This VoxEU article by Charles Goodhart examines the tensions between central banks’ responsibilities, namely price stability and financial stability.
Not only does this piece do a nice job of distilling the issues but it also works through one of the pet remedies being bandied about, namely, implementing counter-cyclical regulatory measures, such as increasing capital requirements in boom times. Goodhart reviews some objections and concludes they are valid but not sufficient to obviate the advantages of pursuing such measures.
Note that we have argued againt having central banks act both as monetary and stability authorities based on the cautionary example of the Fed. As Willem Buiter has noted, it is a victim of what he calls cognitive regulatory capture, in which it identifies too strongly with the world view of its charges, namely, financial services firms. Countercyclical measures are simply an updated version of former Fed chairman William McChesney Martin’s prescription of taking the punchbowl away when the party starts getting good. The fact that the US central bank was unwilling to do that says it might not be the right candidate for the job.
Central banks cannot achieve price and financial stability with one instrument (interest rates). A counter-cyclical regulatory system is needed to dampen asset booms and to smooth busting bubbles. To use such macro-prudential instruments effectively, regulators need courage, quantitative triggers, and independence; they will be criticised by lenders, borrowers and politicians in both booms and busts.
The events of the last year have reminded us all that a central bank does not just have one responsibility, that of achieving price stability. It is indeed its first core purpose (CP1); but as the sole institution that can create cash, and hence bank reserve balances, a central bank has a responsibility for acting as the lender of last resort and maintaining financial stability. This is its second core purpose (CP2).
Two goals but only one instrument
One of the major problems of central banking is that the pursuit of these two core purposes can often conflict, not least because the central bank currently appears to have only one instrument, its command over the short-term interest rate. Indeed, a central purpose of the first two great books on central banking, Henry Thornton’s (1802), Inquiry into the Paper Credit of Great Britain, and Walter Bagehot’s (1878), Lombard Street, was to outline ways to resolve such a conflict, especially when an (external) drain of currency threatened maintenance of the gold standard at the same time as an internal drain led to a liquidity panic and contagious bank failures.
Under such circumstances, however, with rising risk aversion, the central bank would find that it had two instruments, due to its ability to expand its own balance sheet, e.g. by last-resort lending, at the same time as keeping interest rates high, (to deter gold outflows and unnecessary (speculative) borrowing). The greater problem, then and now, was how to avoid excessive commercial bank expansion during good times. With widespread confidence, the commercial banks neither want nor need to borrow from the central bank. A potential restraint is via shrinking the central bank’s own balance sheet, open market sales, thereby raising interest rates. But increasing interest rates during good times, (gold reserves rising and high; inflation targets met), i.e. ‘leaning into the wind’, is then against the ‘rules of the game’, and such interest rates adjustments small enough to be consistent with such underlying rules are unlikely to have much effect in dampening down the upswing of a powerful asset price boom-and-bust cycle.
CP1: ‘Price stability’ versus CP2: ‘Financial stability’
Although the terminology has altered, this basic problem has not really changed since the start of central banking in the 19th century. An additional analytical twist was given by Hy Minsky, who realised that the better the central bank succeeded with CP1 (price stability), the more it was likely to imperil CP2 (financial stability). The reason is that the greater stability engendered by a successful CP1 record is likely to reduce risk premia, and thereby asset price volatility, and so support additional leverage and asset price expansion. The three main examples of financial instability that have occurred in industrialised countries in the last century (USA 1929-33, Japan 1999-2005, sub-prime 2007/8) have all taken place following periods of stellar CP1 performance.
We still have not resolved this conundrum. It shows up in several guises. For example, there is a tension between trying to get banks to behave cautiously and conservatively in the upswing of a financial cycle, and being prepared as a central bank to lend against whatever the banks have to offer as collateral during a crisis. Again, the more that a central bank manages to constrain bank expansion during euphoric upswings, e.g. by various forms of capital and liquidity requirements, the greater the disintermediation to less controlled channels. How far does such disintermediation matter, and what parts of the financial system should a central bank be trying to protect? In other words, which intermediaries are ‘systemic’; do we have any clear, ex ante, definition of ‘systemic’, or do we decide, ex post, on a case-by-case basis?
Bank risk and bank-system risk
Perhaps these problems are insoluble; certainly they have not been solved. Indeed, recent developments, notably the adoption of a more risk-sensitive Basel II CAR and the move towards ‘fair value’ or ‘mark-to-market’ accounting, have arguably tilted the regulatory system towards even greater pro-cyclicality. A possible reason for this could be that the regulators have focussed unduly on trying to enhance the risk management of the individual bank and insufficiently on the risk management of the financial system as a whole. The two issues, individual and systemic risk performance, are sometimes consistent, but often not so. For example, following some financial crisis, the safest line for an individual bank will be to cut lending and to hoard liquidity, but if all banks try to do so, especially simultaneously, the result could be devastating.
The bottom line is that central banks have failed to make much, if any, progress with CP2, just at the time when their success with CP1 has been lauded. This is witnessed not only by the events of 2007/8, but also by the whole string of financial crises (a sequence of ‘turmoils’) in recent decades. Now, there are even suggestions that central banks should have greater (even statutory) responsibility for achieving financial stability, (e.g. the Paulson report). But where are the (regulatory) instruments that would enable central banks to constrain excess leverage and ‘irrational euphoria’ in the upswing? Public warnings, e.g. in Financial Stability Reviews, are feeble, bendy reeds. All that central banks have to offer are mechanisms for picking up the pieces after the crash, and the more comprehensively they do so (the Greenspan/Bernanke put), the more the commercial banks will enthusiastically join in the next upswing.
Besides such public warnings, which the industry typically notices and then ignores, the only counter-cyclical instruments recently employed have been the Spanish pre-provisioning measures, and the use of time-varying loan to value (LTV) ratios in a few small countries, e.g. Estonia and Hong Kong. But the Spanish measures have subsequently been prevented by the latest accounting requirements, the IFRS of the IASB; and the recent fluctuations in actual LTVs have been strongly pro-cyclical, with 100+ LTVs in the housing bubble being rapidly withdrawn in the housing bust.
Indeed, any attempt to introduce counter-cyclical variations in LTVs or in capital/liquidity requirements will always run into a number of generic criticisms:
It will disturb the level playing field, and thereby cause disintermediation to less regulated entities (in other segments of the industry, or in other countries). It will thus both be unfair and ineffective.
It will increase the cost of intermediation during the boom and thereby reduce desirable economic expansion (and financial innovation).
It will increase complexity and add to the informational burden.
These criticisms have force. Indeed, there are empirical studies that suggest that countries which allow a less regulated, and more innovative and dynamic, financial system grow faster than their more controlled brethren, despite being more prone to financial (boom/bust) crises. Nevertheless it should be possible to construct a more counter-cyclical, time-varying regulatory system in such a way as to mitigate these problems, so long as the regulations are relaxed in the downturn after having been built up in the boom.
But those same generic criticisms will also mean that regulators/supervisors will be roundly condemned for tightening regulatory conditions in asset prime booms by the combined forces of lenders, borrowers and politicians, the latter tending to regard cyclical bubbles as beneficent trend improvements due to their own improved policies. Regulators/supervisors will need some combination of courage, reliance on quantitative triggers, and independence from government if they are to have the strength of mind and purpose to use potential macro-prudential instruments to dampen financial booms.
Can we really say there has been price stability since say 1982? Seems more like chronic if low grade inflation. Indeed when was the last time there was any real deflation? 1930s? If central banks want to balance price and financial stability all they have do make the casual observation price stability requires periods of deflation to offset periods of inflation. If economists, central bankers, and financial journalists could get this simple idea through their heads, then the central banking might be saved. As of now it seems that the Reserve Bank of Zimbabwe represents the vanguard of central bank praxis.
Another way inflation screws creditors.
considering that the FED is a political appointment I doubt that expanded powers would create oversight that was not bias towards growth driven by various political winds.
Regulators will always cave in to the bankers. It is along standing tradition that will never be broken (the big boys have the money).
The FED cannot control the banks now. Reserves are not binding. And the money supply can never be managed by any attempt to control the cost of credit.
Take as an example the payment of interest on reserves. Everyone is on the bandwagon. But this is nonsense. Commercial banks create new money when they lend or invest. So if you provide another dollar of reserves, the banks acquire another one hundred dollars of earning assets. I.e., the bankers get paid twice.
Then the treasury recaptures 97% of the interest on open market purchases added to SOMA. That obviously is no tax. The commercial banks can expand when the FOMC decides, not when the bankers decide. This is ludicrous and prejudiced.
I agree with everything in the opening paragraph of this VoxEU article I could have written it myself. There is one misconception, in my view, in the body of the pice, but it is important. Historically, speaking over the last 500 years, price stability—called here C1—was maintained by large _private_ banking interests acting in coordination. They acted to preserve the value of THEIR OWN investments in the face of public debasement of the coinage and later over-issuance of currency. Now such massive private lenders, the ibanks of their times, gradually came to intervene as lenders of last resort in times of illiquidity, again acting in their own larger interests. As banking and speculation grew, however, the size of such C2 illiquidity interventions became too massive for private capital, and in other instances they simply lost their nerve, too. Hence, _public_ central banks were created explicitly to seve as lenders of last resort: this is why the exist. Subsequently, central banks were charge with taking over the C1 task as well. Ostensibly and in some measure realistically, this was because private capital was considered too favorable to its own interests in keeping money tight as well as hard. However, the derogation of the C1 task to a public authority was as well because private capital wanted to get out of the ‘hard money’ business and use their own capital for profit—so long as public central banks toed THEIR line on hard money. This is the root of the conflicted mission of central banks: they were chartered to promote systemic stability, but became ‘captured’ by the task of promoting private profitability. Again, it seems very much a needed policy change that interest rate manipulation and lender of last resort functions—C1 and C2—be delegated to separate, independent entities. Let them fight it out, checks and balances, but in the open.
We also need more counter cyclical tools. Those mentioned at the end of the VoxEU article are welcome, but the key is time-variance. I think that such tools should be trend active, threshold passive, like a thermocouple in a thermostat, or in fact like a margin call. I will speak a little bit toward this concept myself down the road. All ideas are welcome now, though.
Controlling inflation just by controlling the money supply is completely impossible. Inflation measures consist of such a huge range of goods and services, all whose prices range for a wide variety of different reasons. The only way a central bank can completely control inflation is if they control all aspects of the economy, manipulating prices of everything just like they do with interest rates. This is commonly called a command economy and has more to do with communism than capitalism. The more inflation continues to get out of control, the more powers the central banks will try to take in order to contain this inflation.
So Anon of 10:49, I agree and suspect most would as well that the manipulation of _gross_ interest rates for a sovereign currency is a very blunt and inefficient instrument to control anything in that economy, including inflation. Oh, it works, but slowly and in aggregate. This is why it would be, in principle, a good idea to segement interest rate interventions more narrowly. The problem is how, as you allude to. If, for instance, higher rates are put on borrowing for ‘purpose X,’ than firms are likely to look for ways to borrow for ‘purpose Y’ but lend the money back to others (or themselves) to fund purpose X.
I’m more of the view that rates should scale for individual concerns and their specific exposures _as well as_ for the economy as a whole. Private capital is supposed to do this scaling now, as a risk premium among other things—but has conspicuously failed in this ‘quasi-regulatory’ function. The idea of scaling reserve requirements for individual firms is well-taken and needs to be applied, ahh, firmly, but scaling rates at the concern-level of the economy needs some degree of mandates. The key here, to me, is to start very small and then scale up with such regulatory constaints so as not to suddenly crush the life out of investing institutions by hard, tight collars. Such ideas need close consideration, but we don’t have to have a Central Regulator sitting in a bunker pushing buttons to command-optimize; such a result would be terrible regardless because inflexible. If concerns know that their personal rates-and-reserves will scale, and where the passive, mandated triggers are, they will plan accordingly. And any such passive, mandated quantitative triggers need to roll off just as automatically as exposure, concentration, or duration of expansion ease also.
. . . We all need to do some better, close reasoning here. But be sure of this: the market WON’T do it for us. The don’t want any constraints, so we must act before they kill (the money) again.
The influencial commercial banking lobby, i.e., American Bankers Assocation has controlled both the 1) House Committee on Financial Services, and 2) the U.S. Senate Committee on Banking, Housing, and Urban Affairs.
Regulation?? The conspiratorial titans, among other innovations, guaranteed the elimination of REG Q ceilings. It was a pyrrhic victory. Commercial banks compete for deposits by out-bidding their competition. But all of these deposits come from other commercial banks within the System.
I.e., the commercial banks cannot expand unless the FED decides to increase the money supply. However, the thrifts do compete for loan-funds. But even when they do, they cannot take money away from the commercial bankers.
The net of it is, lending by CBs is inflationary, lending by non-banks is not. And money flowing to the non-banks actually never leaves the CB System as anyone who has applied double-entry bookkeeping on a national scale should know.
So why should commercial bankers pay for something they already have? – interest on their deposits (REG Q in reverse). They would be much more competitive, and much more profitable, if they did not.
Lambasting the Pacs has always seemed to be too dry or taboo.
The Fed, though intended to be an “independent” agency has, like the Supreme Court, “followed the elections”. We don’t have captialism, we have regulated capitalism.
We have an “elastic” currency “aided and abetted” by “elastic” legislators. We have perennial Walter Wriston caricatures pressuring the House Committee on Financial Services & the U.S. Senate Committee on Banking, Housing, and Urban Affairs. We have a conspiratorial organization that goes by the name of the American Bankers Association – with its well funded lobbyists (PAC money).
The Board of Governors is self-described as: “subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute” Even so, the Fed is “connected at the hip” with Congressional allies, a la Greenspan, who the New York Times called a “three-card maestro”.
The Fed’s research is politically coordinated, targeted to justify its monetary policy objectives – those that appease the banking community. It’s as the university professor said: “innovate away from home”. Academic freedom has become the “barbarous relic”.
The great German poet and playwright Bertolt Brecht would have agreed and once said it was “easier to rob by setting up a bank than by holding up (one).”
The profit proclivities of the American Banker are responsible for our speculative orgy.
The Fed cannot control interest rates, even in the short-end of the market, except temporarily. The effect of a series of temporary pegging operations (on the one-day, cost-of-carry, on Government bonds), as guide posts; is Indirect, and varies Widely over Time, and in Magnitude.
The effect of tying open market policy to a FFR target is to supply additional (and excessive) legal reserves to the banking System when loan demand increases.
Since the member depository institutions have no excess reserves of significance, the banks have to acquire additional reserves (to support the expansion of deposits), resulting from their loan expansion (excess reserves are reserves in excess of a bank’s requirements, i.e., reserves in excess of the sum obtained by multiplying deposit liabilities by the appropriate reserve ratios).
With the use of the bracket device the Fed since 1965 has actually pursued a policy of automatic accommodation. That is, additional reserves and excess reserves were made available to the banking System whenever the bankers & their customers saw an advantage in expanding loans.
If the aggregate of bank bids for Federal Funds pushed the rate above the bracket set by the “trading desk” this would automatically trigger buy orders, which then ultimately led to an excessive volume of (1) Open Market Purchases, (2) Reserve Bank Credit, and (3) Legal Reserves. Soon a multiple volume of money is created on the basis of any given increase in legal reserves.
“Policy rules” are ex-post, (e.g, Taylor Rule). As applied, ‘true ups”, are necessarily lagging and staggered. In contrast, monetary flows (MVt), as defined, are ex-ante. With minor exceptions, forecasts are infallible.