Sunday, August 26, 2007

Central banks and the financial sector: a complex relationship

Central banks tend to pay too much attention to high-frequency movements in financial asset prices, to financial market developments in general, and to special pleading/moaning by representatives of the financial sector. I say this despite the fact that monetary policy is the setting of prices or quantities in financial markets (mainly short-term money markets, repo markets, debt markets and foreign exchange markets) and is transmitted to the real economy in the first instance through the financial system and through expectations of future monetary policy actions. I am also well aware of the importance of efficient financial intermediation for prosperity. In modern market economies, financial markets and private financial institutions are central to the decoupling of saving and investment by economic agents (that is, to consumption smoothing over time) and to efficient domestic and cross-border risk sharing. Financial instability threatens efficient financial intermediation and the efficient management of financial wealth.

As the number of intermediaries between the ultimate savers/wealth owners (households) and the ultimate investors/custodians of the real capital stock (non-financial firms) has grown, however, and as the number of complexity of financial instruments issued by these intermediaries has exploded, there has been a growing disconnect between the well-being and profits of the financial sector and the well-being and profits of the economy as a whole. Some of the new financial institutions and many of the new financial instruments exist only because of tax avoidance (or tax efficiency, as it is often known), and regulatory arbitrage (getting around regulatory obstacles to making profits).

The rewards individuals can earn in the financial sector appear well in excess of the social marginal product of their contributions. The reasons for this market failure are not immediately obvious, although the privately rational but socially costly search for tax efficiency and regulatory arbitrage must be part of the answer. So of course, are globalisation and the fact (again not well understood), that rewards in the financial sector seem to be determined more according to the ‘winner take all’ tournament model than the conventional model of a competitive market with free entry and exit in which the most talented/lucky do indeed get the biggest rewards, but there is something meaningful left even for those coming second or lower in the ordinal ranking of performance. Whatever the reason(s), the City of London, Wall Street and the private financial sector everywhere have attracted a disproportionate share of the best and the brightest. For instance, whatever may be the contribution of ‘quants’ (specialists in mathematics, computing and finance) to the private profitability of the firms that employ them, their collective contribution to general economic well being is likely to be quite a bit below their take-home pay.

Many of the new financial institutions are very highly leveraged. This means that those who own them put up rather little risk capital of their own and borrow the rest. Examples are hedge funds and private equity funds, but investment banks and commercial banks increasingly fit this description as well. Most of the lending and the buying and selling of securities is between financial institutions, rather than between financial institutions and ultimate savers and investors in physical capital. Most of the exposure of financial institutions is to other financial institutions. Because of this, it is possible for there to be major losses by some financial institutions (say a hedge fund holding credit default swaps) that are matched by matching reductions in the exposure (that is, gains) of other financial institutions. The losers will soon call for a central bank bail-out (through interest rate cuts preferably), but the winners will quietly pocket their innings.

In my view, provided the central bank manages credit and liquidity crises properly, by acting as a market maker of last resort, there is no financial institution in the world today that is too big to fail. A market maker of last resorts intervenes when markets become disorderly, assets become illiquid and credit dries up because of massively increased uncertainty, fear and panic. The market maker offers to buy the illiquid assets on any scale necessary to prevent solvent but illiquid enterprises from going bust, but does so at a sufficiently low price to minimise moral hazard. This is, however, not what central banks have been doing. The ECB has flooded the market with liquidity in exchange for high-grade collateral, when it should have made a market for low-grade collateral. The Federal Reserve Board also did some rather indiscriminate liquidity creation against high-grade collateral (but on a smaller scale than the ECB) and cut its discount rate, for no good reason I can discern other than trying to boost some amorphous feel-good factor. The discount rate cut only benefited those already willing and able to borrow at the discount window. It did nothing to directly address the problem of asset illiquidity.

Because they work in and through financial markets, there is a risk, indeed a likelihood, that central banks will get co-opted, consciously or subconsciously, by the movers and shakers in the financial markets. For every representation made to the central bank by a spokesperson from the real economy, there will be half a dozen from the financial sector. The financial sector also speaks the same language as the central banks, which facilitates the de-facto ‘capture’ of the central bank by the financial sector collective interest. Central bankers often come from the financial sector, and, after their stint in the central bank is over , tend to take on lucrative appointments in the (private) financial sector. There is nothing wrong with that in principle, as long as conflicts of interest are avoided and a decent (preferably legally set) sabbatical or purdah period is observed between the end of the central bank appointment and the start of the private financial sector activities. Yet it all adds up to an environment in which the central bank is more likely, in its monetary policy actions, to accord a weight to the well-being of the financial sector that may well exceed that which is warranted from an economy-wide perspective.

I think some of the actions of Alan Greenspan following every significant outbreak of financial turbulence in his term in office, and, albeit to a lesser extent, the behaviour of the ECB and the Fed during the financial storm we are just emerging from, provide examples of central banks that are ‘too close’ to the financial markets and the private financial institutions that operate in them. This excessive closeness leads them to identify the health and profitability of the financial sector, and indeed at times even of highly visible individual financial institutions, with the health of the economy as a whole. That correlation is, however, far from unity most of the time and can at times even become negative.

So what can be done about this? Not much unfortunately. Two minor measures come to mind.

First, locate the central bank somewhere so far away from the nation’s (or region’s, in the case of multi-country monetary unions) financial capital.

Second, make sure that the head of the central bank, and (where monetary policy is made by committee) the vast majority of the monetary policy makers, are not so deeply immersed in the culture, values and world view of the financial sector that they have lost the ability to view the financial sector as something external to them, something they have to influence and work through and with, rather than something with which they are emotionally and cognitively inextricably intertwined. They must know how the financial sector thinks; they must understand its moods and mood swings, but they have to keep their distance, emotionally and intellectually. They can smoke it, as long as they don't inhale.

The US and Canada have been lucky or wise in locating their central banks. It’s a good thing that the Fed is in Washington DC rather than in New York City, the financial capital of the USA. It is not a good idea, to get someone who is not only from Wall Street, but of and by Wall Street, appointed Chairman of the Federal Reserve Board.[1] We should be pleased that Alan Greenspan is gone and has been replaced by a highly respected academic economist and public servant who does not believe that Wall Street is the centre of the universe, or even of the American economy. Greenspan may not have been the worst central banker ever (there are many stronger contenders for that honour)[2], but he certainly contributed mightily to the post-2000 climate of excessive liquidity, lax enforcement of existing prudential standards on regulated financial institutions, and the spread of the misplaced belief that the new financial institutions and the issuers of most new financial instruments could be left outside any formal prudential regulatory and supervisory framework. The notion that the mere suggestion that self-regulation might be in order represents an undue imposition on hedgefunds and private equity funds will turn out to have done a disservice even to these very institutions in the slightly longer run.

Likewise, it’s a good thing that the Bank of Canada is in Ottawa rather than in Toronto. The Eurozone has no single dominant financial capital, but it is helpful to have the ECB located in Frankfurt, a provincial backwater. I would much rather have the Bank of Japan located in Kyoto rather than in Tokyo, and the Bank of England in Manchester rather than in London, but it’s hard to rewrite history. Fortunately, in the case of the UK, Mervyn King is probably the central bank Governor least likely to overestimate (or underestimate!) the significance of the financial sector for the health of the economy; nor is he likely to believe that there is a positive correlation between the wisdom of a proposition and the vehemence, volume and conviction with which it is uttered. He will need all his strength, stubbornness and intelligence to stay the course through this crisis.

[1] Paul Volcker, the greatest Chairman of the Fed thus far in the post-World War II period, did spend nine years on Wall Street with Chase Manhattan before joining the Federal Reserve Board. He did, however, also spend about 17 years with the Federal Reserve Bank of New York and in government service before becoming Chairman of the Federal Reserve Board. Familiarity with and knowledge of the modus operandi of financial markets and institutions is clearly a major plus for the head of a central bank. To have that familiarity and knowledge, yet still to maintain the proper affective and cognitive distance from the markets, can make for a truly great central banker, as it did in the case of Volcker.

[2] Alan Greenspan does have a strong claim to be the worst former central banker ever. His propensity to speak out on market-sensitive matters since his retirement as Chairman of the Federal Reserve Board, cannot but have been a source of irritation and embarrassment to Greenspan’s successor during the first few months following Greenspan’s retirement from the Fed. I know of no other example of such indelicate behaviour by a retired top central banker. The richly remunerated dinner-engagement-cum-speech with a leading Wall Street firm within a couple of days or so of leaving the Fed, revealed at best a singular lack of judgement and propriety, even if the occasion was technically a ‘closed’ event.

© Willem H. Buiter 2007


Anantha said...

Prof. Buiter: You spoke from my heart. Bravo. Keep up your lone voice (I hope you have some company in the former and present policy-making circles) of sanity.

Anonymous said...

Telling observation on the threat of a prevailing bias.

The growth in the complexity of financial market and their instruments,(though not in their principles)and so in their regulation, may have contributed to the creeping co-option. This indicates a need for two sets of skills, the set based on sound and strong first principles, and as you have pointed out in previous posts, an increasing understanding of the details of financial innovation and its operation.

So the intellectual and emotional and perhaps physical distance you recommend may need to coexist in tension with a degree of intimacy and proximity.

Flow5 said...

Paul Volcker - Greatest Chairman? Truely great central banker?

Hell no. I will just give you one example:

In 1980, Paul Volcker, Past chairman of the Board of Governors of the Federal Reserve System, appeared before the House Domestic Monetary Policy Subcommittee. In response to a question as to why the Fed had supplied an excessive volume of legal reserves to the member banks in the third quarter 1980 (annual rate of increase 13.2%), Volcker's defense was that there are two types of legal reserves: 1) borrowed (reserves obtained by the banks through the Federal Reserve Bank discount windows), and 2) non-borrowed (reserves supplied the banking system consequent to open market purchases). He advised the congressmen to watch the non-borrowed reserves -- "What we do on our own initiative." The Chairman further added --- "Relatively large borrowing (by the banks from the Fed) exerts a lot of restraint."
This is of course, economic nonsense. One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. A new advance can be obtained, or the borrowing bank replaced by other borrowing banks. The importance of controlling borrowed reserves was indicated by the fact that at times nearly 10% of all legal reserves were borrowed.

Volcker was the worst.