A Misguided Federal Reserve, or One That Saved the Day?

One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.” The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.

…Alan Blinder, the former Fed vice chairman, critiquing the paper presented at the Federal Reserve symposium by London School of Economics professor Willem Buiter (Mr. Buiter was born in the Netherlands). Thanks to Sudeep Reddy.

In another report from Jackson Hole, Reddy summarizes a proposal by economist Raghuram Rajan.

Mr. Rajan along with co-authors Anil Kashyap, also of the University of Chicago, and Harvard University’s Jeremy Stein, say banks’ reliance on short-term debt (as in the recent crisis to fund subprime-related securities) carries the problem to the broader economy when credit contracts. Avoiding that through regulation — higher capital standards — may seem the natural response, but heavy regulation simply raises the incentive for getting around it.

Their proposal is to focus on installing sprinklers, rather than just changing the fire code, with capital insurance that resembles disaster insurance. Their analogy is for a homeowner who faces a small chance of a storm that can cause $500,000 of damage; the solution is not to keep $500,000 in a cookie jar where it sits unused. “A better approach is for the homeowner to buy an insurance policy that pays off only in the contingency when it is needed, i.e. when the storm hits,” they write. “Similarly, for a bank, it may be more efficient to arrange for a contingent capital infusion in the event of a crisis, rather than keeping permanent idle … capital sitting on the balance sheet.”

The proposal is designed to prevent a spillover to the overall financial system. The funds raised would be invested in safe Treasuries and placed in a “lockbox.” The insurance policy would be triggered by some measure of overall bank losses (rather than a specific bank), protecting the overall financial system. The authors warn that the proposal is not a cure-all, but a tool that could help the economy in a crisis. “The added flexibility associated with the insurance option may therefore help to reduce the externalities associated with bank distress, while at the same time minimizing the potential costs of public bailouts during crises, as well as the drag on intermediation in normal times,” they write.

Read their paper here [PDF].