Chicken Soup for the New Financial Panic

For anyone that witnessed the sequence of emerging markets crises of the 1990s, yesterday’s sharp falls of the European, Asian, and Latin American financial markets must have created a sense of déjà vu all over again. Indeed, there are several similarities between the current meltdowns and those of a decade ago. But there are new elements as well.

The similarities include that, as Guillermo Calvo and Enrique Mendoza argued about the 1994-95 Mexican crisis, the punishment appears to be much greater than the crime. True, the international banks that invested in structured investment vehicles and other novel but opaque assets lacked, perhaps, a clear understanding of the resulting exposure, and ended up taking excessive risk. But yesterday’s massive sell offs wiped out an amount of world wealth that probably exceeds the value of the banks’ suspect investments by an order of magnitude.

Yesterday’s events also showed that, just like a decade ago, when panic starts driving the markets, investors rush for liquidity. And if liquidity is insufficient, asset prices collapse, which fuels more panic, and makes prices spiral down.

Stopping the panic requires a lender of last resort to step in and reassure the markets, not to bail out excessive risk taking, but to prevent a fire sale unwarranted by fundamentals. That was, I believe, the most important policy conclusion from the 1990s crisis period.

But, given that lesson, it was disheartening to see that central banks in Europe, Asia, and Latin America did not only fail to stop the run: there is little indication that they even tried. Why?

In the 1990s, central banks in crisis countries were committed to pegging exchange rates. Fighting financial panics required using up a stock of foreign exchange reserves that had been built primarily to defend the exchange rate. But then speculators could successfully attack the peg. (This is, in a nutshell, the conflict that Andres Velasco and I discussed and formalized in several papers, and that has become the basis for our current understanding of the links between banking crises and currency peg collapses.)

Today’s situation is very different, and makes it easier for central banks to act as lenders of last resort. There has been a general move towards flexible exchange rates, and many countries have accumulated massive war chests of international currency. From this perspective, the fact that European, Asian, and Latin American central banks have refrained from providing enough liquidity to forestall financial panic is rather puzzling.

Perhaps the explanation for the puzzle is that many of those central banks have adopted an inflation target and are worried that a liquidity injection will compromise it. This seems to be clearly the case in Europe, but I guess that the same is true of Brazil, Peru, and other countries in Latin America and Asia.

Concerns about inflation targets as the financial system is melting down are, however, misplaced. The time frame of financial crises is much faster than the time frame for inflation. In a liquidity crisis, the first order of business is to prevent a panic, which can have huge costs not only for the financial system but for the whole economy. Once that is done, there will be plenty of time to try to bring inflation back to target.

Fortunately, Ben Bernanke and the Federal Reserve must have agreed with the view that liquidity was the immediate problem, and acted forcefully this morning to signal that liquidity will be provided as needed. The 75 basis point cut is unlikely to have significantly changed the probability of a recession. But it may have saved us from a Depression.

3 Responses to "Chicken Soup for the New Financial Panic"

  1. Vitoria   January 24, 2008 at 10:22 am

    Roberto,Why would Latin countries act in tandem with the US Federal Reserve?Don’t you think that what the FED is doing through the TAF is similar to the Japan situation when the government bailed the banks? Or the TAF would not help in preventing a recession and a systemic crisis?

  2. Roberto   January 24, 2008 at 10:57 am

    Hi Vitoria,In my view, there is a difference between a normal “market correction” and a financial panic. Central banks may be well advised to stay away from fighting market corrections. But abstaining from providing liquidity to forestall a panic is most probably a mistake. Latin central banks could have stepped in on Monday (before the Federal Reserve’s move on Tuesday) to ameliorate the turbulence in their financial markets. Also, they had the resources to do so. Isn’t this exactly the kind of event that justifies their holding reserves of more than 20 percent of GDP? As for the TAF, I see it as a good effort to prevent an unwarranted liquidity crisis. I do not believe that it is intended to prevent an upcoming recession, nor that it can. But hopefully it will help preventing a paralysis of the interbank market. Finally, I do not see it as a bank bailout, at least not yet. Granted, it can become one if the Federal Reserve ends up owning a lot of bad collateral, but we are not there.

  3. Vitoria   January 24, 2008 at 12:14 pm

    Roberto,Couldn’t agree more on the ‘financial panic’ scenario. I guess there is still too much uncertainty about the credibility of Latin Central Banks for them to step in before the Fed. There is too much noise in the system for people to screen good from bad news. On the TAF the Fed is already bailing the banks. Take a look at the latest required reserve data released on Jan 17. Great piece.Vitoria