Money Sage (archive)

No central banker has been more aggressive in asserting that there will be no bailout of failing financial institutions than Bank of England Governor King. King has insisted repeatedly that central banks uphold the priciple of "moral hazard." Speculators must eat their losses; niether the government nor the central bank must come to their aid when they are keeling over. To do so would be to encourage more reckless speculation in the future. The malefactors of speculation must be held to account! Hear! Hear!

We wonder how today's news about the situation of Northern Rock Bank comports with these somber principles? Northern Rock, as we all know, made a tremendous number of unwise mortgage loans and speculated unsuccessfully in mortgage-backed securities, bringing it to the brink of bankruptcy. Now, it turns out, the Bank of England has loaned Northern Rock the rather tidy sum of 49 BILLION POUNDS. This money is gone forever, of course. Never mind the ancillary issue of "moral hazard" -- the question here is: has the British government been bailing out the banking system? A collateral question is -- is the Federal Reserve bailing out the U.S. banking system?

To ask these questions is to answer them. We would prefer a little honesty from our central bank. So too would the financial markets, it would seem if we judge from the recent performance of the bond and stock markets both here and in Europe. Those who trumpet clarity and "transparency" might try implementing their noble verbiage, rather than cleaving to, how shall we put it, a certain residual mendacity?

As far as the issue of moral hazard, and the related issue of BAILOUT is concerned, we have, in principle, no problem with the desirability of upholding them. Unfortunately, we do not live in a vacuum: in the actual world we inhabit reality has an unpleasant way of imposing itself. In truth, we all know that the moral sententiousness of the western central banks is "unbankable" nonsense.

We do think it is an analytical error of significant dimension to attribute recurrent bouts of high- risk speculation to government/central bank failure to uphold the principle of "moral hazard." The speculative juices flow because human nature generates them. Clearly, human nature generates an unusually powerful outpouring of speculative juices at certain times. These times are when there has been a mighty run-up in the price of some particular asset or asset class far beyond its fundamental value, and far beyond consensus expectations. When this occurs, human nature does NOT do the smart thing: lead men to pull in their horns in the rational expectation that the over-inflated asset or asset class will return to earth. Rather, it does the OPPOSITE: it produces a mounting herd frenzy to buy more, more, more in the growing certainty that the biggest move up is still AHEAD! And to finance this speculative mania? Why, use leverage, of course. BORROW. And from whom shall the speculators borrow? From anyone who will lend, beginning with those lenders possessed of the largest totality of lendable cash or extendable credit, i.e., from the BANKS, especially the BIGGEST BANKS. And what of the bankers? Why they too are increasingly rabid with the lust to lend, or to participate as heavily in the speculative craze as law, custom, and regulators will permit.

We will leave it to professional social scientists of all stripes to consider the phenomena of the herd impulse and speculative behavior in more profound ways. We, for our part, merely note the tendency of this subversive and trans-rational behavior to erupt at irregular intervals.

To return to the related issues of moral hazard and BAILOUT, all we can reiterate is the rather obvious and decisive point: enforcement of "moral hazard" is nothing but a chimera when the speculative losers are the great banks. These institutions are, of course, far too important to be allowed to fail. The key to containing speculation to manageable proportions -- for it can NEVER be eliminated, human nature and the overpowering tendency to herd behavior being what they are -- is continuing REGULATION and SUPERVISION all along the line. Perhaps someone forgot to tell Messrs. King, Bernanke, and Trichet that this is one of their prime responsibilities. Since it seems to have slipped the mind of our own central bank entirely over the past decade, perhaps a review of the job description of Federal Reserve or Bank of England "policymaker" would be in order.

The failure to fulfill their regulatory obligations has been among the most grievous of all the many errors of our esteemed central bankers, and has played a crucial role in the multi-year development of the sub-prime monstrosity. Perhaps "moral hazard" should begin to closer to home? Perhaps those who have so grossly failed to meet their responsibilities should be removed from office. We have little doubt that a Parliament which for centuries has employed its power of impeachment and removal of officials from office to rectify serious defects in the conduct of His Majesty's Government would be the proper venue to attend to these matters. Similarly, our own Congress possesses the power to both and impeach and remove unsuitable officials. Perhaps it is time to exercise these powers, or, at the least, to make a credible threat to do so. Clearly, it is necessary to regulate the regulators who, it would seem , regularly fail to regulate.