Fed 'Injections': Who Benefits?
The world's central banks have promised to keep "injecting" tens of billions of dollars into investment markets to allay fears of a price crash related to defaults on subprime mortgages and securities backed by such loans. Senior Writer Kim Clark asked Alan Blinder, former vice chairman of the Federal Reserve and now a professor of economics at Princeton, how much this fiscal medicine would cost taxpayers or help investors.
What should taxpayers know about the Fed's injection of $38 billion into the markets over the past several days?
The most important thing for taxpayers to know is that it is virtually inconceivable that it will cost any taxpayer money. What the Federal Reserve is doing is lending to banks that need the funds and charging them interest. These banks are not going to default. And besides the Fed is taking as collateral very good assets [including Fannie Mae guaranteed mortgage-backed securities, but not bonds based on subprime mortgages].
Where did the Fed get this money?
The central bank controls the printing presses...Of course, literally, these days, printing money is really just a matter of keystrokes on a computer.
But these loans to banks are only for a short time—the longest was for 14 days. How will that resolve concerns about the subprime-mortgage-backed securities?
They, of course, hope the short-term crisis will be over in 14 days. Mortgage-backed securities had suddenly become illiquid [because investors wouldn't buy them]. One of the very unusual things the Federal Reserve did was to encourage banks to use [high-quality] mortgage-backed securities as collateral for loans of Fed funds...Cascades of guilt by association are the hallmark of a panic. Stuff that isn't really toxic waste gets treated as if it was.
So if these injections don't lose us money, do they make money? And if so, what does the Fed do with the profits?
Think of the Federal Reserve as a bank. One aspect of what it does is lend money. It makes a profit and, after funding its own operations out of that, sends the rest to the U.S. Treasury—perhaps $40 billion to $50 billion a year.
Why should the Fed inject money into investment markets? Are you afraid that the Fed will be bailing out investors who made bad decisions and creating a "moral hazard" that will encourage investors to take riskier bets in the future in the hope that they'll also be rescued?
In general, you want to try to allow the investors that made foolish or bad bets to lose money. However, you don't want a lot of innocent bystanders brought down for the pure pleasure of seeing those investors lose money. If market turmoil doesn't look to be systemic, you don't do anything about it and say, "Too bad, you lost money." But if the crisis looks to be systemic, the central bank must look to protect the system. Investors in subprime mortgages are not getting bailed out. The prices of these bad assets are falling. The hedge funds that created the derivatives are losing money...But if the Fed lets the whole thing go to hell in a handbasket, you, I, and everybody who is either borrowing or lending will suffer.
You sound like you think the fundamentals are good and that this is an irrational panic that will blow over. No worries?
Well, all panics blow over. The questions are how long they last and how much damage they do. Before the central bank's injection of funds, some good, sound banks were having trouble raising funds in the marketplace...Is it over? I'm not convinced. I am a bit worried, for example, that some little event will blow up, and the panic will go to another level.
Is it irrational? Well, most of us economists have been waiting for risk spreads [between high- and low-risk loans of all types] to widen for years now. As recently as one month ago, Colombian treasury debt was trading for just 100 basis points above U.S. treasury debt. Do you think that's right? As a part of this "crisis," risk premiums are now widening. The widening of risk premiums strikes me as a return to rationality. The mystery is how they got so narrow for so long.