Two types of risks are particularly important for understanding financial instability. The first is what I will refer to as valuation risk: The market, realizing the complexity of a security or the opaqueness of its underlying creditworthiness, finds it has trouble assessing the value of the security. For example, this sort of risk has been central to the repricing of many structured-credit products during the turmoil of the past few months, when investors have struggled to understand how potential losses in subprime mortgages might filter through the layers of complexity that such products entail.
The second type of risk that I consider central to the understanding of financial stability is what I call macroeconomic risk–that is, an increase in the probability that a financial disruption will cause significant deterioration in the real economy. Because economic downturns typically result in even greater uncertainty about asset values, such episodes may involve an adverse feedback loop whereby financial disruptions cause investment and consumer spending to decline, which, in turn, causes economic activity to contract. Such contraction then increases uncertainty about the value of assets, and, as a result, the financial disruption worsens. In turn, this development causes economic activity to contract further in a perverse cycle.
So what is the Fed to do?
Monetary policy cannot have much influence on the former, but it can certainly address the latter–macroeconomic risk. By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction in uncertainty can then make it easier for the markets to collect the information that enables price discovery and to hasten the return to normal market functioning.
The point is that, although the Federal Reserve can and should offset macroeconomic risk with monetary policy decisions, investors remain responsible for dealing with valuation risk. Indeed, monetary policy is and should be powerless in that respect. It is solely the responsibility of market participants to do the hard work of price discovery and to ascertain and manage the risks involved in their investments.
I dunno, I buy it. But maybe I’m just gullible that way.