Tag Archive for 'Credit crisis'

Woodford, QE and the BoE’s FLS

I’ve been thinking a bit about the efficacy of QE, the potential benefits of the Bank of England’s Funding for Lending Scheme (FLS) [BoE, HM Treasury] and the new paper Michael Woodfoord presented at Jackson Hole [pdf here] (it’s a classic Woodford paper, by the way, even if it is is almost entirely equation free: a little difficult to wrap your head around, but ultimately very, very insightful).  Woodford’s conclusion starts with an excellent statement of the problem:

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit.

The interest-rate lower bound here is not necessarily zero, but rather whatever rate is paid on excess reserves, which may indeed be equal to zero, but need not be.  In the US, interest on reserves for depository institutions has been 0.25% since Oct 2008; in the UK it has been Bank Rate, currently 0.5%, since Mar 2009.  In principle, one might push the interest rate paid on reserves into negative territory, but such an action would come at the cost of destroying a subset of the money market and with a very real risk that economic agents (banks or, worse, businesses and households) would instead choose to hold their money in the form of physical currency.

Woodford advocates a strong form of forward guidance — that is, the abandonment of restriction (i) — as the optimal policy at the present time, on the basis that all monetary policy is, fundamentally, about expectations of the future.  In particular, he uses the paper to make an argument for nominal GDP level targeting.

This is vitally important stuff, but in this post I want to talk about quantitative easing, in the general sense of the phrase, or what Woodford far more accurately refers to as “balance sheet policies.”

First up is the purchase of short-dated safe assets, paid for with the creation of new reserves.  For the financial sector, this means giving up a safe, liquid asset with a steady revenue stream in return for money.  In normal times, the financial sector might then seek to increase their lending, providing a multiplier effect, but with interest rates on short-dated safe assets at the same level as interest paid on reserves, the financial position of the bank does not change with the purchase, so their incentive to lend can’t increase.  In this case, the short-dated safe asset has become a perfect substitute for money and, absent any forward guidance, such a policy can have no effect on the real economy.  Krugman (1998) and Eggertson and Woodford (2003) provide two-period and infinite-horizon treatments respectively.  Forward guidance in this setting might be anything from the private sector observing the purchases and inferring a more accommodative policy stance in the future (and the central bank doing nothing to disabuse them of that belief) to an outright statement from the central bank that the increase in reserves will be permanent.

Next up is the idea of purchasing long-dated safe assets, or even long-dated risky assets.  Woodford stresses that this can be decomposed into two distinct parts:  An initial expansion of the central bank’s balance sheet via the purchase of short-dated, safe assets and then an adjustment of the composition of the balance sheet by selling short-dated safe assets and buying long-dated assets.  Since the first step is thought to be ineffective (by non-Monetarists, at least), any traction should be obtained in the second step.

But because the second step represents either an adjustment in the relative supply of short- and long-dated government debt (in the case of limiting oneself to safe assets) or an allocation of capital directly to the real economy (in the case of purchasing risky assets), this is arguably fiscal policy rather than monetary and should perhaps be better done by the Treasury department.  Putting that concern to one side, I want to consider why it might, or might not, work.

The standard argument in favour is that of portfolio rebalancing: now holding extra cash and facing low yields on long-dated safe assets, a financial actor seeking to equate their risk-adjusted returns across assets should choose to invest at least some of the extra cash in risky assets (i.e. lending to the real economy).  Woodford emphasises that this story implicitly requires heterogeneity across market participants:

But it is important to note that such “portfolio-balance effects” do not exist in a modern, general-equilibrium theory of asset prices — in which assets are assumed to be valued for their state-contingent payoffs in different states of the world, and investors are assumed to correctly anticipate the consequences of their portfolio choices for their wealth in different future states — at least to the extent that financial markets are modeled as frictionless. It is clearly inconsistent with a representative-household asset pricing theory (even though the argument sketched above, and many classic expositions of portfolio-balance theory, make no reference to any heterogeneity on the part of private investors). In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, where the present value is calculated using an asset pricing kernel (stochastic discount factor) derived from the representative household’s marginal utility of income in different future states of the world. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, the representative household’s marginal utility of income in different states of the world should not change. Hence the pricing kernel should not change, and the market price of one unit of a given asset should not change, either, assuming that the risky returns to which the asset represents a claim have not changed.

He goes on to stress that if the central bank were to take some risk off the private sector, the risk still remains and, in the event of a loss, the reduction in central bank profits to the treasury would require a subsequent increase in taxes. Consequently, a representative household would experience the loss no matter whether it was formally held by itself or the central bank.  Crucially, too …

The irrelevance result is easiest to derive in the context of a representative-household model, but in fact it does not depend on the existence of a representative household, nor upon the existence of a complete set of financial markets. All that one needs for the argument are the assumptions that (i) the assets in question are valued only for their pecuniary returns [John here: i.e. their flow of revenue and their expected future resale value] — they may not be perfect substitutes from the standpoint of investors, owing to different risk characteristics, but not for any other reason — and that (ii) all investors can purchase arbitrary quantities of the same assets at the same (market) prices, with no binding constraints on the positions that any investor can take, other than her overall budget constraint. Under these assumptions, the irrelevance of central-bank open-market operations is essentially a Modigliani-Miller result.


Summing over all households, the private sector chooses trades that in aggregate precisely cancel the central bank’s trade. The result obtains even if different households have very different attitudes toward risk, different time profiles of income, different types of non-tradeable income risk that they need to hedge, and so on, and regardless of how large or small the set of marketed securities may be. One can easily introduce heterogeneity of the kind that is often invoked as an explanation of time-varying risk premia without this implying that any “portfolio-balance” effects of central-bank transactions should exist.

Of the two requirements for this irrelevance result, the second is clearly not true in practice, so large-scale asset purchases should, in principle, work even in the absence of any forward guidance, although the magnitude of the efficacy would be in doubt.

On the first, Woodford does acknowledge some work by Krishnamurthy and Vissing-Jorgensen (2012) which shows that US government debt possesses non-pecuniary qualities that are valued by the financial sector.  In particular, safe government debt is often required as collateral in repo transactions and this requirement should give such assets value above that implied by their pure pecuniary returns.  However, as pointed out by Krishnamurthy and Vissing-Jorgensen in a discussion note (pdf), to the extent that this channel is important, it implies that central bank purchases of long-dated safe assets can even be welfare reducing.

To see why this is so, I think it best to divide the universe of financial intermediaries into two groups:  regular banks and pure investment shops.  Pure investment shops have, collectively, particularly stable funding (think pension funds) although the funds might swoosh around between individual investment shops.  Regular banks have some stable funding (from retail deposits), but also rely on wholesale funding.

Up until the financial crisis of 2008, regular banks’ wholesale funding was done on an unsecured basis.  There was no collateral required.  There was very little asset encumbrance.  But since the crisis (and, indeed, arguably because of it), regular banks have had essentially no access to unsecured lending.  Instead, banks have been forced to rely almost entirely on secured borrowing (e.g. through covered bonds at the long end or repos at the short end) for their wholesale funding.  In addition to this, new regulations have been (or are being) put in place that increase their need to hold safe assets (i.e. government debt) even if unsecured borrowing is available.

QE has therefore acted through two, broad channels.  In the first, portfolio rebalancing may still have worked through the pure investment shops.  Having sold their government bonds and now holding cash, they reinvested the money but since the yields on government bonds were now lower relative to other asset classes, they put a larger fraction of that money into equity and corporate bond markets.  To the extent that such investment shops are not able to perfectly offset the central bank’s trade, or are unable to full recognise their need to bear any potential losses from any risk the central bank takes on, large non-financial companies (NFCs) with access to stock and bond markets should therefore have seen a reduction in the price of credit and, in principle, should have been more willing to undertake investment.

On the other hand, QE has also served to lower the supply of eligible collateral at precisely the time when demand for it among regular banks has shot up.  The banks have then been faced with an awful choice:  either pay the extra high cost to get the required collateral (buying it off the pure investment shops), or deleverage so that they don’t need the funding any more.  As a result, their funding costs will have gone up as a direct result of QE and if they have any pricing power at all (and they do), then interest rates available to households and small-to-medium sized enterprises (SMEs) will be forced to be higher than they would otherwise have been.  No matter which option banks choose (and most likely they would choose a combination of the two), a negative supply (of credit) shock to the real economy would occur as a result.

If this second broad channel (through regular banks) were to outweigh the first (through pure investment shops), then QE focused on the purchase of long-dated safe assets would, in aggregate, have a negative effect on the economy.  I believe it is this very possibility that has given both the Federal Reserve and the Bank of England pause in their consideration of additional asset purchases.

Of course, if the central bank were not to buy long-dated safe assets but were instead to purchase long-dated risky assets (bundles of corporate bonds, MBS, etc), the supply of safe assets needed for collateral purposes would not be artificially reduced and, to the extent that portfolio rebalancing helps at all, the full efficacy would be obtained.   However, such a strategy would go against the principle that central banks ought to stay away from the decisions regarding the allocation of credit.

All of which is why, I suspect, that the Bank of England has decided to go for their Funding for Lending Scheme.  At it’s heart, the FLS is a collateral swap.  The BoE gives banks gilts and the banks give the BoE bundles of their mortgages and SME loans, plus interest.  The banks can then use the gilts to obtain funding on the wholesale market, while the interest that banks pay the BoE is a decreasing function of how much additional lending the banks make to the real economy.  The mortgages and SME loans that the banks give the BoE will have a haircut applied for safety.  It’ll be pretty tricky to get just right, but in principle it should be able to offset any increase in funding costs that QE may have imposed.

A clear majority of credit creation in Britain takes place via regular banks, so this has the potential to have quite a dramatic effect.  We’ll just have to wait and see …

Policy options for the Euro area [Updated]

I here list a few policy options for the Euro area that I support, broadly in descending order of my perception of their importance.  Everything here is predicated on an assumption that the Euro itself is to survive and that no member nation of the Euro area is to exit the union.  I don’t claim that this would solve the crisis — who would make such a claim? — but they would all be positive steps that increase the probability of an ultimate solution being found.

  • Immediately establish a single, Euro area-wide bank deposit guarantee scheme.  A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany.  That means that retail and commercial deposits in each should be backed by the same guarantee.  I have no firm opinion on how it should be funded.  The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them.  Just get the thing up and running.  Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing.  There are many and varied forms that fiscal union can take; this is the most urgent of them all.  I am shocked that this does not already exist.
  • The ECB should switch from targetting current inflation to expected future inflation.  The Bank of England already does this.  Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years.  This is important.  Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%.  On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany.  They will be much lower for the rest of the Euro area.  Monetary policy in the Euro area is much, much too tight at the moment.  At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.
  • The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation.  This follows on from my previous point, but is still logically distinct.  The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements.  I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP.  I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.
  • The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough.  The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this.  I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral.  I certainly believe (see my second point above) that interest rates should be lowered.  The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.
  • A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first).  The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability.  When banks are instead deleveraging, the problem is made worse by waiting.
  • Credit Default Swaps must be permitted to trigger.  The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky.  By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better.  Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.
  • Every member of the Euro periphery should be in an IMF programme.  Yes, I’m looking at you, Italy.  If the IMF does not have sufficient funds to work with, the ECB should lend to it.  All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity.  These things cannot be fixed in two or three years.  They can, at best, be put on the right path.
  • For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it.   If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%.  The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis.  Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere.  Note, too, that a central bank is only meant to be a lender of last resort to banks.  The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation:  Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT.  Any member country would retain the ability to provide benefits above and beyond the minimum.  This will have several benefits:

  • Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
  • It will help provide pan-European automatic stabilisers in fiscal policy;
  • It will provide crucial intra-European stabilisation;
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.


Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks.  This is a good thing. Press releases:

Regulation should set information free

Imagine that you’re a manager for a large investment fund and you’ve recently been contemplating your position on Citigroup.  How would this press release from Citi affect your opinion of their prospects?:

New York – Citi today announced the sale of its entire ownership interest of three North American partner credit card portfolios representing approximately $1.3 billion in managed assets. The cards portfolios were part of Citi Holdings. Terms of the deals were not disclosed. Citi will continue to service the portfolios through the first half of 2010 at which time the acquirer will assume all customer servicing aspects of the portfolios.

The sale of these card portfolios is consistent with Citi’s strategy to optimize the assets and businesses within Citi Holdings while working to generate long-term profitability and growth from Citicorp, which comprises its core franchise. Citi continues to make progress on its strategy and will continue to pursue opportunities within Citi Holdings that create the most value for stakeholders.

The answer should be “not much, or perhaps a little negatively” because the press release contains close to no information at all.  Here is Floyd Norris:

A few unanswered questions:

1. Who is the buyer?
2. Which card portfolios are being sold?
3. What is the price?
4. Is there a profit or loss?

A check of Citi’s last set of disclosures shows that Citi Holdings had $67.6 billion in such credit card portfolios in the second quarter, so this is a small part of that. Still, I can’t remember a deal announcement when a company said it had sold undisclosed assets to an undisclosed buyer for an undisclosed price, resulting in an undisclosed profit or loss.

Chris Kaufman at Reuters noted the same.

Now, to be fair, there is some information in the release if you have some context.  In January 2009 Citigroup separated “into Citicorp, housing its key banking business, and Citi Holdings, which included its brokerage, consumer finance, and troubled assets.”  In other words, Citi Holdings is the bucket holding “assets that Citigroup is trying to sell or wind down.”  The press release is a signal to the market that Citi has been able to offload some of those assets – it’s an attempt to speak of improved market conditions.  But the refusal to release any details suggests that they sold the portfolios at a deep discount to face value, which implies either that Citi was desperate for the cash (a negative signal) or that they think the portfolios were worth even less than they got for them, which doesn’t bode well for the rest of their credit card holdings (also a negative signal).  It’s unsurprising, then, that Citi were down 4.1% in afternoon trading after the release.

Some more information did emerge later on.  American Banker, citing “industry members with knowledge of the transaction,” reported:

The buyer was U.S. Bancorp, according to industry members with knowledge of the transaction, who identified the assets as the card portfolios for KeyCorp and Associated Banc-Corp, which Citi issues as an agent bank, and the affinity card for the American Dental Association.

But a spokeswoman for Citi, which only identified the portfolios as “North American partner credit card portfolios” in a press release, would not comment, identify the buyer, or elaborate on the release. U.S. Bancorp, Associated Bank and the American Dental Association did not return calls by press time; a spokesman for KeyCorp would not discuss the matter.

It’s tremendously frustrating that even this titbit of information needed to be extracted via a leak.  Did Maria Aspan — the author of the piece at American Banker — take somebody out for a beer?  Did the information come from somebody at Citigroup, Bancorp or one of the law firms that represent them?

In what seems perfectly designed to turn that furstration into anger, we then have other media outlets reporting this extra information unattributedHere‘s the Wall Street Journal:

Citigroup Inc. sold its interest in three North American credit-card portfolios to U.S. Bancorp of Minneapolis, continuing the New York bank’s effort to unload assets that aren’t considered to be a core part of its business, according to people familiar with the situation.


Citigroup announced the sale, but it didn’t identify the buyer or type of portfolio that was being sold. Representatives of U.S. Bancorp couldn’t be reached for comment.

That’s it.  There’s no mention of where they got Bancorp from at all.

It’s all whispers and rumours, friendships and acquaintences.  It’s no way for the market to get their information.

Here’s my it’ll-never-happen suggestion for improving banking regulation:

Any purchase or sale of assets representing more than 1% of a bank’s previous holdings in that asset class [in this case the sale represented 1.9% of Citi’s credit card holdings] must be accompanied by the immediate public release of information uniquely identifing the assets bought or sold and the agreed terms of the deal, including the price.  Identities of all parties involved must be publicly disclosed within 6 months of the transaction.

An information-based approach to understanding why America let Lehman Brothers collapse but saved everyone afterwards

In addition to his previous comments on the bailouts [25 Aug27 Aug28 Aug], which I highlighted here, Tyler Cowen has added a fourth post [2 Sep]:

I side with Bernanke because an economy can withstand only so much major bank insolvency at once. Lots of major banks were levered up 30-1 or so. Their assets fell in value more than a modest amount and then they were insolvent, sometimes grossly so. (A three percent decline in asset values already puts you into insolvency range.) If AIG had gone into bankruptcy court, some major banks would have been even more insolvent. Or if Frannie securities had been allowed to find their non-bailout values. My guess is that at least 15 out of the top 20 U.S. banks would have been flat-out insolvent if, starting at the time of Bear Stearns, all we had done was loose monetary policy and no other bailouts. Subsequent contagion effects, and the shut down of short-term repo markets, and a run on money market funds, would have made even more financial institutions insolvent. The world as we know it then becomes very dire, both for credit reasons and deflation reasons (yes you can print up currency to keep measured M up and running but the economy still collapses). So we needed not just emergency lending but also resource transfers to banks, basically to put them back into the range of possible solvency.

I really like to see Tyler’s evolving attitudes here.  It lets me know that mere grad students are allowed to not be sure of themselves. 🙂  In any event, let me present my latest thoughts on the bailouts:

Imagine being Bernanke/Paulson two days before Lehman Brothers went down:  you know they’re going to go down if you don’t bail them out and you know that to bail them out creates moral hazard problems (i.e. increases the likelihood of a repeat of the entire mess in another 10 years).  You don’t know how close to the edge everyone else is, nor how large an effect a Lehman collapse will have on everyone else in the short-run (thanks, in no small part, to the fact that all those derivatives were sold over-the-counter), but you’re nevertheless almost certain that Lehman Brothers are not important enough to take down the whole planet.

In that situation, I think of the decision to let Lehman Brothers go down as an experiment to allow estimation of the system’s interconnectedness.  Suppose you’ve got a structural model of the U.S. financial system as a whole, but no empirical basis for calibrating it.  Normally you might estimate the deep parameters from micro models, but when derivatives were exempted from regulation in the 2000 Commodities Futures Modernization Act, in addition to letting firms do what they wanted with derivatives you also gave up having information about what they were doing.  So instead, what you need is a macro shock that you can fully identify so that at least you can pull out the reduced-form parameters.  Letting Lehman go was the perfect opportunity for that shock.

I’m not saying that Bernanke had an actual model that he wanted to calibrate (although if he didn’t, I really hope he has one now), but he will certainly have had a mental model.  I don’t even mean to suggest that this was the reasoning behind letting Lehman go.  That would be one hell of a (semi) natural experiment and a pretty reckless way to gather the information.  Nevertheless, the information gained is tremendously valuable, both in itself and to society as a whole because it is now, at least in part, public information.

To some extent, I feel like the ideal overall response to the crisis from the Fed and Treasury would have been to let everyone fail a little bit, but that isn’t possible — you can’t let an institution become a little bit bankrupt in the same way that you can’t be just a little bit pregnant.  To me, the best real-world alternative was to let one or two institutions die to put the frighteners on everyone and discover the degree of interconnectedness of the system and then save the rest, with the nature and scale of the subsequent bailouts being determined by the reaction to the first couple going down.  I would only really throw criticism at the manner of the saving of the rest (especially the secrecy) and even then I would be hesitant because:

(a) it was all terribly political and at that point the last thing Bernanke needed was a financially-illiterate representative pushing his or her reelection-centred agenda every step of the way (we don’t let people into a hospital emergency room when the doctor isn’t yet sure of what’s wrong with the patient);

(b) perhaps the calibration afforded by the collapse of Lehman Brothers convinced Bernanke-the-physician that short-term secrecy was necessay to “stop the bleeding” (although that doesn’t necessarily imply that long-term secrecy is warranted); and

(c) there was still inherent (i.e. Knightian) uncertainty in what was coming next on a day-to-day basis.

A pragmatic libertarian defense of the bank bailouts

Tyler Cowen is defending the bank bailouts in America: 25 Aug, 27 Aug, 28 Aug.  I generally like what he says.  I want to highlight the third post in particular:

General pro-market or anti-government arguments don’t rule out the recent bailouts.  Let’s take the hardest, least Friedman-friendly case, the insolvent banks.  For insolvent banks (and for some of the illiquid banks, which might have failed without bailouts), the alternative to those bailouts is calling in deposit insurance and the bankruptcy courts, both of which are, for better or worse, forms of government intervention.  In particular today’s bankruptcy procedures are ill-suited for disposing of a large financial institution in a timely manner and this can be considered a form of gross government failure.

Note that even when the Fed “bails out” a large investment bank, or insurance company, they are checking a chain reaction which would likely spread to some commercial banks, thus bringing in deposit insurance as well, not to mention further bankruptcies.  And that’s not even considering that Congress probably would have stepped in, I’m just looking at laws already on the books.

So if you’re “opposed to financial bailouts,” as a libertarian, you’re not for the market.  You’re saying that one scheme for governmental disposition is better than another.  Of course you are entitled to that opinion but the sheer force of libertarian doctrine is not necessarily on your side.  The general pro-market and anti-government arguments are not necessarily on your side.  I think it is quite plausible for a libertarian to believe that the Fed is “less bad” than the bankruptcy courts and the FDIC.

Now, all things considered, I don’t see why this “libertarian two-step” move should be needed.  I think it’s enough to simply ask whether the bailouts were a good idea and proceed accordingly.  But if you’re concerned about compatibility with libertarian principle, this is one simple way of seeing why my view fits right in.  In fact I think it is the more libertarian of the views under consideration, as it keeps the very worst of the government interventions on the table at bay.

No doubt some libertarians will counter that the FDIC and bankruptcy courts ought not to exist either (I disagree with that – while neither is perfect, they’re both needed.  But then, I’m hardly a libertarian), but that misses the point of Tyler’s title for the post:  “A second-best theory of libertarian bailouts”.  The world of second-best is the real world.  It accepts that things are currently as they are and asks what is best given the current state of the world, not in all possible worlds.