Why it’s all about the policy

June 2, 2017

The biggest shock to capitalism since the Great Depression in the 1930s was the Great Recession that followed the credit crunch and banking crisis that started in 2007. The important questions are: whether the crisis could have been expected; the extent to which policy was the cause or aggravated the circumstances that led to them; and how those circumstances can be avoided in the future.

Central banks have benefited from the crisis
Central banks – their role, function and performance – are at the heart of any proper discussion of financial crises. In many respects, these already powerful technocratic institutions, which are significantly removed from democratic and effective political direction, have benefited from the crises. Their role and powers have been expanded and the capabilities attributed to them have increased. Yet there is an awkward feature of the present debate about their role that ignores the part they played in creating the circumstances that led to the credit crunch in the first place.

Most of the official inquiries into what happened concentrated on particular regulatory deficiencies and defects. Problems were found in securitisation, the regulation of US mortgages, the federal agencies and the over-the- counter derivative trading arrangements, and also with the effectiveness of bank examiners and in the perverse incentives that credit rating agencies exploited for their own profit. The one area that tended to be ignored was the role of central banks and their policies in shaping monetary conditions and liquidity.

A good example of this failure to hold the central banks to account is the report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. The commission was established under the Fraud Enforcement and Recovery Act passed by Congress and President Barack Obama in May 2009 and reported in 2011.

The dissenting statement from three of its commissioners expressed the nub of the issue. That is: there was a succession of financial crises in the US and Europe; different regulatory regimes failed; and banking crises erupted in countries that if anything had tighter banking regulation regimes than the US. But there were common monetary dimensions to the crises. These were:

  • a credit bubble that raised house prices between 2002 and 2008 by 118 per cent in the US, 142 per cent in Ireland, 152 per cent in France, 158 per cent in the UK and 192 per cent in Spain;
  • international capital flows from China and oil-producing countries fed by high savings ratios that drove down yields in advanced economies in Europe and the US with open capital accounts (making investors there prepared to hold risky assets for relatively low returns);
  • too low interest rates; and
  • monetary policy that amplified the credit bubble.

The dissenting commissioners complained that the commission did not give enough time to consideration of these monetary and credit matters.

Asymmetry in monetary policy since 1971
Since 1971, when the residual link between the dollar and gold within the Bretton Woods system was broken by US President Richard Nixon’s Treasury secretary John Connally, there has been a huge expansion of international liquidity. At the heart of that expansion have been the actions of the world’s main central banks – the Federal Reserve Board, the ECB, the Bank of England and the Bank of Japan. At every moment of economic worry there has been a consistent reflex to lower interest rates and ease monetary conditions.

When the stock market fell in October 1987, the response of the Fed and the other central banks was a significant easing of policy (the “Greenspan put”). Was it needed? No, the action was the final stimulus that led to inflation that brought the long expansion of the 1980s to an end. During the Asian and Russian crises in the late 1990s, there was the same response. It aggravated the run-up in equity prices and led to the so-called “tech wreck” in 2000.

In the UK in 2016, the central bank responded to the political uncertainty surrounding the EU referendum decision with a further domestic monetary easing. This boost was given to an economy that was already in the mature phase of an economic expansion, probably growing faster than its trend rate of growth, and that exhibited little spare capacity, given the levels of employment and the balance of payments deficit. If nothing else, the latter had just received a significant and powerful monetary stimulus arising from a lower exchange rate.

There is a consistency in this policy response. It is a reflex to employ stimulus in the event of any worry and a reluctance to tighten monetary conditions when the period of neurosis is over. The difficulty is that in dealing with the immediate worry, and failing to drain unnecessary liquidity, central banks store up much greater potential risks of the sort that ignited in financial institutions and markets in 2007.

Central banks are sensitive about their independence and the prospect of effective political scrutiny and general criticism of their conduct. The account given by Ben Bernanke, the former chairman of the Federal Reserve, of the “audit the Fed” movement in his memoirs, The Courage to Act, illustrates how sensitive central banks are when it comes to having their own conduct interrogated. The Fed is audited in the sense that it has accounts and that the Government Accountability Office (GAO) can examine it in relation to fraud, waste and abuse, and can also examine its non-monetary policy functions, such as its role in regulation and the payments system. But the GAO cannot investigate the Fed’s actions in relation to monetary policy, reserves, the operation of the discount window and open market operations.

An independent monetary authority
The classic rationale for making a central bank independent is that the leads and lags in the monetary transmission mechanism give rise to a potential time inconsistency. This provides an opportunity and a temptation for politicians to manipulate monetary conditions and interest rates in line with the electoral cycle and, in the process, amplify the economic cycle and raise the level and variability of inflation – so damaging economic performance in the medium and longer term.

The difficulty is that the central banks with their much-vaunted independence have managed to do something worse. They have set off a credit cycle that yielded the biggest crisis in market economies since the Great Depression.

Complex, distorting and unconventional policies
Central banks have been rewarded in the same way that they were in the 1930s with more powers of regulation and oversight of the financial system. Yet many of these rules appear to impair the normal functioning of the credit system and set up perverse incentives and unexpected feedbacks that create serious micro-economic distortion to credit allocation.

There is currently a debate about secular stagnation (a condition of negligible or no economic growth in a market- based economy) and the ultra-low rate of interest, led by Laurence Summers, the US economist and former US Treasury secretary, and a number of theories have been put forward. But it may turn out that the cause of ultra- low bond yields is to be found in the capital adequacy and insolvency rules applied to banks and insurance companies, which oblige them to hold bonds, and government bonds in particular. That creates the conditions for a period of extended financial repression of the sort that is associated with the loose fiscal policy often conducted in an emergency period.

A narrow technocratic elite
Central bankers themselves have become part of a closed elite associated with academic economics that is increasingly divorced from a policy perspective, let alone a practical policy interest. Where they have had market experience, it tends to be with firms such as Goldman Sachs. This refracts economic judgment through an intellectual lens that is too narrow. This narrowness of perspective is exemplified by official discussion of the European single currency. Since the concept was first floated when the Jacques Delors’ expert report was published in 1989, economists at the IMF, the OECD and the world’s principal central banks have turned a blind eye to its structural defects. They are happy to debate in public, but anything except the obvious. Since his retirement, Lord King, the former Bank of England governor, is an interesting exception willing to dissent on the euro.

There needs to be a debate about the objectives that are given to central banks, how they attempt to carry them out and how they are held to account for them. The financial crisis has demonstrated that a neat division between monetary policy and fiscal policy – in which narrow technicalities can simply be left to the central banks – does not exist. There has been something of a fusion between monetary policy and fiscal policy through bank rescue and taxpayers underwriting unconventional monetary policy tools. The expansion of central bank balance sheets that has resulted from quantitative easing has also raised significant and contentious distributional issues. Such issues are clearly political and invite political questioning.

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