Project Syndicate - The insistence that those responsible for today’s financial crisis pay a price lest they repeat their mistakes – the so called moral hazard argument – recalls the great American orator William Jennings Bryan’s immortal “cross of gold” speech: “You shall not press down upon the brow of labor a crown of thorns. You shall not crucify mankind upon a cross of gold.” In other words, ordinary people should not be made to suffer for the foibles of policymakers enthralled by some defunct economic theory.

Today, the defunct economic theory is that a rapid shift in preferences – colorfully called a “reduced appetite for risk” – is the key reason behind the current sub-prime mortgage and financial crisis. To avoid future increases in this appetite, policymakers and pundits have focused on the so-called “moral hazard problem”: the “bad guys” must pay for their mistakes, lest they make them again.

One would have expected the modern-day William Jennings Bryan to be warning central bankers not to crucify mankind on a “cross of moral hazard and no-bailouts.” But, surprisingly, the opposite is occurring.

Some on the left, motivated in part by revulsion against financial types who are thought to reap unjustified incomes, have joined forces with conventional economists, whose almost religious belief in their models has blinded them to the harm their dubious economic theory can do to the real economy and the interests of ordinary people. No bailouts can mean no college for the kids – or, for many, no house.

The key question economists should now be asking is why financial markets are “seizing up” when banks and other financial institutions are flush with liquidity.

The conventional explanation – a reduced appetite for risk – is not convincing. The sub-prime market seems too small to have caused such a broad-based change in risk preference.

A more convincing explanation is that the current crisis, with its unknown dimensions and scope, has so clouded the economic landscape as to freeze market participants in their tracks, so to speak, until things clear up.

That is the fundamental lesson of an important new book, Imperfect Knowledge Economics: Exchange Rates and Risk, by Roman Frydman and Michael Goldberg. The key to understanding financial markets, especially when they are as unsettled as they have been in recent weeks, is not a change in preferences, but inherent imperfection of knowledge and altered expectations concerning the future course of macroeconomic fundamentals.

What policy prescriptions does the “imperfect knowledge” approach imply for the current crisis? The most important one for central bankers is that they should cut interest rates – and cut them fast – to re-assure market participants that turmoil in financial markets will not be allowed to affect the real economy.

Judging by its recent policy reversal, the US Federal Reserve acts as if it were a late convert to the imperfect knowledge hypothesis. Led by Ben Bernanke, a former leading academic economist, the Fed at first fell into the trap of turning a blind eye to the wider consequences of the sub-prime mortgage crisis. It injected money into the system, but ruled out interest-rate cuts.

The results of this misguided policy proved so disastrous – financial markets seized up almost immediately – that a mere ten days after its “What, me worry?” message, the Fed made an embarrassing but necessary about-face and lowered the discount rate by 50 basis points. Downward risks to growth had significantly increased, Fed officials explained.

It matters little that the Fed could have gone further and cut the federal funds rate as well as the discount rate at its emergency meeting – indeed, that may have to be done. The important thing is that the Fed’s policy crossed the bridge from indifference to re-assurance. Could it be that Bernanke obtained an advanced copy of the Frydman-Goldberg book during those pregnant ten days in August?

Bernanke, after an initial stumble—a rookie mistake as one commentator put it--appears to be following in his predecessor Alan Greenspan’s footsteps. But what of Jean-Claude Trichet, president of the European Central Bank?

The ECB had indicated in August that it would raise rates in September but backed down when the financial crisis continued unabated. Good for it. By in effect cutting rates from their expected levels, the ECB joined the US Federal Reserve in moving from a policy of indifference to one of reassurance. This should help stabilize financial markets.

The ECB and Fed now seem to be moving in tandem to limit the effects of the crisis on the real economy. Realism has thankfully trumped theory.

Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University.

Copyright: Project Syndicate, 2007.
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