Sunday, November 23, 2014

The Uncertain Future of Central Bank Supremacy

NEWPORT BEACH – History is full of people and institutions that rose to positions of supremacy only to come crashing down. In most cases, hubris – a sense of invincibility fed by uncontested power – was their undoing. In other cases, however, both the rise and the fall stemmed more from the unwarranted expectations of those around them.

Over the last few years, the central banks of the largest advanced economies have assumed a quasi-dominant policymaking position. In 2008, they were called upon to fix financial-market dysfunction before it tipped the world into Great Depression II. In the five years since then, they have taken on greater responsibility for delivering a growing list of economic and financial outcomes.

The more responsibilities central banks have acquired, the greater the expectations for what they can achieve, especially with regard to the much-sought-after trifecta of greater financial stability, faster economic growth, and more buoyant job creation. And governments that once resented central banks’ power are now happy to have them compensate for their own economic-governance shortfalls – so much so that some legislatures seem to feel empowered to lapse repeatedly into irresponsible behavior.

Advanced-country central banks never aspired to their current position; they got there because, at every stage, the alternatives seemed to imply a worse outcome for society. Indeed, central banks’ assumption of additional responsibilities has been motivated less by a desire for greater power than by a sense of moral obligation, and most central bankers are only reluctantly embracing their new role and visibility.

With other policymaking entities sidelined by an unusual degree of domestic and regional political polarization, advanced-country central banks felt obliged to act on their greater operational autonomy and relative political independence. At every stage, their hope was to buy time for other policymakers to get their act together, only to find themselves forced to look for ways to buy even more time.

Central banks were among the first to warn that their ability to compensate for others’ inaction is neither endless nor risk-free. They acknowledged early on that they were using imperfect and untested tools. And they have repeatedly cautioned that the longer they remain in their current position, the greater the risk that their good work will be associated with mounting collateral damage and unintended consequences.

The trouble is that few outsiders seem to be listening, much less preparing to confront the eventual limits of central-bank effectiveness. As a result, they risk aggravating the potential challenges.

This is particularly true of those policymaking entities that possess much better tools for addressing advanced economies’ growth and employment problems. Rather than use the opportunity provided by central banks’ unconventional monetary policies to respond effectively, too many of them have slipped into an essentially dormant mode of inaction and denial.

In the United States, for the fifth year in a row, Congress has yet to pass a full-fledged budget, let alone dealt with the economy’s growth and employment headwinds. In the eurozone, fiscal integration and pro-growth regional initiatives have essentially stalled, as have banking initiatives that are outside the direct purview of the European Central Bank. Even Japan is a question mark, though it was a change of government that pushed the central bank to exceed (in relative terms) the Federal Reserve’s own unconventional balance-sheet operations.

Markets, too, have fallen into a state of relative complacency.

Comforted by the notion of a “central-bank put,” many investors have been willing to “look through” countries’ unbalanced economic policies, as well as the severe political polarization that now prevails in some of them. The result is financial risk-taking that exceeds what would be warranted strictly by underlying fundamentals – a phenomenon that has been turbocharged by the short-term nature of incentive structures and the lucrative market opportunities afforded until now by central banks’ assurance of generous liquidity conditions.

By contrast, non-financial companies seem to take a more nuanced approach to central banks’ role. Central banks’ mystique, enigmatic policy instruments, and virtually unconstrained access to the printing press undoubtedly captivate some. Others, particularly large corporates, appear more skeptical. Doubting the multi-year sustainability of current economic policy, they are holding back on long-term investments and, instead, opting for higher self-insurance.

Of course, all problems would quickly disappear if central banks were to succeed in delivering a durable economic recovery: sustained rapid growth, strong job creation, stable financial conditions, and more inclusive prosperity. But central banks cannot do it alone. Their inevitably imperfect measures need to be supplemented by more timely and comprehensive responses by other policymaking entities – and that, in turn, requires much more constructive national, regional, and global political paradigms.

Having been pushed into an abnormal position of policy supremacy, central banks – and those who have become dependent on their ultra-activist policymaking – would be well advised to consider what may lie ahead and what to do now to minimize related risks. Based on current trends, central banks’ reputation increasingly will be in the hands of outsiders – feuding politicians, other (less-responsive) policymaking entities, and markets that have over-estimated the monetary authorities’ power.

Pushed into an unenviable position, advanced-country central banks are risking more than their standing in society. They are also putting on the line their political independence and the hard-won credibility needed to influence private-sector behavior. It is in no one’s interest to see these critical institutions come crashing down.

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    1. CommentedAngel Gavieiro

      I think Mohamed is right in the point that Central Banks can not be left alone on this task; he is right also by pointing to the lack of sense of Estate and responsibility of many policians & legislatures across the world. However, it touches very briefly in the role of the markets, particularly institutional investors (like PIMCO). These institutions could do way much more that are doing: 1) as he pointed, changing from short term oriented investment for the quarterly gain, to a proprer LT horizon; 2) reducing allocation to speculative investment (ie Hedge Funds), and so take proper responsibility of your own investment instead to delegate it to others; 3) embrazing the non-liquid part of the market (SMEs & MidCorps) that are the engines of job creation; 4) taking a properly activist and LT oriented presence in the boards of public companies to change CEO hubris & behaviours; 5) changing their own business models to develop origination capability with geographical capilarity (to reach those SMEs), and so assume direct financing vs the stretched banks.... But of course, these changes, beyond a great courage, also require to diminish quite considerably the internal pay & bonuses if you want to keep running an Asset Mgmt. business at decent Cost-to-Income ratio... as usual, what damages your pocket does not call for action! Thus, it is time for the Institutional Investors worldwide, ultimately owing their mandate to the countries population (via pension, insurance policies and the like) to step up and do their bit (and for politicians & regulators to start changing the rules of the game of the investment process from The Inception, the trustees & the insurance cies.... so that all the chain behind them of Asset Managers and ultimately Investment Bankers change their behaviour consequently... which will undoubtedly and reluctantly have to do because they are agents paid by the former... let's recall, the human beings owners of the pension plan & the insurance policy).

    2. CommentedLarry Lindquist

      I recall that Fed leaders have repeatedly stated that their policies and actions cannot be fully effective, nor would they have been as extended as has been the case, if Fiscal policy and action by the US Congress had been taken up in a reasonably responsible manner, rather than how it has been over the last several years. It seems that the Central Bank does what it does in large part because it's the only oar working in the boat - of course that means we may well just be going in a large circle, in terms of real economic effect.

    3. CommentedJames Benjamin

      Central banking is neither democratic nor capitalistic. It is first and foremost a pragmatic response to an inherent characteristic of our desire for stable and sustainable credit markets. Credit provision and use follows a cycle, we use central banks to extend that cycle. Our mistake has been thinking we can eliminate the cycle. Central to the success of extending the cycle is the maintenance of a fiat money system, where by money can be created with the stroke of a pen, as opposed to working to dig it up.

    4. CommentedArmen Papazian

      This is good news, because if we are ever going to evolve as a species, we need to transcend debt based money. In a debt based monetary system, the other policy makers you refer to have not much choice. The sad thing is, the current system of debt based money is founded, or at least it is kept alive, by the unwarranted principle of scarcity in economics... in an abundant and miraculous cosmos! This uncertainty should give birth to innovation so that this species and this planet can address and embark on the evolutionary path it wants to pursue.

    5. CommentedGunnar Eriksson

      The paradigm change most needed and effective would be to increase the lowest wages.
      With declining wages there is no way we can achieve genuine growth.

    6. CommentedLoren Mant

      If no one else is listening to, let say FED's warnings, then why FED as an "independent" institution doesn't stop doing this madness of QE? It doesn't stop, because it is so good for the whole financial sector, regardless of inefficiency for the rest of the economy. There is no doubt who the FED works for. The same is with any central bank in the world. And it is ridiculous to even suggest that there is no other ways for solving the crisis.

    7. CommentedLoren Mant

      Are you joking? FED knows what is doing and it is doing it with the full conscious that it helps Wall Street to recover its losses.

    8. CommentedProcyon Mukherjee

      From the list of Fed’s dappled accomplishments, the one that would stand out is the continuity of ultra-looseness that allows printing to be done at such perfecting speed that any thought of a change in the drip feed rate of $85 Billion a month makes a storm look pale in the financial markets, while a $Trillion is sitting on the liability side of its balance sheet stemming from excess bank reserves of commercial banks. There is no other action in sight while the government is left to the fence-sitting role it had assumed blissfully, as passing budgets and raising debt ceiling are left to abstractions of occasional nature.

      The predictability of Fed, if it changed a wee bit, could have done better in these uncertain times.

    9. CommentedMarc Laventurier

      As the creature of both the U.S. Congress and private banking interests, the Fed is the hybrid spawn of democracy and capitalism (such as they are). Designed primarily to avert and mitigate financial panics through regulation, the Fed's use of tactics such as financial repression and asset inflation through the medium of financial markets reinforces the American ideology of self-interest and limitless consumption in pursuit of the nominal growth that hides costs in balance sheets, deficits and promised but undeliverable essential future benefits. A classic con job, in whose interest?

    10. CommentedJohn A Werneken

      Actually, to reduce central banks to impotence beyond liquidating insolvent institutions, would be excellent, particularly is NO other human institution capable of fiddling with currency value, interest rates, or the general level of economic activity were allowed to exist.