4

The Temptation of the Central Bankers

WASHINGTON, DC – The banking system has become most central bankers’ Achilles’ heel. This may seem paradoxical – after all, the word “bank” is in their job description. But most people currently at the top of our central banks built their careers during the 1980’s and 1990’s, when the threat of inflation was still very real, so this – rather than bank regulation and supervision – remains a major focus of their intellectual and practical concerns.

Moreover, a formative experience for many central bankers over the past half-decade has been the need to prevent a potential collapse of output, including by preventing prices from falling. They have achieved this goal largely by propping up credit, regardless of what that may do to the banking sector’s structure or incentives.

It is not surprising that today’s central bankers continue to be deferential to those who run large private-sector banks. Central banks have a great deal of control over an economy’s money supply, and they can affect interest rates across a wide range of loans and securities. But private-sector banks do the lending, while also bearing responsibility for important dimensions of how financial markets operate.

Thus, keeping global megabanks in business and highly profitable has become a key objective for policymakers in the United States, Europe, and many other countries. All too often, however, this means that central bankers defer to these firms’ executives.

José De Gregorio, the governor of the Central Bank of Chile from 2007 to 2011, is an important exception. In How Latin America Weathered the Global Financial Crisis, he combines recent history and personal insight to offer a fascinating account of how to apply a more balanced policy approach – both in emerging markets and more broadly. (De Gregorio’s book is published by the Peterson Institute for International Economics, where I am a senior fellow, though I was not involved in commissioning or editing his work.)

There is plenty of conventional macroeconomics in De Gregorio’s story, including the value of careful fiscal policy and the advantage of maintaining a flexible exchange rate guided largely by supply and demand in the market. When countries seem committed to a fixed exchange rate (say, relative to the US dollar), firms and individuals feel encouraged to borrow in foreign currency (like the dollar) in order to lock in what are typically lower interest rates.

But such a perception can easily become a trap. When capital flows out of the country – as is happening now in some emerging markets – it may be helpful if the central bank allows the currency to depreciate in an effort to boost exports and reduce imports. But if the country’s borrowers have a lot of dollar-denominated debt, depreciation can be ruinous.

De Gregorio covers all of these issues very well – and also discusses the importance of luck. Chinese growth remained relatively strong in 2009 and after, which kept the price of commodities high. This benefited Chile – a major copper producer – and much of Latin America.

But De Gregorio’s analysis of banking is what really stands out. Here the key issue is leverage, or how much banks are allowed to borrow relative to their equity, and the temptation that policymakers face to allow banks to borrow more, particularly when times are good and asset prices are rising.

Big banks’ executives often want to increase their institutions’ leverage, typically because they have various forms of guarantee – in particular, deposit insurance and access to central-bank financing on advantageous terms. In addition, the executives’ pay is typically based on return on equity, unadjusted for risk.

The danger for central banks stems from the fact that the implicit subsidies provided to major financial institutions are not measured in any budget. Moreover, the build-up of risk in the financial system that accompanies higher leverage is both hard to measure and likely to materialize only after a few years (for example, after a governor’s term of office has expired).

De Gregorio’s views differ from those of many of his colleagues in other countries, because he sees clearly the risks in allowing banks to become bigger and apply what he calls “clever” strategies that require a great deal of leverage.

Higher leverage creates macroeconomic risk – not least for fiscal balances when implicit guarantees must be honored. By keeping banks and other private-sector firms at lower levels of debt, vulnerability to shocks is reduced. In a boom, this may seem irrelevant; but, as De Gregorio knows, pressure on emerging markets – and richer countries – arises all too often, and frequently at unexpected moments.

Growth based on high leverage typically proves to be illusory. And yet the illusion continues to entice policymakers. That is why De Gregorio’s book should be required reading for all central bankers.