Montrose Journal Summer 12
The Bankers Who Failed: Were Central Bankers the Guilty Men?
Many years ago I was lucky enough to be asked to take a trip around the US as a guest of the State Department. Among the many wonders I saw were the Grand Canyon, pre-Katrina New Orleans and Disneyland. In Disneyland itself the high spot was a life-sized marionette of Abraham Lincoln reading some of his choicest lines.
Later in the trip I arrived in Chicago, where a leading figure in the local community was kind enough to invite us to dinner. Our host had two apartments high up in the John Hancock building (the one with the sloped sides) one of which looked over the lake and the other over the city. I happened to mention Disneyland and that the Lincoln exhibit had been particularly notable. This turned out to be the right thing to say, because our host was not merely a leading expert on Abraham Lincoln. It was he who had acted as historical adviser to Walt Disney on choosing the lines for the RoboLincoln to speak, so conversation went easily.
Then as dusk settled the lights of the city started to come on, confirming Chicago’s position as most architecturally distinguished of all American cities and I said how beautiful I thought it was.
Like all Chicagoans, our host was quietly (but not too quietly) proud of his city. “Yes it is beautiful,” he said. “It reminds me of something Walt said to me when we had just finished Disneyland, We were standing in his office looking over the Disneyland Park and I said to him “that’s really great Walt.” And Walt replied, “Yes, it just shows you what God could do if he he’d got the money.”
That indeed is the point. For there are many problems in the world which can only be solved if you’ve “got the money.” And nowhere is this more true than in the financial crisis which has been gripping the world for the past five years.
It is universally agreed that Walt Disney is dead, and while theological opinion is divided on the other matter, it is likely that God is not going to get directly involved in the financial crisis. And the only people who have unlimited money are the central bankers. In the modern world they are the controllers of fiat money. Since the end of the gold standard, central banks have been able to create money whenever they want to.
This is a very great power. And was it not Rousseau who said “With great power comes great responsibility? †”
The power is all the greater because a distrust for politics and politicians has led to an elaborate system being created to make the Central Banks independent of any outside control. Once appointed, no central bank head can be sacked for having the wrong policy or being incompetent. In Europe, no government can order a central bank what to do. Central banks, on the other hand freely issue statements telling governments what actions they should take. How well have central banks used their power?
How well have they understood the nature of the crisis and what needed to be done?
The short answer, on this side of the Atlantic at least, is “not well.”
Before the Storm
The years before 2007 were a Golden Age for central banks. Not only had governments transferred effective control of demand management to them by giving up discretionary fiscal policy. They were able to bask in the glow of praise, as the economy seemed to flourish with low inflation. They were not shy about taking the credit for this state of affairs. Economic policy was a simple matter. Set short-term interest rates in the market at a level which kept inflation low and everything would be fine. Everything wasn’t fine even then of course. But there was an explanation for that which meant nothing was the central banks’ fault. Minor issues like unemployment and slow growth could be dismissed as “supply-side” problems which central banks could do nothing about.
This view of the world has very peculiar characteristics. It sets itself firmly against the sort of holistic, “joined-up” approach which is fashionable in other areas. It says that if central banks do what they think is right and governments do what is right then all will be well.
Interestingly enough, this view of the world had been subjected to a test in the first real attempt to model the way the economy works, the “Phillips machine” sometimes known as the Moniac built at the London School of Economics in the late 1940’s. This was a remarkable collection of glass pipes through which coloured waters were pumped to reflect the flows in the economy.
One student pretended to be Chancellor (Finance Minister) and the other Governor of the Central Bank. When they coordinated tax and interest rate policy all went smoothly. But when they were told not to talk to each other but just do what seemed right in their own field, everyone got very wet as water splashed around. So there was reason to doubt whether this idea of complete separation of monetary and fiscal policy, which lies at the heart of central bank independence, is a good idea.
Running the Economy
Separating fiscal and monetary is only part of the problem, however. For until the crisis blew up, central banks had successfully persuaded people that fiscal policy should not be used at all to regulate the economy. Instead, everything should be left in their hands through changes in interest rates. The role of governments was just to set a long-term fiscal policy of responsibility, with the government deficit held down to leave room for the private sector to borrow.
Lying behind this was a belief that governments are feckless creatures who will always accept a little more inflation if it makes room for them to grow spending or cut taxes to buy votes. This belief that the democratic process is biased to inflation is deeply held. It is also almost certainly wrong. The events of the past 40 years have shown voters are willing to punish governments which allow inflation far more severely than governments which experience recessions. The reason is obvious. Inflation affects everyone, whereas even in quite severe recessions most of the population can still find work. So the inflation bias is not there.
It’s understandable that people made this mistake in the 1970s when inflation had its huge surge. And most of the policy makers who have been running the world had their first experience of economics at a time when inflation was a big problem.
But this led to a policy prescription which has turned out to be disastrous. For it led people to think that low inflation was not only necessary for good economic performance, but also sufficient. And so the idea of inflation targeting was born.
The economic policy of the past 15 years or so has had three main components. One, governments have to borrow any money to cover deficits from the market, not the central bank (an irony since the Bank of England was set up specifically so that the government could borrow from it;)
Secondly, central banks regulate the economy through interest rates at which they offer short-term money to banks;
Third, the goal for the central bank is simply to keep inflation at a steady low level.
These principles are all enshrined in the Maastricht Treaty. And it is because the ECB has followed them that ECB President Trichet, reviewing a devastated economy at the end of his term was able to call the ECB’s performance “impeccable.”
Each of these pillars has contributed in its way to the problems the economy has faced. It is because in the heat of the crisis in 2008, many of them were ignored, that most Anglo-Saxon economies have weathered the crisis better than the Eurozone. Even in the Eurozone, there was at least a passive willingness to let government deficits balloon out which probably is what prevented recession from turning into full-blown recession.
Proving how fast people can forget lessons they didn’t want to learn, all of the debate in the Eurozone now is about building brittle structures. This would ensure that next time a crisis comes, there is no way to prevent it causing total collapse.
Take the ban on governments borrowing from central banks. Defenders say that ending this would mean the central bank “printing money.” But the current system, where commercial banks can borrow from the central bank and then lend multiples of the amount they have borrowed, allows the private banks to print money and lend it to property and share bubbles, as they did in the run-up to 2007.
Second, a simple reliance on moving short rates failed to noticed that falling inflation was allowing long-term borrowing at very low rates, which drove up asset prices far more quickly than the economy was growing.
And finally, because inflation remained low and wages grew slowly, central banks ignored or welcomed this bubble in asset prices, which turned out to be so disastrous.
There’s no doubt that the quality of central bankers is uneven just like any other segment of society. But the great danger is not in weaknesses in individuals but in the whole system, which they exist to implement.
The Crisis Strikes
It’s now generally recognised that the crisis started in the summer of 2007, not late 2008 when it really came to people’s attention. Two examples can be cited to give some sense of the awareness of the central banking community.
In September 2007 the Governor of the Bank of England was questioned by a parliamentary committee on why the Bank of England had not been able to solve a crisis at Northern Rock, one of the pre-shocks of the crisis before the main events of 2008. His answer astonished the MP’s, because he said both the British Takeover Code and the EU Market Directive made it impossible to save a bank in such a situation.
So what he was admitting was that the Bank of England had allowed rules to be passed which meant it could do nothing to handle a financial crisis. (The EU denied his interpretation of the Market Directive, by the way.) Astonishingly, in the light of this admission he was later appointed to serve another term as Governor. It’s hard to imagine any field outside central banking where that could happen.
Such a level of unpreparedness is shocking. But it took place against a background where central bankers seemed blind to the nature of the crisis which was looming. Let us look at the Bank for International Settlements, commonly known as “the central banker’s central bank.”
Its annual report is always an impressive piece of work of high intellectual standard. But in August 2007 the judgements it put forward, which conditioned what the central banks actually did at that time, were extraordinarily wide of the mark. It identified three issues of concern.
First, inflation might rise, always a preoccupation with them. Actually, the world was heading to deflation.
Secondly, the dollar might crash. Actually as the crisis intensified the dollar went up.
And a very poor third, there might be some dislocations in the financial sector. But the BIS played down the risk: “The big investment and commercial banks seem very well capitalised, and many have been making record profits. Their attention to risk management issues has also been unprecedented.” (My emphasis).
Yet within a year, one of the “Big Six” investment banks had needed to be bailed out and by the end of 2008, another had been bankrupted, and the others were living off life support from action by the Fed. And we all know now just how good the risk management had been.
Move forward to 2008, as crisis was beginning to tip into catastrophe. What was the ECB’s contribution to saving the world? It RAISED interest rates. Nothing could have been more guaranteed to exacerbate the crisis.
In the private sector, anyone as wide of the mark as that would be fired. In politics, they would be voted out of office. In central banking there are no sanctions.
So when people talk about risk and reward and say that the banking system with its high bonuses for success leads to too much risk, take a look at central banking as a field where you get paid however wrong you are. It is not obvious that the results are better.
Regulation, Regulation, Regulation
The macroeconomic function of the ECB is one way in which central banks affect Europe.
And how have they used the other great power they possess, to regulate and monitor the financial system and to influence how that system goes about creating its own money? In 14 out of the 17 countries in the Eurozone the central banks of the country concerned are responsible for financial regulation. It is now obvious that trying to do this at national level in a financial system as integrated as the European (or indeed the global) system makes no sense. Yet in the 13 years since the creation of the Euro, the central banks did virtually nothing to bring about an integrated system of banking supervision. Since the crisis erupted it has been painfully obvious that a collapse of banks in one country would lead to at best severe problems everywhere and probably to a collapse of banks right across Europe.
Why was nothing done before? An answer may lie in the fact that central bankers are no more immune to confusing their own self-interest with that of the common good than anyone else. Banking regulation is described by the Bundesbank as a “core business” and it provides many jobs at a time when other part of the bank have been shrinking.
So it is understandable that while the Bundesbank has been very vociferous about telling governments they should move much more control over their budgets to Brussels, it showed little interest in handing over supervision to a European-level body. It will be interesting to see just how enthusiastically the central banks hand over this function to a new European body.
There is in any case another problem. Just as the ECB says it wants to separate monetary from fiscal decision, so it wants to separate monetary (interest rate) from supervisory decisions. But the split is an artificial one.
The ECB has been able to keep the banking industry afloat through its use of special lending facilities, which allow banks to borrow on generous terms for long periods, something which it would have been much more sensible for the ECB to provide for governments. So it is impossible to separate monetary and regulatory policy. Because it is the provision of liquidity by the ECB, which determines whether commercial banks will survive.
What is to be Done?
Any honest assessment of prospects for Europe has to be relatively pessimistic because the whole framework of allowing central banks to run the economy is deeply flawed. Even worse, the Treaty structure of the EU means that it is exceptionally difficult to bring about change. But that is no excuse for not coming up with proposals for what should be done.
1. There should be genuine European supervision of all the major banks which are systemically important. Some of them are probably insolvent and should either be wound up or recapitalised. Because this is being done to ensure the integrity of the European-wide finance system, most of the cost of this will have to be borne at a European level. The Spanish banks may be the ones in debt; but the northern European banks that lent to them are at least as much at fault.
2. End the fake divide between monetary and fiscal policy. For all its faults, democracy seems more likely than technocracy to punish mistakes, so governments not central banks should be responsible for making key economic decisions. Central banks have the privileged uncontrolled status today that the German army had in Wilhelmine Germany and we all know what that led to.
3. In the short term, monetise a large part of the government debt as a necessary step towards giving the macroeconomic easing needed if the necessary ruthlessness of the sorting out of the banking industry is to go ahead.
It’s hard to see this programme winning support. That doesn’t mean it is wrong. Europe is drifting in semistagnation. It doesn’t have to. There is a brilliant scene in Some Like it Hot where Marilyn Monroe is caught swigging from a hip flask in Prohibition-era America: “I can give up drinking any time I want to. I just don’t want to.”
Europeans can give up allowing their economies to drift any time they want to. They just don’t want to.
† No, it was Spiderman.
David Blake is a financial analyst and commentator.