Moral hazard and central banks

Central banks have felt obliged to intervene in the recent credit crunch, introducing a bunch of liquidity into European and US financial markets. This has led market participants to say that “It helps with the confidence and the feeling that the Fed is going to help out the financial system“, but is this what the central bank should be doing?

Now some might say that putting a bit of liquidity in the system and risking a bit of inflation might be a small price to pay to prevent the ‘collapse’ of the financial sector. However, this is not the only costs associated with Central Bank intervention, we also have the problem of moral hazard.

A moral hazard problem occurs when the ‘agent’ (in this case financial market participants) change their behaviour after the ‘insurance’ provided by an accommodating Central Bank is in place.

With no central bank, market participants would be willing to take on a certain amount of risk for a given return, based on their individual preferences.  Now this is fine, ex ante people are making decisions that are socially optimal, as they face the whole risk associated with their investment choices (excluding great things like limited liability of course 🙂 ).

Now the central bank has an instrument, the interest rate, which it uses to control inflation, maintain output (or stability thereof).  The choice of the interest rate also defines a given quantity of money, where it meets the markets demand for money.  If credit markets begin to struggle, because their choices weren’t ex post optimal, the central bank can intervene by cutting rates and introducing more liquidity into the system.

However, if our financial market agents see a central bank that is willing to bail them out in times of trouble, they will be willing to take more risks (given that greater risk implies greater expected return).  By removing the likelihood that financial agents will ever face the worst outcomes, the central bank gives these agents the incentive to take on more risk than is socially optimal, and helps lead to situations like the current one.

The Federal Reserve has tried to say that there behaviour does not lead to this, as they do not provide liquidity for insolvent institutions.  However, they are willing to give liquidity to institutions that would otherwise struggle, suggesting that their intervention does limit the downward risks faced by financial agents.

Ultimately, credit markets are important for the dissemination of credit between agents.  However, the Feds historic willingness to counter any hiccup ensures that distribution of credit is inefficiently heavy at the riskier end of the market, helping drive economic crises such as asset bubbles.  It may be a better strategy to sacrifice current financial agents to the whim of the market, in order to improve future credit market outcomes.

“We’ll only ease policy over (your) dead bodies” might provide a good motto for this type of Federal Reserve.