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Thursday, 27 August 2009


FT's Krishna Guha writes on the meeting of central bankers (except Mervyn King) at their regular Jackson Hole, Wyoming, gettogether, "As central bankers from around the world queued on the terrace of Jackson Lake Lodge at the weekend to gaze at the stars above the Teton mountains through almost Nasa-sized telescopes, they must have wished they had as much clarity on the economic horizons they usually scan as they did on the constellations above... though they are now confident that the world has avoided an economic black hole." - a very non-Roubiniesque comment? I offer a vision photographed when the crisis was in meltdown in August 2007by Tyler Nordgren who captured this lunar eclipse sequence from his campsite in Grand Teton National Park on August 29. He took an exposure of the moon every 10 minutes until it disappeared and the sun lit up the mountains with alpenglow. I can do no better than to begin with krishna's text, "That is not an easy idea to sell to politicians, voters – or even regulators. After all, as Turner points out, world without a reliable compass is frightening, exhausting and time-consuming to navigate. “For the regulators of the world, once you have accepted that you don’t have an intellectual framework of “more market is always better” you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions.” And it remains crucially clear whether Turner will ever be able to actually turn any of his rhetoric into policies, given the scale of backlash that his comments will undoubtedly spark from the banking world. But I, for one, reckon he is to be applauded, for at least trying to think the unthinkable again - and move away from a crude reliance on creeds. The only question now whether other regulators will follow, not just in Europe, but, above all, in the US, where so many of the free-market dogmas first sprung to life?"
Free market may or may not be fairly described as "dogma" even if for many it is undoubtedly no better than this. The British alone running a trade deficit for free trade reasons for most of the 19th century that made the country rapaciously interested in finding gold to pay its creditors, is probably the better starting place for earmarking the origin of this 'dogma'. The USA was doing similar for most of the 20th century and there can be little doubt that while extreme imbalances in world trade led to the Credit Crunch (and other negative blips and major downturns from time to time) this also generated much that has been positive, if as in everything neither all negatives nor all positives. What now seems indubitable is the new central role for central banks who must now address problems with more empicism less dogmatic theory, more Keynesianism less Monetarism, more prudential macro- finance & macro-economics less micro-finance & supply-side theory; is Quantitative Easing supply-side finance or merely clearing the decks (debt restructuring) preparatory to massive issues of government bonds and ultimately replacing private indebtedness poorly collateralized (that grew to 3 times GDP in many countries when public sector debt stuck at half of GDP) with public debt (fully collateralized) that can profit for the taxpayer from interbank wholesale funding when private finance dried up (Credit Crunch)? Global finance appears to most peoplemore avant-garde puzzling abstractions than Cubist paintings seemed a century ago. Krishna reports, "Instead, much of the talk in the formal seminars and during the hikes in the lower slopes of the Tetons – although, ahead of his renomination on Tuesday as Fed chairman, Ben Bernanke opted to go (horse) riding instead – revolved around the lessons of the crisis for the future of central banking. Unease was widespread that even when the last asset they have had to purchase has been refinanced or sold off and the last unorthodox bank loan cleared, it would not be possible to go back to the pre-crisis status quo."
Well, indeed not for 5-6 years, by which time we might only be a year or two before the next set of global cyclical downturns? Macro-economics should now dominate in central bank analysis and prognosis, as it should do so too in banks' governing bankers thinking much thoroughly and ethically about their role in the global economy? "Central banking is going to change – in all cases, though more for some central banks than others – as policymakers seek to live up to elevated, and in some cases newly formalised, responsibilities for financial stability. It will become a broader, messier and more complex business, with objectives that may appear at times to be in conflict, new tools that are as yet largely untested and – at least at the margin – possible changes to the operation of monetary policy as well." As, central banks, especially the ECB, now realise it is not their remit and ideas only that have to change, but also undo how now discredited ideas are hard-wired into their constitutions; they need constitutional change?
Krishna says, "Although no one at Jackson Hole put it in such terms, there was a time when the life of a central banker was relatively straightforward, if not exactly easy. The job was to ensure economic stability by managing inflation, the monster that had ravaged the world economy in the 1970s. Most central bankers and academic economists were confident they knew how to do this: through some variant of inflation targeting, pioneered 20 years ago by the Reserve Bank of New Zealand and adopted by many others including the Bank of England. The Fed operates a de facto inflation targeting regime, which Mr Bernanke pushed to make more explicit, and academics claimed that even authorities such as the European Central Bank that deny being inflation targeters were so in practice. Implement such a regime successfully, the thinking went, and a central bank would not only achieve low and stable inflation but in doing so would ensure economic stability and the optimal platform for growth and prosperity. For a while it seemed to work. The 'great moderation' ensued – an era of low and stable inflation accompanied by long expansions and short and shallow recessions. But the credit crisis put paid to the idea that inflation targeting – at least as often practised, with a focus on consumer prices and a short policy horizon – was enough to ensure stability and growth." This was rather like finding a way through the thicket without worrying overmuch about what was living and what was dead wood, so long as general confidence was maintained about getting through. Now, the onus on central banks is to be far more comprehensive about the totality of economics + finance and to take fuller responsibility for systemic problems, which means being able to issue instructions that banks have to formally take full notice of and be made responsible for taking necessary actions - and that in turn means central banks no longer issuing complex double-sided advice like brokers, but actually issuing firm orders to banks to stop doing X and do more of Y etc.
Krishna reflects the Jackson Hole discussion, by reporting ""It is a good time to review the prevailing philosophy in the light of the current crisis," Masaaki Shirakawa, governor of the Bank of Japan, told his peers at the Jackson Hole conference. He said central banking before the crisis rested on three assumptions of "pre-established harmony", all of which now appear flawed. The first of these was that "macroeconomic stability can be achieved by monetary policy which pursues low and stable inflation" and that "price stability and financial stability are complementary". The other assumptions were that the authorities needed simply to keep an eye on individual financial groups rather than consider risks in a system-wide context, and that liquidity would be continuous in wholesale funding markets.
Inflation targeting did not fail, at least in the eyes of most central bankers, and it will continue to be the cornerstone for most. But policymakers now know that managing the outlook for consumer prices over horizons of a few years is insufficient to ensure financial and economic stability. "There is an emerging consensus that price stability does not guarantee financial stability and is in fact often associated with excess credit growth and emerging asset bubbles," said Mark Carney, governor of the Bank of Canada, which operates an inflation targeting regime.
Low inflation and moderate interest rates feed investor confidence and over time reduce conventional measures of financial risk, spurring financial groups to take on more leverage and fund longer-term investments with short-term funds. The crisis shows how disastrously that can end.
What is being rethought is the idea that the macro-economy can be tracked and deemed ok by merely tracking some very broad indicators such as prices, stability and consumer confidence. Indeed, this was not unlike risk management by score-card; if the lid continues to fit the refuse bin we need not worry about the mess of waste inside it. Confidence was always a lunatic indicator centrally revered by banks. Commercial and consumer confidence was really a reflection of how easy they perceived it is to get bank credit i.e. banks lent more the more borrowers perceived it was easy to get loans - totally circular perception. Central bankers agree on a first line of defence against instability is tougher regulation of financial institutions, to make it harder to load up on debt funding mismatches in good times – caps on leverage plus new "macroprudential" powers to limit risk-taking system-wide. Jaime Caruana, head of BIS, said at Jackson Hole that these powers could come in two forms: tools to curtail concentrations of risk in the financial system, and policies that tighten requirements during an economic upswing, mitigating the extent to which risk-taking builds during booms. This all presumes a cyclical awareness and predictive modeling that central banks do not have, neither do governments. Central banks and government are not allowed to forecast downturns publicly. In economies with global banks, the regulators are also limited in the orders they can issue based on national economic concerns - and who other than the UN has global economic models, not the IMF or World Bank or BIS?
Krishna comments, "Like most of his peers, Mr Bernanke sees these macroprudential powers as providing the most promising way to ensure stability, in large part because they can be targeted at specific financial excesses. Awarding such powers to central banks is proving controversial, though, with Congress balking at proposals to make the Fed America's systemic risk regulator. While politicians mostly worry about the concentration of power in the central bank, some experts also worry that deploying macroprudential tools – for instance in a way that slowed the flow of funds to subprime borrowers – could drag the (central) bank into political controversy. Mervyn King, governor of the Bank of England... warned in June against placing the Bank in a situation where it had a formal mandate for financial stability but not the tools with which to achieve it. That would leave it "in a position rather like that of a church whose congregation attends weddings and burials but ignores the sermons in between"."The lack of models for analysis and lack of integrated finance sector data into macroeconomic models problem is alluded to by krishna, "But even if they win these powers, central banks know little about how to calibrate these tools or how they will interact with interest rates. On how to manage matters monetary, the core issue remains whether central banks should "lean against the wind" by running a tighter policy during asset and credit booms even if this means undershooting an inflation target for a couple of years – a debate that the crisis has revived with a vengeance." This raises a phenomenally big question, that of attempted or desirability of trying to banish by pre-empting cyclical events, and whether the emphasis has to be on equipping banks with sufficient capital reserve to ride out downturns - thereby acting anti-cyclically alongside fiscally-keynesian governments? Recessions easily wipe out 90% of bank reserves (at Basel Accord levels) and the current crisis is doubling this normal expectation. The implication could be that banks have to double their capital reserves, which of course would be an enormous motivation to push a great deal more of assets growth off balance sheet? Central banks have a lot of partial theories, but have failed to try to integrate them into a total system view - globally it is a bit like having to figure out how sunspots impact all of the earth's and humankind's infrastructure - less about pre-emption and prescription and more about understanding the interdependancies of our economic systems. I offer this interesting graphic, which I hasten to say is not a macro-economic or macro-financial model, but interesting none the less. Jean-Claude Trichet, president of the ECB, told the Jackson Hole symposium that the traditional objections to leaning against the wind are harder to sustain. As Krishna reports, "He said the ECB in effect leans against rising asset prices already – through its two-pillar approach that takes into account monetary and credit aggregates. "I trust that our own monetary policy concept is approximately this idea – that we should incorporate in a rules-based framework this leaning against the wind," Mr Trichet added. Some other central banks – including the Bank of Canada – put some direct weight on asset values by targeting a consumer price index that includes house prices. The Fed focuses on an index that includes a proxy for rent but not prices and has always rejected leaning against the wind on asset price. Although Mr Bernanke (who did not address the issue at Jackson Hole) has said he is open to reviewing the arguments, particularly if credit bubbles are involved, his instinct is that it is almost always better to use more targeted instruments to deal with credit excesses. Yet there may be common ground over the need to take a longer-term perspective on inflation. The ECB has always emphasised its focus on the medium term and Mr Bernanke has long argued in favour of a "flexible" form of inflation targeting that seeks to hit the spot over the medium term – as opposed to the formal two-year horizon at the Bank of England. In principle, this allows a central bank to set interest rates at a level that it thinks will result in inflation undershooting in two years' time, in order to reduce the likelihood of a bigger miss further down the line when a bubble may burst. That is hard to pull off in practice, because it is very difficult to forecast inflation many years out and virtually impossible to predict whether a bubble will burst soon on its own (in which case the central bank should be lowering rates, not raising them). Still, in at least one respect it may be easier than before for central bankers to exploit whatever flexibility there is in their legal inflation targeting regimes." There will always be at least two very different ways of seeing the same shapes. Krishna expresses this with, "...But in the aftermath of the crisis, the cost of not curtailing financial imbalances – even in a world of moderate inflation – is plain for all to see, even if how best to curb them remains rather more blurry a reality than the view of the stars through a high-powered telescope against the dark Wyoming sky."

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