Mohamed El-Erian, in “A route back to potency for central banks,” in today’s Financial Times, gives a short but persuasive analysis of what ails central banks today and what they need to do to strengthen their role.
El-Erian is insightful and his opinions often carry some weight, by virtue of being both a Serious Economist (former Harvard prof) and a Serious Investor (former head of Harvard Management Corporation, now co-chief executive of Pimco).
El-Erian characterizes central bankers’ problems as two-fold. Their power has diminished as the financial system has gotten much better at generating liquidity outside their purview. Yet despite this shrunken role, politicians and the public expect them to be able to steer macroeconomic policy as before. Any manager will tell you that having responsibility without having authority is a terrible position to be in.
El-Erian gives a five point program. Two items are revealing:
First, they need to improve their understanding of the new financial landscape….Third, they need to improve, directly or indirectly, scrutiny of financial activities that have migrated outside their formal jurisdiction.
While undeniable accurate, the fact that these recommendations are on his list is an appalling indictment of the job central bankers are doing. The Fed, for instance, did not do its own homework and was unduly influenced by Brave New World views of investment banks and commercial banks merrily reaping current profits with little thought as to the long-term consequences of their moves (and why should they be? They don’t affect this year’s bonus).
For instance, the savvy and straight shooting New York Fed President Timothy Geithner gave a speech “Credit Market Innovations and Their Implications” last March that looked unduly cheerful even at the time. Some of our contemporaneous comments:
Perhaps I have an eye for problems, but I saw in Geithner’s straight-up-the-center description plenty of cause for worry. First, banks, the financial institutions that are most closely regulated, hold only 15% of the “nonfarm nonfinancial” debt outstanding (remember financial institutions do lend to each other, so that is excluded). By contrast, hedge funds are becoming increasingly important players, and their investing operations are unregulated, unsupervised, and largely unreported. So while the Fed has good information about what its banks are doing, and can send in extra examiners when warranted, it has no idea what is up with the biggest players in the credit markets.
Second is that the variety and complexity of instruments has exploded. Geithner believes this is a plus, giving issuers and investors more choice, and investors greater ability to diversify and fine tune their risks. Yet we’ve been told that one of the effects is that very complex and risky instruments have wound up held by weak institutions that really don’t understand them. This is not a pretty picture.
Third, Geithner indicates that while disintermediation (borrowers going directly to investors rather than via banks) has been around for some time, new instruments and vehicles have proliferated. He indicates that the Fed has taken steps to assure that mechanisms are in place to make sure that operational as well as credit risks are managed. Yet look at the first concern above. Most of this activity is taking place outside the Fed’s purview. All it has to work with is moral suasion, not regulatory authority. That is not a position of strength.
Finally, Geithner has no objective foundation for his rosy view. He has essentially admitted the Fed and other regulators lack a complete, or even good, picture of what is happening. We’ve had money supply growth well in excess of GDP growth, and loose monetary conditions can obscure underlying weaknesses. His argument boils down to,”Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK.” I don’t find that terribly convincing. And I find one quote particularly troubling:
…these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.
Look at this picture. I don’t mean to personalize this discussion, but consider: I just a chump with a little experience in the markets who reads the financial press regularly. I have no inside sources or insight. If someone as far removed from the action as I am could see what was afoot, where the hell were the supervising adults?
Don’t expect to see the Fed implement the measures El-Erian recommends (I can’t comment on other central banks, but I suspect the same holds true for them). It would require not only a very considerable increase in staffing for them to get a more comprehensive picture of the financial world we live in, but it demands a more skeptical attitude towards the pablum market participants feed them.
From the Financial Times:
As Ben Bernanke, chairman of the Federal Reserve, heads to Capitol Hill on Thursday, we should sympathise with the challenges facing central bankers around the world. Once praised for facilitating high growth and low inflation, they now find themselves in a potential “lose-lose” situation: should they risk fuelling future inflation in order to avoid a recession induced by a market-driven credit crunch, or maintain low inflationary expectations at the risk of both depressed economic growth and serious financial market dislocations?
Too many observers have cited changes in personnel as an important part of the explanation for this shift. Tempting as this is, it is not appropriate. The better approach is to analyse how far global financial transform ations have eroded the potency of trad itional central bank tools.
Central bankers now operate in a world where monetary policy influences only a small part of the fluctuations in overall liquidity in the economy. “Endogenous liquidity”, or the extent to which the market itself expands and contracts liquidity, has taken over as the main driver. As a result, successive interest rate increases did little to contain excesses during the expansion in market liquidity that came to an end last summer – a phase turbo-charged by financial innovation and alchemy. Today, interest rate cuts are having difficulty countering the forces of endogenous liquidity contraction that are being accentuated by the impact of the large losses at many financial institutions.
This transformation is challenging for central banks, especially in a world that has seen them as the wise guardians of responsible macroeconomic policies. The challenge is particularly acute for those banks, like the US Federal Reserve, with a dual mandate: controlling inflation and maintaining solid economic growth and employment.
In response, some central bankers have shifted to a more responsive and opportunistic approach. Indeed, this was a big factor in the decision by the Financial Times to name Jean-Claude Trichet, head of the European Central Bank, as its “person of the year”. Not all central bankers have his ability and willingness to respond in a bold and timely fashion. As such, they need to rely on structural adaptations to address the difficulties. To this end, these five items should be pursued.
First, they need to improve their understanding of the new financial landscape. This is an absolute must when it comes to the activities of the big investment banks, especially those with privileged access to various central bank financing windows. It will help counter some of the systemic risk posed by off-balance-sheet conduits, lax risk management practices and aggressive financial alchemy.
Second, central bankers need to revisit the conventional wisdom that calls for separation of monetary policy and bank supervision. With the growing impact of endogenous liquidity such separation can inhibit rather than facilitate the conduct of good monetary policy – as recently discovered by the Bank of England.
Third, they need to improve, directly or indirectly, scrutiny of financial activities that have migrated outside their formal jurisdiction. At the minimum, this involves better co-ordination with and skill transfers to supervisory bodies in the insurance, mortgage and pension domains.
Fourth, excessive reliance on interest rate changes as the tool of monetary policy should give way to a broader approach. This entails greater recourse to open market operations and further revamps to the discount window in the US in particular.
Finally, central bankers need to work harder to manage policy expectations and improve communication. The public should have clarity about their policy goals and operating processes but also be aware of what central banks cannot do. This is important when the onus of a suitable policy response to the subprime debacle should be placed, either directly or indirectly, at the feet of the fiscal agencies.
Central banks must urgently act on these five items. If they do not, the damage will go well beyond eroding any chance they still have to reclaim a leadership role on liquidity management, albeit a more modest one. Instead, they will be condemned to walk behind the financial market parade. In the process, they will continue to be blamed for, and expected to clean up, the occasional large mess, but with declining effectiveness.