Public sector support of the banking industry
pered by continued political bickering as politicians, both in and out of government, seek to take political advantage of the situation. This is not to say that the government support of the banks of October of 2008 was not needed, but had other alternative policies been pursued at the same time, the scale of support required might have been much smaller. And pursuing other policies may allow banks to be returned to fully private ownership much quicker than would otherwise be the case.
Using fiscal and monetary policy to support credit markets Since this crisis is different from that of Scandinavia, a different response is needed, using fiscal and monetary policy to directly support credit assets and credit markets and hence ending the crisis of confidence and illiquidity that are behind the cumulative credit collapse. How is this to be done?
One way to support credit markets is for the central bank to purchase undervalued credit assets Increasing the central bank balance sheet to purchase government bonds affects credit markets only very indirectly, through longterm interest rates. There is a bigger impact on credit markets if the central bank uses its balance sheet to buy not government bonds but better quality currently illiquid and undervalued structured and mortgage-backed securities (i.e., the same illiquid securities that are the root of the funding and balance sheet constraints that inhibit bank lending). By purchasing these securities off the banks, the central bank directly strengthens bank balance sheets and so allows banks to expand their lending. Moreover, as the economy recovers credit spreads will fall and so the central bank can make a profit, rather than make a loss as it would do from purchasing government bonds. The central bank can also purchase other credit risky assets such as commercial paper or corporate bonds. In other words, the policy of ‘credit easing’ now being actively pursued by the U.S. Federal Reserve. Perhaps the clearest way to present this point is to put the question in another way. Normally central banks use the nominal interest rate as the instrument of monetary policy using open market monetary operations to keep very short-term market rates of interest close to their announced policy rate. Once the announced policy rate falls to zero they can do more, they can now use a further instrument provided that their choice is consistent with short-term interest rates remaining at zero. The question then is what will be the most appropriate alternative instrument of monetary policy during the period when money market interest rates are reduced to their zero floor? Aggregate bank reserves or money stock are poor choices for the monetary instrument since in present depressed circumstances they can increase by huge amounts without impact-
ing credit or expenditure. A better choice is market credit spreads. The Bank of England Monetary Policy Committee or the Federal Reserve Open Markets Committee or the Governing Council of the European Central Bank can use their regular meetings to announce their preferred levels for average market credit spreads. Monetary operations can enforce this decision. By setting credit spreads at appropriate levels, this will put a floor under market values, restore credit market liquidity and economic activity, and make a handsome profit to boot. Both the U.S. Federal Reserve and the Bank of England are now adopting policies of this kind. In fact these polices can be pursued even when monetary policy continues to operated in the orthodox fashion with the central bank maintaining close control over very short-term interest rates. Instead of the central bank increasing its reserve base to purchase credit risky assets off the banks, it is possible for the government to sell either Treasury bills or long-term government bonds in the market and deposit the proceeds with the central bank, which then in turn uses this money to purchase credit risky assets. Now there is expansion of the stock of outstanding government debt instead of the stock of base money. But however it is achieved, government-backed or money-backed, large scale purchase or other techniques to support the value of credit risky securities is a necessary policy for restoring investor confidence, improving bank balance sheets, and getting credit flowing again.
Using a pooled bidding process to avoid adverse selection There is a problem with large scale purchase of credit assets, a problem that in insurance is known as ‘adverse selection.’ A wellknown example from medical insurance is offering protection against an extreme illness such as heart disease. Adverse selection takes place because healthy individuals with low risk of heart failure view the insurance as expensive and so tend not to purchase it. This means that there is adverse selection, the people who take out the insurance are at greater risk of a heart attack than the population at large. One solution to adverse selection is to tailor the cost of the insurance to the risk, so in the medical example the costs of the insurance might be reduced if the individual passes a medical examination. Exactly the same problem arises when the central bank purchases senior credit securities. But the central bank does not have enough information about the risks of default on individual securities so it cannot tailor the price it pays in this way. If it is not careful it will end up purchasing all the poor quality securities and none of the better ones. As a result it could end up losing rather than making money. This sounds like a serious problem with the public purchase of credit related assets. But the central bank is a monopoly purchaser of these securities and it can use this monopoly to get around the problem of adverse selection. For example, the central bank can
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