A year into the subprime crisis, Jiang Wang, professor of finance at the Massachusetts Institute of Technology, Cambridge, Mass., is suggesting that the Federal Reserve's attempts to rescue troubled markets by flooding the financial system with cash might do more harm than good.
Market Liquidity, Asset Prices and Welfare, a research paper by Mr. Wang and Jennifer Huang, assistant professor at the McCombs School of Business at the University of Texas, Austin, makes the point that monetary intervention has a complex impact. By its very nature, it interferes with market forces and thus distorts asset prices and lowers market-makers' profit opportunities, they say.
The authors recommend that the government instead should use its influence to persuade banks to join forces, raise new capital and inject more liquidity themselves to stabilize the market.
In general, our theory suggests that mechanisms that resemble "forced spot participation (by traders),' especially if they are anticipated by the market, are better at improving liquidity than those that resemble "subsidized spot participation (by the Fed),' they wrote.
While it would be desirable for the market to heal its self-inflicted wounds, it might be difficult to persuade Wall Street to choose the greater good over the opportunity to snatch a rival's assets or to put a firm's balance sheet at risk to save a faltering competitor.
It simply might not be feasible either. In crises, confidence is the first casualty, time is in very short supply and the magnitude of the problem is usually bigger than the readily available resources, as evidenced by the sudden collapse of Bear Stearns & Co. Inc.
Through dire straits, the Fed is not only the lender of last resort, but also the friend of last resort.
Yet, the downside of government intervention is to foster the notion of too big to fail or save me or I'll take you down with me. The Fed creates moral hazard via expectations of a rescue, which gives the financial industry less incentive to solve its own problems.
Mr. Wang concludes that if firms do not expect to be subsidized during crises, hence the anticipation of future interventions does not hinder their ex-ante incentive to supply liquidity.
But the moral hazard issue might have deeper, subtler roots than the Fed's willingness to step in during a crisis. In the 1990s, the Fed changed the way it conducted monetary policy, making it a habit of telegraphing its intention ahead of scheduled meetings, which market participants viewed as mere confirmation of the Fed's stated intentions. Financial intermediaries loved the Fed's predictability, which removed a crucial element of risk and therefore caution in an economy that makes business decisions quarter to quarter.
As an empirical observation, is it just a coincidence that two major asset bubbles were followed by two major debacles in the decade after the new policy was implemented?
By giving up its ability to keep markets on their toes, the Fed unwillingly emboldened those who want to push the envelope as far as possible in today's complex financial system.
Former Fed Chairman Paul Volcker, possibly the greatest central banker ever, rejected a dogmatic method for monetary policy, preferring a discretionary approach in which the Fed did not signal its intentions and was prompt to reverse policy as developments warranted, thus removing the certainty that paves the way for complacency.