If Only Central Bankers Would Hit Bottom

I’m told that alcoholics and addicts have to hit bottom before they are able to renounce their self destructive ways. Ironically, their personal collapse makes them more capable of change than scientists, who, according to Thomas Kuhn in his landmark, The Structure of Scientific Revolutions, were so incapable of abandoning core beliefs that it would take an entire generation for significant advances to become widely accepted. The old guard literally had to die off before the new paradigm could take hold.

Bear with me in delving deeper into this comparison. The Wikipedia entry on Kuhn’s work gives a sense of the power and durability of existing frameworks:

There is a prevalent belief that all hitherto-unexplained phenomena will in due course be accounted for in terms of this established framework. Kuhn states that scientists spend most (if not all) of their careers in a process of puzzle-solving. Their puzzle-solving is pursued with great tenacity, because the previous successes of the established paradigm tend to generate great confidence that the approach being taken guarantees that a solution to the puzzle exists, even though it may be very hard to find. Kuhn calls this process normal science.

As a paradigm is stretched to its limits, anomalies — failures of the current paradigm to take into account observed phenomena — accumulate. Their significance is judged by the practitioners of the discipline. Some anomalies may be dismissed as errors in observation, others as merely requiring small adjustments to the current paradigm that will be clarified in due course. Some anomalies resolve themselves spontaneously, having increased the available depth of insight along the way. But no matter how great or numerous the anomalies that persist, Kuhn observes, the practicing scientists will not lose faith in the established paradigm for as long as no credible alternative is available; to lose faith in the solubility of the problems would in effect mean ceasing to be a scientist.

In any community of scientists, Kuhn states, there are some individuals who are bolder than most. These scientists, judging that a crisis exists, embark on what Thomas Kuhn calls revolutionary science, exploring alternatives to long-held, obvious-seeming assumptions. Occasionally this generates a rival to the established framework of thought. The new candidate paradigm will appear to be accompanied by numerous anomalies, partly because it is still so new and incomplete. The majority of the scientific community will oppose any conceptual change, and, Kuhn emphasizes, so they should. In order to fulfill its potential, a scientific community needs to contain both individuals who are bold and individuals who are conservative.

We are desperately in need of radical new thinking among the financial elite. We may not simply be at the end of an era, we may be on the verge of a reformulation of capitalism itself. However, the signs are that there are few iconoclasts among the policy elite. Central bankers in particular seem hopelessly stuck in their world views, starting with their conception of their role.

Bloomberg’s story, “Central Bankers at Retreat May See Few Options to Fix Economy,” would normally get me riled up, but I am suffering from central banker fatigue. Railing at them is an exercise in futility, so I’ll just hit the high points and encourage readers to jump into the fray.

Key excerpts:

The world’s top central bankers gather at their annual U.S. mountainside symposium today with a sense there’s not much more they can do to repair credit markets and rescue the global economy.

Reports in the last week showing a surge in inflation reinforce expectations that Federal Reserve Chairman Ben S. Bernanke will have to keep U.S. interest rates on hold. Similar conditions in Europe are paralyzing his counterparts at the Bank of England and the European Central Bank.

“All the central banks can provide now is time for the banking system to heal,” Myron Scholes, chairman of Rye Brook, New York-based Platinum Grove Asset Management LP and a Nobel laureate in economics, said in an interview. “What more they have to offer is now very limited.”….

“There isn’t a lot they can do” now, said former Fed Governor Lyle Gramley, senior economic adviser at Stanford Group Co. in Washington. “The Fed really has to hope and pray that credit markets begin to heal by themselves.”…

The Fed, while leaving the benchmark interest rate unchanged for its last two meetings, says financial markets “remain under considerable stress.” One gauge watched by the Fed, the premium for banks to borrow for three months over a measure of the future overnight lending rate, averaged 0.77 percentage point last week, the highest since April.

The Fed’s rate cuts also have failed to pass through to the housing market. The average rate on a 30-year fixed mortgage was 6.47 percent last week, about where it was a year ago….

Apart from lowering rates, Bernanke has pushed the limits of the Fed’s powers to ease the crisis in credit markets. In December, he started auctioning 28-day loans to commercial banks. He followed that in March with a $200 billion program to auction Treasuries to investment banks in exchange for mortgage-backed securities and other debt. Bernanke also offered cash loans to other bond dealers that trade with the Fed.

With all these programs in place, Fed officials may be reluctant to do more without assurance that it will ease the credit crisis and not do more harm.

“They have done a lot, and at some point they simply have to give the markets the time needed to heal,” said former Fed researcher Brian Sack, senior economist at Macroeconomic Advisers…

Some, such as former Bank of England policy maker Willem Buiter, who will address the meeting tomorrow, argue that the Fed’s actions to date store up trouble for the future.

“There will have to be a lot of soul searching about whether central banks, in their rush to forestall a financial disaster, have created moral hazard and perverse incentives on an unprecedented scale,” Buiter said.

The repeated use of the word “heal” says that the Fed has done a great job of pre-selling its message and the words of realists with Buiter will fall on deaf ears.

So what’s wrong with this picture? Here is a starter list. Readers are encouraged to add to it.

1. There is a remarkable lack of introspection. The Fed (and by extension other central banks) seem to think they performed ably and are victims of circumstance. They seem to see themselves as agents that act on the system, and implicitly deny their role in creating the current circumstances.

2. Part of the lack of introspection is how mission creep worked to their disadvantage. The Fed in the old days understood its job: take the punchbowl away before the party got good. But Congress gave the Fed the dual mandate of price stability and creating full employment. The Fed was effectively given responsibility without having authority, yet over time seemed to develop unwarranted belief in its ability to deliver on these objectives (as opposed to the more modest aim of doing what it could around the margin to help). We recall hearing paeans to the financial authorities almost like clockwork before crises (well, maybe not 1997-1998): “Gee, they have things so well under control, we won’t have a recession.”

That false confidence got worse under Greenspan, who loves scouring data and took an inordinate interest in the stock market, indeed, seemed to regard rises in the averages as validation of his policies (see here for a longer discussion). And this misguided thinking conditioned Bernanke’s reflexes when the crisis hit, His priority became validating asset prices, when the experience of Japan showed what a misguided course of action that was. Indeed, the most successful example of coping with a housing/banking crisis was Sweden in the early 1990s, when the markets were permitted to fall but the authorities moved quickly to recapitalize the banking system. Funny that we never hear anyone in the officialdom mention that model.

The Fed even considers itself to be in charge of the stability of the financial system , even though Congress has not added that to its job description. Moreover, the Fed has direct oversight over only a relatively small subset of market participants. For instance, only 15% of non-agricultural debt in the US falls under its purview.

Now the US central bank could kid itself that it, along with its peers, was doing a good job based on the so-called “Great Moderation,” a twenty-year period that featured more stable growth (although it also came with more frequent financial crises). However, economist Thomas Palley disputes the conventional account of the success of this period and the contribution of central bankers to it:

It is often said that the winners get to write history, which matters because the way we tell history frames our understandings. What is true for general history also holds for economic history…

The last twenty-five years have witnessed a boom in the reputation of central bankers…based on an account of recent economic history that reflects the views of the winners…

The raised standing of central bankers rests on a phenomenon that economists have termed the “Great Moderation.”… the smoothing of the business cycle over the last two decades….

Many economists attribute this smoothing to improved monetary policy by central banks….This explanation is popular with economists since it implicitly applauds the economics profession by attributing improved policy to advances in economics and increased influence of economists within central banks….

That said, there are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages…rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth….

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending…

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

3. Focus on monetary policy and liquidity and lack of attention to regulatory and structural reform. The credit crisis has been a massive indictment of financial deregulation. Yet the Fed remains a hostage of free market ideology and what Willlem Buiter calls “cognitive regulatory capture.” The Fed is too close to banks and industry, and almost seems to lack belief in the importance of oversight.

A full year ago, a vocal minority recognized the role of structural failings and called for the Fed and other regulators to investigate and develop new approaches. The proponents included Henry Kaufman, Australia’s former Reserve Bank Governor Ian Macfarlane, Steven Roach, and Jim Hamilton. Kaufman in particular has offered some sound analysis and proposals that have languished on op-ed pages (one example here); others over the past year have pondered the need for reform and made recommendations.

But what do we see instead? The Treasury launching a plan to make the Fed into an uber-regulator, with the Fed having no particular idea of what it would do with its new powers. This is the worst of all possible worlds. The current fragmented system allows an ambitious or progressive regulator to take ground, which forces the other to react to protect their turf (Eugene Ludwig, head of the Office of the Comptroller of the Currency in the Clinton Administration end ran the Fed more than once).

Now one can correctly argue the central bank lacks formal authority to do much in the way of regulatory reform. Yet first, Bernanke has been extraordinarily aggressive in going to the limits of, even beyond, the Fed’s charter (it most assuredly did not have the authority to stick taxpayers with the losses that eventually result from the Bear bailout, but Congress failed even to slap the central bank on the wrist for overstepping its bounds). Second, there has been an intellectual vacuum about what to do about the mess. The Fed and other central banks could readily have framed the debate and taken the lead in proposing reforms. But that role instead seems to have been seized by the Treasury, which seems more interested in quick fixes and the appearance of being in charge rather than the harder job of trying to achieve lasting progress.

I’m sure there is plenty to add to the Fed’s rap sheet, and I hope readers will provide input.

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  1. RK

    One thing the bankers might consider is the distortions, both intentionally designed, as in core versus headline inflation, or the rental equivalent of housing in the CPI, or productivity growth, a la Fleckenstein’s “Greenspan’s Bubbles”, by way of Jim Grant, on which they base their view of the economy.
    If the “reams of data” they pore over are convenient
    distortions of the real world, formed by ideological bias, the chances for sound policy conclusions are
    proportionally diminished.

  2. Marcus Aurelius

    We’re looking for open-minded innovation from these criminals when all we really need is strong rope and a gibbet.

  3. Richard Kline

    The best advice I could give anyone wanting to come by deep insight in a focus of study is, “Probe anomalies.”

    The passivity expressed in the ‘let it heal’ formulation smacks greatly of denial in the face of conditions unresolvable by present means: the CBers have given up, in their own way. Of course, the banking system is _not_ recapitalizing itself, and more, massive losses are in the pipeline and impending. That little hand wound on the banking system may stop seeping pus but the gut full of shrapnel is going black at the edges of the wounds.

    I wish that I could say that we are looking at some crisis of capitalism, but really this does not seem in the cards. I’d opine my mouth of further, but I’ve got a bus to catch and I’m a working stiff so gotta run.

  4. Lee

    A fine piece Yves. The only thing I disagree with is your statement “Yet the Fed remains a hostage of free market ideology…”.
    The Fed, this government, and the corporate world are not at all free market idealogues, they are plutocrats. They believe in their own wealth and that’s all. They love the free market when it works for the them (which is most of the time) but when they start losing money they, magically, become Marxists.

  5. Iconoclast421

    wow talk about gobbledegook. A radical new way of thinking? How about they take over the world and then carry out eugenics operations on your dumbed down ass? lol. They rule the world. They could kill off 90% of the population right now, and only a few easily-dealt-with “quacks” would notice. There is a reason the founders were against having a central bank.

    It is not the central bankers who need to hit bottom. It is the american people who need to hit bottom, and then wake the hell up!

  6. Alan von Altendorf

    Yves wrote: “The credit crisis has been a massive indictment of financial deregulation.”

    Er, no. It’s a massive indictment of GSE securitization and ballooning unsecured personal debt, exacerbated by the Greenspan put IMO.

  7. Anonymous

    Maybe if central bankers sticked to their job which is, as far as I know, to fight inflation – and if they stopped trying to stimulate economy, save the world, bail out everyone etc. – then we wouldn’t be in such a mess. I am for tradintion not innovation here.

  8. tyaresun

    1. If we want free markets we cannot have entities that are too big to fail. Do not allow mergers and acquisitions that create too big to fail.

    2. In the case of banks, bring back the Glass Steagall act, or at least most of it.

    3. Reduce fed powers drastically, remove the dual mandate and let it focus solely on inflation like the ECB. This will go a long way in strengthening the dollar which is sorely needed.

  9. William Mitchell

    “Central banker fatigue” is appropriate, because central banks are no longer central to this crisis.

    The risk-free rate isn’t the problem — it’s opacity in the riskier rates. If fed funds were zero, credit would still be frozen, because no one trusts the debt ratings. Is a triple-A really triple-A? No one knows, so no one buys. This is also true, through phrased in different language, of consumer lending.

    Restoring even a little confidence in the rating agencies, say via a regulatory dog-and-pony show, would begin to break the logjam.

  10. Anonymous

    In the movie “Mrs Harris”, Ben Kingsley plays the Scarsdale diet doctor offed by Mrs. Harris.
    There is one early scene, perhaps meant to demonstrate the Doctors phallic powers, where Kinsley in a very long scene walks nude through a men’s locker room.The other men are forced to look in awe at him.
    My somewhat twisted mind recalled that scene when I thought of Greenspan appearing before Congress (tho to be sure it was his big head that awed them.)
    Greenspan obviously ate it up and in a psychological inflation believed in his own omnipotence.

    Unfortunately Greenspan seems to be not unique in his beliefs of the maturity of the field of Economics. Application of this still infant “science” to real world situations is to me of questionable ethics.
    One of the events which caused Medicine to become acutely aware of unintended results of drug application was Thalidomide. I do not think the field of economics took proper cautions after the Social Thalidomide results of the the IMF application of its theory to many third world countries. So we will suffer from the side effects applied economics.
    I think a good initial corrective to the inflated opinion many economists have of their discipline is to stop awarding Noble prizes to Economicds. It is in no way a “hard” science and should not be treated as such. It is a Social Science and a very complex one

  11. Anonymous

    Yves — first, the citation to Kuhn’s theory of scientific revolutions is really brilliant, thanks for that. Second, in my view, the new thinking required is just an enlightened awareness of the limits of policy. Too many our worst economic diseases are iatrogenic (caused by the physicians), and those that aren’t generally are incurable anyway. I am not hopeful that policymakers will take a minimalist’s approach to their work, because the kind of people who get attracted to work in government generally think that more government is wonderful. Sometimes it is, but usually it’s not.

  12. David Merkel

    We need to leave behind the neoclassical synthesis, and the overemphasis on complex mathematical modeling in economics, which has stifled a lot of qualitative thinking, and replaced it with pointless mathematical speculation about how the world should work, given our axioms.

    After that, to the degree that we model, we need to think of the world from an ecological standpoint, and model in the longer term feedback loops that thwart policymakers, because economic systems adapt.

  13. donna

    The problem is thinking of things that don’t fit your world view as anomalies, when the actual anomalies are in your world view that doesn’t fit reality. Those who can realize this can come to new insights. I doubt there are many of those people at central banks.

    Scientists who make breakthroughs are those who are able to realize the model is just a model, and incorporate their anomalies into a new model that absorbs the anomalies. Getting others to accept it is difficult at best, and can take a generation. I think we’re at one of those points financially right now as the Chicago school breaks down.

  14. Anonymous

    Outstanding post.

    I do think you are overly enthusiastic about the merits of public introspection on the part of central banks. Openly ‘fessing up could hurt confidence.

    I think the best move is not to be publicly introspective until you have a sure sense of reform priorities and are ready to make their case. The lack of the first may indicate a lack of the latter – and that is indeed the biggest problem.

  15. RebelEconomist

    As central banks became more academic, the type of people they employ changed. They insist on outstanding academic qualifications but their current pay (as opposed to pension benefit) is mediocre, so central banks tend to recruit the kind of people who succeeded in education by being sensible and compliant rather than sceptical and audacious. Dissent is not in their nature.

  16. Anonymous

    My summary is that IB have forgotten they are a service industry; they are not a part of the world’s economic base that creates value by actually making things or providing direct services. Their function is to price and provide capital; they do not create fundamental wealth. Because they have levered too much debt on too little income the entire system is now seeing the destruction and delevering of wealth. Unfortunately, there is a mismatch between the sectors past ability to extract wealth from the real economy and who is suffering from the inevitable loss of wealth from their past overpricing of their “services.”

  17. Anonymous

    Brilliant analysis, Yves. And some very good comments as well.

    Having worked as a compliance officer in several financial institutions, it’s clear to me that the US regulatory system is undermined by competing bureaucratic and political interests, which are usually covert and of which the US public is not generally.

    There’s little question in my mind that this is a crisis of capitalism – just stop and consider how much farther this crisis has moved in the direction of socialized finance.

    As such, it becomes a more overt political fight as well.

    But all large political struggles are based on even deeper philosophical divisions. I would suggest that those divisions are also becoming more apparent – consider the rise of Asian economies, which generally come from a far different world-view than the Northern European assumptions that gave birth to classical economics and capitalist systems. The form of capitalism practiced in those systems is having an impact on traditional capitalism that is not well enough understood.

    At some point, it becomes mere hubris for the practitioners of any human intellectual discipline or tradition to believe that it can actively manage the course of events.

    So, while I share your discomfort over the lack of leadership of central bankers, I also sense that the real questions needing resolution are far, far deeper than any of us really understands…

    – Eric Dewey, Portland, OR

  18. Anonymous

    Any moderation of the business cycle has more to do with the reduction of agriculture as percent of economy over last 100 years and not the guidance of the fed. Better than fed to smooth out rest of cycle is states celebrating xmas and new years in diff months of the year.

  19. Anonymous

    Lets be honest, we have had 10 years of asset inflation, money has been too cheap and too easy to borrow, many company accounts reflect this.

    Removing mark to market from accounting standards would be my first step back to reality. The equity market represents the price a leveraged (or in the current market deleveraging) investors will pay to exchange a small percentage of a company for easy money. To claim share price reflect the value of the whole asset value is unmitigated rubbish.

    We now have ( in some cases bigger) derivative markets betting on what the leveraged or whatever investors will do to asset inflation. Perhaps central banks can work on a method to bring casinos into the game. Perhaps start with a paper on why the risk involved in a random walk can be mitigated with the throw of a dice.

    If the inflation measure had been real and included asset inflation we would have seen unacceptable inflation numbers for the last 10 years, oh it was great fun, but the party had to end.

    Change the inflation measure so it includes asset inflation.

    Going forward one of two things has to happen, the unit of measure ($) has to be devalued until the asset numbers are right (inflation in the real economy) or the numbers have to change to reflect some sort of reality (deflation in the asset economy). It looks like the central banks are going for the inflation option (however 0% interest didn’t work for Japan did it).

    I can’t see any way the central banks can stop things happening, nor why they should (we are all going to suffer may be a good reason if they could). Asset deflation has happened in the equity market, property is on a slower cycle and it is yet to finish, it is just the way it is.

    If I was Uncle Sam the first thing I would do is stop pretending I can run two wars and reduce taxes. He is going to have to face that reality one day.

    Sorry nothing for the central banks (except work on the casino problem), in fact I think it is a waste of time trying to blame them, the problem is a lot bigger.

    The central banks has been trying to fill the punch bowl but it’s been broken by the drunks and the party is dead.

  20. Anonymous

    What we (the World) need is a visionary LEADER. Someone who is a true leader with forward looking visions and not just to the next election cycle. A true leader who doesnt succumb to the masses (ie lower the bar to the lowest common denominator).

    Sadly, 25 years of increasingly easy credit has created a mindset and expectations of the general population that will not be unwound in 5 or even 10 years. We are talking about the values of a generation here.

    We truly are stuck. What needs to be done will not win many popularity votes. So more bandaides will be slapped on while the crack becomes ever deeper (although I suspect we have reached the point where bandaides will be futile and an amputation is needed).

    Dismantling is easy. Reconstructing is hard.

    As to the Asian economies (refer Anon above) – we cannot compare. They are in different place on the growth curve and in any event are set on imitating our (now clearly) disasterous system. Further, consuming half the world’s available resources and ruining their environment and ours (a lot of that chinese polution ends up in the US! – causing heavy metal poisoning to fish populations and that is only part of a story best saved for a relevant topic) to produce cheap disposable consumer items will be looked upon by future generations as madness.

    We know what needs to be done. But who can get this job done?
    And would such a person ever be voted in or appointed?

  21. Anonymous

    ps How can good decisions be based on such a faulty framework and dodgy numbers. GDP inflated beyond reality. CPI similarly understated.

    No wonder everyone is confused. Its felt like a recession for a long time now but the figures dont reflect that reality.

    When will everything be true and accurate again? ITs like the Emperors New Clothes.

    How can the situation be remedied when a true prognosis cannot be determined due to faulty wobbly and unreliable numbers?

    How many sets of books does the Fed and the government keep? One for the public and one for them?

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