Friday, October 31, 2014
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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.

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  1. CommentedEdward Ponderer

    That the central bankers expertise developed in a different error is no doubt correct. However, the assumption that the fix is to slide focus to a different portion of the multidimensional economic cycle, i fear misses the point. We are not cycling--we are spiraling out of orbit. Now, the warning signs of world economy moving from the simple cyclical into the domain of deterministic chaos were pointed out by Peter Drucker in his seminal 1981, THE NEW REALITIES, certainly have not gone unnoticed. They seem to play an important part in Alan Greenspan's long successful stewardship of the US economy through rough waters exactly by using specific measures to course-correct, predict the limits of linear or simple second-order approximations of subsequent economic evolution, and then remeasure and remap. We are past that point because all sorts of economic factors from resource and waste management limits, to over-and above them all (as again pointed out by Drucker -- see The FUTURIST Magazine, November 1998 issue P.16-18), demographic changes. The chaotic elements of the actual total economic system--the sum relationship between humans, and Humanity vis-a-vis Nature, are blooming non-linearly--heading into the exponential. Relating to the effect of demographic shift is also that the early effects of multi-pole economic influence from this, initiated an international "fractal basin," whose most famous example is the well-known "chaotic pendulum."

    The continuing attempts at classical analysis of international economy are a study of interior decorating of the sand castle as its basic structure evolves into sand storm.

    The only solution is exactly what Nature does when natural communities (and isn't human civilization one of those--matters are too serious to play vanity games here any longer) reach such chaotic crisis. The members enter, by necessity, a state of mutual responsibility--mimicking the human attribute of altruism. In this, they integrate as though a single body (and in some cases, evolve into an actual higher form of being). In such, they don't "fear" chaos, they ride with it, "zoning" into fractal sensory, internal-communications/"nervous", round-table/"brain-logic-emotion/analysis, and motor/response systems -- and all other functional systems about these.

    It is a path to survival, nay prosperity, if Humanity can do this as well. Our disadvantage is our personal egoism and habits--as the habits of the central bankers that Professor Johnson bemoans, but far broader and deeper. On the other hand, we have minds and common sense. Lets hope these will prove enough to overcome.

  2. CommentedRichard Sorenson

    Inflation...isn't that an academic way to explain away price fixing -gouging - controlling (restricting) output so you can justify price increases in the financial media that you control? If government and money were managed for We the people inflation would be nearly impossible. The problem & solution were to be a part of John 2, the cleansing of the temple, but someone kept that from being added.

  3. CommentedStamatis Kavvadias

    "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.
    [...]
    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)."

    These sound exactly like the reasons that, supposedly, politicians cannot be trusted to decide the amount of money in the economy (the function that was the purpose of central bank creation). It is time to establish a transparent process for money creation and remove it from unaccountable institutions.

    Unfortunately, economists become mute when this issue is mentioned and it is not out of concern about the alternatives, because, at the same time, there is no research on this issue!!!

  4. CommentedBernhard Kopp

    Inept Crisis Management
    If governments and parliaments would base their decisions on clear objectives for 'the common good', then they would not fall prey to lobbying of the financial industry to the extend they do. Only much higher caital requirements will make banks safer.

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