Bill Emmott - International Author & Adviser


The Free Market Saves The Fed
Corriere della Sera - March 25th 2008

It is a debate that will never die. The rescue this week by the Federal Reserve Board of Bear Stearns, Americaís fifth-biggest investment bank, and its decision to extend its borrowing privileges to all such trading firms as well as the commercial banks, has rekindled the argument over how far the state should intervene in financial markets and the economy in general. Some see the Fedís rescue, with its consequent costs for taxpayers, as outrageous. Others hope that it marks the beginning of the return of government control.

            As you would expect, since I am a former editor of the very free-market Economist, my starting point in this argument is one of scepticism about state regulation. It has failed so often in the past. Yet the Fed was surely right to act in the way it did this week. The very existence of central banks and other bank-supervisory agencies is evidence that, for the past century or more, it has been necessary at times for the state to prevent events in financial markets from damaging the overall economy, and hence the public interest. This was one of those times. And the Fedís intervention must come with a price attached: tighter regulation in future of what banks can do.

            The reason why the Fed was right to intervene is that banks and investment banks are so tightly inter-connected through their loans and trading positions with each other: the bankruptcy of Bear Stearns would have caused many other bankruptcies, just as the failure of commercial banks in America in the 1930s caused other banks to fail too. The Fed chose to punish Bear Stearnsí shareholders, who would have done better in a bankruptcy than they did in last weekís $2-a-share sale to JP Morgan, in order to protect the firmís creditors. That is why JP Morgan feared lawsuits from the shareholders and chose to quintuple its offer to $10 a share on March 24th in the hope of appeasing them. Credit markets were further protected by the Fedís guarantee to JP Morgan of $30 billion-worth of Bear Stearnsís worst liabilities.

            There is now talk, on both sides of the Atlantic, of intervention by central banks directly in the collapsing market for mortgage-backed securities. The Financial Times reported on March 22nd that the Bank of England is keen on such a move, and the Fed is considering it. This would be a drastic step, since it would add hugely to the risks being borne by taxpayers. It should certainly be done only as a last resort. So far, at least in public, little evidence has been shown to prove that it is really necessary.

            All this sort of intervention by central banks can be justified by reference to the risks of a collapse of the financial system and so of lending to ordinary companies and households. The danger of it, however, is that it may turn financial speculation into even more of a one-way bet than it has already become: if financiers are allowed to take the rewards from reckless speculation, but are bailed out by central banks when their speculation goes wrong, they will simply take even bigger risks in future. So the quid pro quo for any central bank bail-outs must be tighter regulation of the risks banks can take.

            This does not mean that in future governments should again own banks, or give them instructions about who they should lend money to and what shares they should own. Virtually all the experience of the past 50 years shows that such interference is a disaster: it harms economic growth and turns banks into tools of politicians rather than independent enterprises. What it does mean, however, is that governments can and should impose more restrictions on how much capital banks must set aside in reserve against the loans and investments they make, which means restrictions on how risky their business models are allowed to be.

            Over the past 20 years or more, governments have been trying to use capital-adequacy controls to regulate banking, but they have allowed too many financial firms to evade those restrictions. It is time for a crackdown, in the interest of economic stability. It is not time, however, for governments to interfere directly in what banks do.



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