In a fine comment in today’s Financial Times, Wolfgang Munchau argues that central bankers need to straighten out our current credit mess, since they created it in the first place. He argues that many of the alleged causes are actually secondary, and the underlying source was negative real interest rates, which is guaranteed to produce unrestrained and unwise borrowing. And ironically, the reason that past periods of negative interest rates didn’t produce as much damage as this one did is that our credit markets are far more efficient.
And these observations lead to some interesting corollaries: it means that central bankers cannot blindly follow inflation targets, since they can lead them precisely into this negative real interest rate territory. And it also means that central bankers do need to watch for and prick asset bubbles if they are the result of overly expansive monetary policy. Note that this recommendation is at odds with the current orthodoxy which holds that central bankers can’t possibly second guess the markets and call a bubble for what it is, and even if they see one, it’s not their job to intervene.
Two months after the beginning of the credit crisis, the monetary policy establishment has reached a consensus on its causes: the complexity of some of the instruments, shortcomings in the mathematical models, weakness in risk management and, of course, the role of the ratings agencies. In other words: someone else.
I concede that each one of these factors contributed to this crisis. But to blame ratings agencies is like blaming shopkeepers for inflation. If you look for an underlying cause of this credit bubble, one of the biggest of all time, then surely you are looking at something bigger than a couple of ratings agencies. I believe that the explosive growth in credit derivatives and collateralised debt obligations between 2004 and 2006 was caused by global monetary policy between 2002 and 2004.
In parts of 2002-04, both the US and Europe experienced negative real interest rates – nominal rates adjusted for expectations of future inflation. From 2003 until 2004, the Fed funds rate stood at 1 per cent. In Europe, short-term nominal interest rates reached a low of 2 per cent between 2003 and 2005.
A negative real interest rate is actually a troubling concept. It means that those who have access to credit at that rate – in this case commercial banks – have an interest in borrowing an infinite amount. Individuals and companies generally borrow at higher rates but the closer a real interest rate gets to zero, the greater the incentives become for people to take on large amounts of debt. In a world of perfect credit markets, one would expect negative real interest rates over a long period to cause a credit bubble. Oddly, economists seem perplexed by the fact that something that was supposed to occur in theory actually happened in practice.
Back in the 1990s, when the credit markets were a good deal less developed, low or negative real interest rates did not have this catastrophic impact. That was because, even if you had an incentive to borrow an infinite amount, the bank would simply not give it to you.
The whole point of securitisation is to give individuals and small and medium-sized companies indirect access to the capital markets. Small loans were pooled, sliced into tranches with different risk profiles, and then sold on to investors. This ensured that those who did not have access to credit before were suddenly eligible for a loan. It also meant that more credit was available to anybody, as evinced by the significant rise in loan-to-value ratios or income multiples for mortgages. In other words, the innovation in the credit markets made these markets more perfect.
This world of securitised credit is here to stay. Collateralised debt obligations cannot be uninvented. There will be regulatory changes, a clampdown on mortgage sellers and ratings agencies and new transparency rules. The revenge may be cruel. But the channel through which negative real interest rates can translate into a credit bubble will remain open.
All this puts severe constraints on monetary policy in the future. Let us recall that the US Federal Reserve and the European Central Bank did not actually intend to cause a credit bubble. They pursued a monetary policy to stabilise some chosen measure of inflation. Neither of them is a direct inflation targeter, like the Bank of England or the Swedish Riksbank. But for practical purposes both have behaved in this manner – although the ECB uses monetary analysis as a “cross-checking” device and started to raise interest rates in 2005, earlier than would have been warranted otherwise.
A few years ago the Riksbank was confronted with a similar dilemma to that of the Fed. It was faced with a combination of low inflation and an escalating property price bubble. But unlike the Fed, the Riksbank set interest rates higher than the inflation target would have permitted. Inflation subsequently undershot the target range.
The Riksbank never admitted that it abandoned its framework. It actually did the right thing, except that it would have been more honest to say so outright.
Like the Riksbank, the other central banks will also have to find ways to take account of money, credit and asset prices. By this I do not mean that they should target asset price indices or “prick bubbles” or follow some static money supply rule. What they need to do is to take credit channels into account to a much greater extent than they did in the past and to correct their policy judgment accordingly.
Mervyn King, governor of the Bank of the England, once famously said that good central banking is “boring”. This is true only if you are a monolithic inflation targeter. A boring central banker is somebody who blindly follows a stochastic dynamic equilibrium model, a strangely sanitised world free of money and credit.
It was boring central bankers who unwittingly got us into this mess in the first place. In the future, the non-boring variety will be in greater demand.
There is no point in blaming any individual, least of all Alan Greenspan, the former Fed chairman, just as it is wrong for him to blame the ratings agencies.
Instead it is time to learn the main lesson of this crisis, which is that credit matters for monetary policy, a fact over which many central bankers are still in denial.