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From the horse’s mouth: Lawrence Summers on market manipulation in times of

crisis – Part I

26 March 2010

A research paper by Lawrence Summers presented at a National Bureau of Economic


Research conference on 17 October 1989 makes the case for coordinated international
intervention in the currency markets as a policy tool to prevent a Dollar currency crisis.
Moreover, it proposes direct intervention by the authorities to prop up asset prices, in
particular the stock market via index futures manipulation to “increase confidence in the
financial system and reduce the need for reductions in interest rates that would otherwise
lead to a currency collapse”.1

The paper, Planning for the Next Financial Crisis, was part of a series of research papers
by academics and policy-makers organized by Martin Feldstein at the NBER in the
aftermath of Black Monday on 19 October 1987, whose aim was to prevent and plan a
policy response to potential future financial crises and to mitigate their real economy
impact.

In the paper, Summers’ develops an extreme crisis scenario analysis as a way to test four
distinct lender of last resort policy responses starting from the least to the most intrusive,
of which the laissez-faire position states that there is no reason for the authorities’
intervention in financial markets, essentially taking the position that free markets tend to
self correct. The second, monetarist approach holds that any intervention should be
limited to maintaining a stable money stock to provide ongoing liquidity to the overall
financial system during the crisis. It does not contemplate targeted assistance to any
entities. The third position, which Summers’ refers to as classical follows the Bagehot
approach that “to avert panics, central banks should lend early and freely, to solvent
firms, against good collateral, and at ‘high rates’”.2

The fourth position, which Summers calls pragmatic, in his own words, “is the one
embraced implicitly, if not explicitly by policymakers in most major economies. It holds
that central banks must always do whatever is necessary to preserve the integrity of the
financial system regardless of whether those who receive support are solvent or can
safely pay a penalty rate. This position concedes that some institutions may become too
large to fail. While lender-of-last-resort insurance, like any other type of insurance, will
have moral hazard effects, I argue that these may be small when contrasted with the
benefits of protecting the real economy from financial disturbances” [emphasis mine].

The focus of my analysis is on the last section of the paper, which proposes that under the
so-called pragmatic position, a sufficiently activist lender of last resort monetary

1
Summers, Lawrence H., “Planning for the Next Financial Crisis”, Chapter 3 Macroeconomic
Consequences of Financial Crises, in The Risk of Economic Crisis, NBER, Martin Feldstein Editor,
University of Chicago Press, 1989
2
Tucker, Paul, “Financial System and Monetary Policy: Implementation”, Bank of Japan 2009
International Conference, Bank of Japan, Tokyo, 27-28 May 2009
response is itself destabilizing due to the conflicting nature of the domestic and
international objectives of the policy response.

Currency market intervention: Two objectives, two instruments


The paper makes the case that in an open economy with floating exchange rates, there is
an inherent conflict of interest between the loose monetary policy needed to alleviate a
liquidity crisis and thus save financial institutions, and the international dimension that
results in currency collapse due to foreigners’ loss of confidence in U.S. Dollar assets and
financial institutions. On the other hand, the high interest rates needed to prevent a
currency crisis would lead to a credit and liquidity contraction and endanger the viability
of financial institutions.

As a solution to this conflict, Summers’ proposes a second policy instrument to deal with
the international dimension of the crisis “so that a measure of stability can be maintained
in both the foreign exchange market and the banking system”.

The paper does not go into the design detail of this policy instrument, which it refers to as
foreign monetary policy, however, is clear in that its objective is to focus on managing
foreign exchange rates so as to isolate the currency dimension of the crisis from the
domestic objective of liquidity provision. In his own words, “Perhaps this is an argument
for fixing exchange rates or at least institutionalizing the principle of cooperation to
insure that they do not move too rapidly”.

I argue that it is in the context of this policy proposal that the size and number of
currency swap lines established by the Fed with several foreign central banks during the
2007-09 period need to be examined. 3A forthcoming Part II will deal with this analysis.

However, there is another very important aspect of the paper that provides a valuable
insight at Lawrence Summers’ current policy-making role at the National Economic
Council.

Stock market intervention via equity index futures


Summers’ argues that another possible policy response is “direct intervention to prop up
asset prices. If this is possible, it will serve to increase confidence in the financial system
and reduce the need for reductions in interest rates that would otherwise lead to a
currency collapse” [emphasis mine].

The paper makes reference to the widely accepted view that the authorities intervened in
the futures market on the Tuesday after 1987’s Black Monday stock market crash to
prevent a further rout that might have spiraled out of control. In his own words, “The
situation was turned around, but if a misstep had been made, or if the MMI [futures]
contract had not mysteriously rallied by the equivalent of over 300 Dow points within a
few minutes, the market might have fallen much further”.

3
See also, “Upside Down and Backwards: Is Central Banking on Death’s Door Step?” by Rob Kirby,
Kirby Analytics, July 27, 2009, at (http://news.goldseek.com/GoldSeek/1248718634.php);
Summers’ proposal strongly resonates with the opinion expressed, only 10 days after the
NBER conference, on the Wall Street Journal on 27 October 1989 by former Fed board
member Robert Heller in an article under the title “Have Fed Support Stock Market,
Too”. “Instead of flooding the entire economy with liquidity, and thereby increasing the
danger of inflation, the Fed could support the stock market directly by buying market
averages in the futures market, thereby stabilizing the market as a whole”.4

Heller’s reasoning is exactly along the same lines as Summers’, that is, extreme liquidity
provision can lead to runaway inflation expectations, and hence to currency collapse. The
proposals by both men indicate that this line of thinking was very close to policy-makers
minds in the aftermath of the 1987 stock market crash.5

Summers’ paper concludes his analysis by re-stating his proposal in no uncertain terms,
“Notice that the argument in this section strongly supports the conclusion of the last one
that there is a case for direct lender-of-last-resort policies beyond the general provision of
liquidity. Targeted assistance can presumably restore confidence in financial institutions
with less of a reduction in interest rates than would be necessary with general monetary
policies” [emphasis mine].

It is in light of these statements by policy-makers that anecdotal claims by market


observers and participants that question the stock market’s resilience since its multi-year
low on 6 March 2009 should be examined.6 A forthcoming Part III will deal with this
4
For other relevant quotes from Heller’s 1989 WSJ opinion article see: “Management or Manipulation:
The TIO Story” by Bart in Safe Heaven, September 18, 2006 (http://www.safehaven.com/article-
5910.htm); “The Stock Market Da Vinci Code” by Jonathan Moreland in RegisteredRep, March 1, 2006
(http://www.registeredrep.com/mag/finance_stock_markets_da/index.html); “The Plunge Protection Team”
by Steve Chris in Wealth Daily, June 11, 2009 (www.wealthdaily.com).
5
Importantly, see also a 1990 research article by James T. Moser, a then Senior Economist at the Federal
Reserve Bank of Chicago, which is based on Robert Heller’s proposal, “Robert Heller (1989) recently
suggested a revision to the Federal Reserve’s approach to breaks in the market for equities. The problem
he addresses is the threat that liquidity constraints will aggravate shocks to the financial system. The Fed
reacted to these October episodes in 1987 and 1989 by supplying liquidity through open-market operations.
Heller argues this approach tends to work against monetary policy. He suggests a more direct operation,
namely, long positions in stock index futures. These long positions would tend to bid up stock prices,
ameliorating needs for additional liquidity. He contends that interventions of this sort will lessen
disruptions to monetary policy objectives”, in Moser T. James, “Public policy intervention through futures
markets operations”, Journal of Futures Markets, Vol. 10, Issue 6, p. 567-571, 1990 [emphasis mine]. Of
note, James T. Moser currently holds the Deputy Chief Economist post at the Commodities Futures
and Trading Commission.
6
Various: “Guest post: The 5% Solution by Tyler Durden at ZeroHedge, March 2, 2010, at
(http://www.zerohedge.com/article/guest-post-5-solution); “Knife edge economics” by Keynesius Fraudius
at EarthBlog News, February 28, 2010, at (http://earthblognews.wordpress.com/2010/02/28/post-collapse-
active-market-management-and-knife-edge-economics/#comments); “Does the government manipulate
stock prices” by TPC at The Pragmatic Capitalist, February 26, 2010, at (http://pragcap.com/does-the-
government-manipulate-stock-prices); “Who Is Responsible For The Non-Stop Market Rally Since March;
Gives Some Suggestions” by Charles Biderman at TrimTabs, December 31, 2009, at
(http://www.zerohedge.com/article/trimtabs-asks-who-responsible-non-stop-market-rally-march-
givessome-suggestion); “Move over Adam Smith: The Visible Hand of Uncle Sam” by Eric Sprott and
Hepburn A., Sprott Asset Management, August 2005, at
(http://www.sprott.com/Docs/SpecialReports/08_2005_TheVisibleHand.pdf); “The Invisible Hand (of the
analysis in the context of the Fed’s extraordinary liquidity injections in the current crisis
via Quantitative Easing and the monetary policy “transmission” role of the Primary
Dealers.

Policy response “Handbook” and the authorities as The Market


I argue that Summers’ 1989 paper ranks alongside with current Fed’s Chairman Bernanke
anti-deflationary papers from the period of 2002-047, which can be considered an
important part of the intellectual basis, a handbook of sorts, for economic policy-makers
in both administrations in the shaping of the 2007 crisis policy-response.

To be clear, the context in which policy-makers refer to market intervention is non other
than plain and simple market manipulation, that is, “[It] describes a deliberate attempt to
interfere with the free and fair operation of the market and create artificial, false or
misleading appearances with respect to the price of, or market for, a security, commodity
or currency.8

Whether these actions are justifiable by the authorities on the basis of “greater good” is
questionable, and in itself raises important issues of moral hazard, conflict of interest,
choosing of winners and losers, unintended consequences, etc. 9 A forthcoming Part IV
will deal with this analysis.

Moreover, it adds to the body of evidence that point to manipulation by the authorities of
key domestic and international markets, many of which due to their size and nature had to
be made in an overt manner10: Bond market (Federal Reserve pre 1951 Treasury Accord,
Treasuries and Agency securities Quantitative Easing), Real Estate & Automobile

U.S. Government) in Financial Markets” by Robert Bell at Financial Sense, April 3, 2005
(http://financialsense.com).
7
Various: Bernanke, Ben, “Deflation: Making Sure "It" Doesn't Happen Here”, Speech at the National
Economists Club, Washington, D.C., November 21, 2002, Federal Reserve Board; Bernanke, Ben, “Some
Thoughts on Monetary Policy in Japan”, Speech before the Japan Society of Monetary Economics, Tokyo,
Japan, May 31, 2003, Federal Reserve Board; Bernanke, Ben and Reinhart, V., “Conducting Monetary
Policy at Very Low Short-Term Interest Rates”, Presented at the Meetings of the American Economic
Association, San Diego, California, January 3, 2004, Federal Reserve Board; Bernanke, Ben, Reinhart, V.
and Sack B., “Alternatives at the Zero Bound: An Empirical Assessment”, Research paper presented at the
Brookings Panel on Economic Activity, September 9, 2004, Federal Reserve Board & Macroeconomic
Advisers, LLC. Of note, Brian Sack is currently at the FRBNY as head of the Markets Group, which
is responsible for open-market operations (i.e. including implementing Quantitative Easing policies).
8
http://en.wikipedia.org/wiki/Market_manipulation.
9
For example, Bradley raises the valid question of whether many of the authorities’ ad hoc policies in
response to the 2007 crisis are misguided in that they seem focused on maintaining market confidence as
opposed to market integrity. See Bradley, Caroline, “The confidence game: Manipulation of the markets by
governmental authorities”, University of Miami School of Law, posted on November 10, 2009 at
(http://ssrn.com/abstract=1502897).
10
"An appropriate institution should be charged with the job of preventing chaos in the market: the Federal
Reserve....The Fed already buys and sells foreign exchange to prevent disorderly conditions in foreign
exchange markets. The Fed has assumed a similar responsibility in the market for government securities.
The stock market is the only major market without a marketmaker of unchallenged liquidity or a buyer
of last resort.", Robert Heller, “Have Fed Support Stock Market, Too” in Wall Street Journal, October 27,
1989. [emphasis mine]
(GSE’s conservatorship, foreclosure forbearance, purchase tax credits), Regulatory and
Accounting forbearance (short-selling ban, mark to market rules, real estate collateral
valuations), Foreign Exchange market (Plaza & Louvre Accords), Gold market (London
Gold Pool in 1960’s, European Central Banks 1999 Joint Gold Agreement), Labour
market (tax refunds, extended unemployment benefits).

Alfredo Ley
Founder, Ley Investor B.V.