Bernanke's Puzzle

Over at Econbrowser, James Hamilton suggests that the Fed may have trouble preventing cascading liquidity problems now that support for the dollar is so fragile. Such trouble could be close at hand given the unfolding subprime mess. Hamilton leads off by explaining how the Fed has averted past panics, but then goes on to explain how such power may not be available in the future. Hamilton's arguments on both fronts are worth a look:

Financial Crises, James Hamilton, 3/6/2007: … [W]hen the World Trade Center towers collapsed on September 11, many of the financial institutions [PDF] that played a key role in trades of government securities and interbank loans were wiped out or incapacitated, posing potentially huge liquidity problems [PDF]. The Fed reacted with an extremely aggressive temporary creation of reserves, which prevented those liquidity disruptions from having major consequences. Americans were appropriately focused on other concerns that day. But we can thank the Fed that among those concerns was not a financial panic. …

So does this have anything to do with current concerns about subprime mortgages and interlayered hedge fund risk? I would take away two points from this discussion. First, insofar as we are talking about solvency problems, there is little the Fed is able to do to prevent those— some subprime mortgages are going to default, and that's that. However, the Fed can and will prevent these from cascading into broader liquidity problems, by which I mean insolvencies created solely because of forced liquidation or unavailability of short-term credit. Even so, the Fed's capacity to move aggressively on this front is potentially limited by the need to avoid a precipitous collapse in the value of the dollar. Whether the outcome would look more like the U.S. in 2001 or Korea in 1997 remains to be seen.

Comments

[bailey]

Ouch!

[michael jones]

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