of bubble blowing is to abolish the Fed. There is only one candidate with that on his platform and that person is Ron Paul. I support Ron Paul.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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