It can only be attributable to human error September 18, 2013 at 4:48 pm
Dave: Hello, Hal. Do you read me, Hal?
Hal: Affirmative, Dave. I read you.
Dave: Open the central bank window, Hal.
Hal: I’m sorry, Dave. I’m afraid I can’t do that.
This classic exchange, or at least my version of it, came to mind as I listened to an excellent talk by Hal Scott yesterday. Scott’s paper on Interconnectedness and Contagion is justly well-known. One of its theses is that contagion between financial institutions in a crisis might well be inevitable; that capital cannot reasonably be raised to levels where contagion cannot occur; and that liquidity risk similarly cannot be reduced to the point where runs on some class of financial system liabilities are impossible. Scott then argues that if this is true, then the FED has been shot in the foot by Dodd Frank’s restrictions* on who it can lend to in extremis. The lender of last resort function is the most important tool in killing contagion, Scott suggests, and as you don’t know a priori which class of institutions you will have to lend to, restricting yourself to banks is counterproductive. Resolution is a useful tool in dealing with the consequences of contagion, but wouldn’t it be better to have a wide spectrum antibiotic which can deal with the infection rather than an efficient funeral and burial service?
Perhaps, then, one of Hal’s best lines should really be spoken by the architects of the Dodd Frank restrictions on who can access the FED window:
I know I’ve made some very poor decisions recently, but I can give you my complete assurance that my work will be back to normal. I’ve still got the greatest enthusiasm and confidence in the mission. And I want to help you.
*Section 1101 of the Dodd Frank Act, Federal Reserve Act Amendments on Emergency Lending Authority, since you ask. And Section 716 restrictions on lending to swap entities for that matter.