Central bankers need to update their outdated analytical toolkit
Comment of the Day

October 21 2011

Commentary by David Fuller

Central bankers need to update their outdated analytical toolkit

My thanks to a reader for this interesting article (may require subscription registration, PDF also provided) by Gillian Tett for the Financial Times. Here is the opening:
Eight years ago, Claudio Borio, a senior economist at the Bank for International Settlements, co-authored a paper which warned that the world's financial system was spinning out of control, due to excess in the complex credit world. At the time, the paper was largely ignored, if not derided by many senior policymakers. But now it looks prescient; so much so, in fact, that Borio and his co-author, Bill White (who also used to work at the BIS), are some of the few economists who have emerged from the recent financial crisis with their reputations intact.

Given this, investors might do well to look at another paper that Borio has just produced. This looks not at securitisation - or issues such as collateralised debt obligations - but at the loftier question of central banks. While it remains to be seen whether this work is equally prescient, the conclusions are sobering.

He argues that the world's central banks are currently labouring with an almost impossible task: although the expectations of investors and politicians of these institutions are rising apace, central bankers themselves are at sea in this post-2007 land. Or, to use his metaphor, they are struggling to find any workable "compass" in these new, stormy waters.

The essential problem is that the crisis has tossed central banking into an intellectual limbo. Before 2007, their reputation appeared to be sky high, since central bankers appeared to have produced a Great Moderation of low inflation and growth (remember, those pieces lauding Alan Greenspan as the so-called "maestro"?). But these days, it is clear that many elements of that pre-2007 central bank intellectual model were flawed: central bankers were too obsessed with watching price stability, at the expense of monitoring financial stability; they overestimated the power of short-term interest rates in controlling the economy; and they thought - wrongly - they could shape monetary policy by watching national issues alone.

So far, so obvious. And Borio offers a sensible list of measures that might address these flaws: central banks need to adopt a wider sense of responsibility that combines an awareness of monetary trends and financial stability; they need to take an international, not national, view of the markets; they need better toolkits to monitor financial stability; they must take steps to protect themselves from political meddling. Last, but not least, he also thinks they need to wean themselves away from the idea that suppressing short term interest rates - via quantitative easing or anything else - will fix the current woes; while this might work during a normal business recession, it does not cure a balance sheet recession. Instead he - like many Japanese officials - argues that excessively cheap money tends merely to stave off the eventual adjustment, prolonging the woes. Call it a "time inconsistency" problem.

David Fuller's view Claudio Borio was certainly prescient eight years ago. He has identified the current problem faced by central bankers and offered some commonsense solutions - things that any international investor should also consider plus some Austrian School thinking.

The problem in our modern, fast paced, globalised, scrutinised world is that the individual who could deal successfully with today's myriad challenges as the central banker of a significant economy may not have been born yet. In other words, they are fated to ride the tiger, hoping to cling on, rather than lead it.

Consequently, the reputations of central bankers are more likely to be made (or broken) by events. Given the occasional luck of ideally benign conditions they can look like geniuses - Greenspan in his earlier years as Chairman of the US Federal Reserve. When the black swans arrive, let along a major credit and insolvency crisis, they look like the problem rather than the solution - Greenspan in his latter years at the Fed.

We need to remember that these rough economic periods are usually cyclical rather than secular.

Back to top