A reader pointed me to Willem Buiter’s blog, and it is a real find. For those who haven’t heard about him, he (along with Anne Siber) has proposed a rethinking of central bankers’ roles in times of crisis, arguing that they should serve as market makers of the last resort.
One reason to read Buiter, aside from the intrinsic merit of his ideas, is that he is almost certain to capture the attention of policy makers (although they may be loath to admit it, since Buiter is blunt and often highly critical of current practice). But Buiter has the sort of blue-chip economics/regulatory credentials that mean he can’t be dismissed easily.
In his current post, “Central banks and the financial sector: a complex relationship,” Buiter hones in on the thorny relationship between regulators and their charges.
Regulators often face conflicting directives: while they have to make sure the public at large’s interests are served, they also are responsible for assuring that the institutions they oversee are healthy. Where to draw the line between societal and industry interests is often a judgment call. Buiter points out how the deck in the financial services industry is stacked in favor of the regulated (we’ve seen similar issues come up with the Food and Drug Administration, which critics feel has been too easy on Big Pharma).
With all due respect to Buiter, there is one issue he omits, namely, that in the end, the industry understands its business better than the regulators do. That was not always the case. When change moved at a slower pace, the overseers often had better insight by virtue of looking at practices across many players.
Now, particularly in industries like financial services that feature rapid product and process innovation, regulators are constantly in catch-up mode. In the US, this limitation is further compounded by the fact that the real action is taking place in institutions that for the most part are beyond the Fed’s reach.
Thus, when the industry comes in and tells regulators that they’ve gotten something all wrong, the authorities have to take that view seriously. And of course, the industry, having better data about its own activities than outsiders can readily muster, is generally able to make a persuasive case, or at least muddy the waters considerably.
Some of Buiter’s observations echo those of Jim Grant in today’s New York Times , but Buiter also notes that Wall Street seems to be an example of market failure, since compensation bears little resemblance to the value of the contribution to society.
That last issue is easy to explain. It’s called barriers to entry…..
Central banks tend to pay too much attention to high-frequency movements in financial asset prices, to financial market developments in general, and to special pleading/moaning by representatives of the financial sector….
As the number of intermediaries between the ultimate savers/wealth owners (households) and the ultimate investors/custodians of the real capital stock (non-financial firms) has grown, however, and as the number of complexity of financial instruments issued by these intermediaries has exploded, there has been a growing disconnect between the well-being and profits of the financial sector and the well-being and profits of the economy as a whole. Some of the new financial institutions and many of the new financial instruments exist only because of tax avoidance (or tax efficiency, as it is often known), and regulatory arbitrage (getting around regulatory obstacles to making profits).
The rewards individuals can earn in the financial sector appear well in excess of the social marginal product of their contributions. The reasons for this market failure are not immediately obvious….Whatever the reason(s), the City of London, Wall Street and the private financial sector everywhere have attracted a disproportionate share of the best and the brightest. For instance, whatever may be the contribution of ‘quants’ (specialists in mathematics, computing and finance) to the private profitability of the firms that employ them, their collective contribution to general economic well being is likely to be quite a bit below their take-home pay.
Many of the new financial institutions are very highly leveraged. This means that those who own them put up rather little risk capital of their own and borrow the rest. Examples are hedge funds and private equity funds, but investment banks and commercial banks increasingly fit this description as well. Most of the lending and the buying and selling of securities is between financial institutions, rather than between financial institutions and ultimate savers and investors in physical capital. Most of the exposure of financial institutions is to other financial institutions. Because of this, it is possible for there to be major losses by some financial institutions (say a hedge fund holding credit default swaps) that are matched by matching reductions in the exposure (that is, gains) of other financial institutions. The losers will soon call for a central bank bail-out (through interest rate cuts preferably), but the winners will quietly pocket their innings….
Because they work in and through financial markets, there is a risk, indeed a likelihood, that central banks will get co-opted, consciously or subconsciously, by the movers and shakers in the financial markets. For every representation made to the central bank by a spokesperson from the real economy, there will be half a dozen from the financial sector. The financial sector also speaks the same language as the central banks, which facilitates the de-facto ‘capture’ of the central bank by the financial sector collective interest. Central bankers often come from the financial sector, and, after their stint in the central bank is over , tend to take on lucrative appointments in the (private) financial sector. There is nothing wrong with that in principle, as long as conflicts of interest are avoided and a decent (preferably legally set) sabbatical or purdah period is observed between the end of the central bank appointment and the start of the private financial sector activities. Yet it all adds up to an environment in which the central bank is more likely, in its monetary policy actions, to accord a weight to the well-being of the financial sector that may well exceed that which is warranted from an economy-wide perspective.
I think some of the actions of Alan Greenspan following every significant outbreak of financial turbulence in his term in office, and, albeit to a lesser extent, the behaviour of the ECB and the Fed during the financial storm we are just emerging from, provide examples of central banks that are ‘too close’ to the financial markets and the private financial institutions that operate in them. This excessive closeness leads them to identify the health and profitability of the financial sector, and indeed at times even of highly visible individual financial institutions, with the health of the economy as a whole. That correlation is, however, far from unity most of the time and can at times even become negative.
Buiter concludes that there is little one can do to remedy this situation, save locating central bankers far away from a nation’s financial capital and making sure that the top echelon is not dominated by individuals who think the universe revolves around the financial markets.
I must confess to having particularly enjoyed this footnote:
Alan Greenspan does have a strong claim to be the worst former central banker ever. His propensity to speak out on market-sensitive matters since his retirement as Chairman of the Federal Reserve Board, cannot but have been a source of irritation and embarrassment to Greenspan’s successor during the first few months following Greenspan’s retirement from the Fed. I know of no other example of such indelicate behaviour by a retired top central banker. The richly remunerated dinner-engagement-cum-speech with a leading Wall Street firm within a couple of days or so of leaving the Fed, revealed at best a singular lack of judgement and propriety, even if the occasion was technically a ‘closed’ event.