Monday, September 3, 2007

Is this liquidity or a solvency crisis? US crisis is going to spread..

One of the problems the monetary authorities have to deal with is moral hazard. This is not a theoretical issue, as some suggest, but a far more immediate concern. Moral hazard is the result of asymmetric expectations, as markets expect the central bank to bail out the financial sector during a time of crisis.

The problem of moral hazard is to some extent related to the monetary policy strategy of central banks, with their mechanistic focus on a single consumer price index. Such strategies often have no space for asset prices, but markets know fully well that central banks must invariably take account of asset prices during sharp downturns. One way out of this asymmetry is for central banks to include asset prices into their policy frameworks in some form or other.

This said, a bail-out of the financial system will probably become unavoidable, but it should be accompanied with structural policy changes. Tighter financial regulation is probable. The role of the ratings agencies is bound to change too. And central banks should reconsider their monetary policy frameworks. They are part of the problem.

read more | digg story

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