BIS: limits to what central banks can do

A Bloomberg article reports that the Bank for International Settlements said

Central banks in developed nations are confronting the limits of their ability to aid economic recovery as government efforts to strengthen their finances fall short... 

“Central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed,” the Basel, Switzerland-based BIS said in its annual report, published today. “Both conventionally and unconventionally accommodative monetary policies are palliatives and have their limits.”

Please re-read the highlighted text as this is exactly what your humble blogger has been saying about all the policies implemented under the Japanese model for handling a bank solvency led financial crisis.

This policies are all palliatives designed to buy time as the policymakers pray for a miracle.

While central banks’ actions were key to limiting damage from the collapse of Lehman Brothers Holdings Inc., interest rates are now “as low as they can go” and debt purchases have swollen central bank balance sheets, the BIS said....

Actually, beyond extending liquidity, the evidence suggests that conventional and unconventional central bank actions like zero interest rate policies have made the situation far worse.

For example, Walter Bagehot, who wrote the book on modern central banking in the 1870s, said that interest rates needed to be at least 2%.

For example, economist Anna Schwartz, who co-authored with Milton Friedman the book on monetary policy, said that the Fed had not learned the lessons of the Great Depression and was following the wrong policies.

“In the middle of all this we find the overburdened central banks, pushed to use what power they have to contain the damage,” Stephen Cecchetti, BIS economic adviser, said on a conference call. “There are very clear limits to what central banks can do. It’s critical for the health of the global economy to break the vicious cycles and reduce the pressure on central banks.”

Regular readers know that in a modern banking system it is bank book capital that is suppose to protect the real economy by absorbing the damage from the losses on the excesses in the financial system.

Banks can do this because of the combination of deposit guarantees and access to central bank funding.  With these in place, a bank with negative book capital levels can continue to operate and support the real economy.  Over time, it can rebuild it book capital levels through retention of 100% of pre-banker bonus earnings.

The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities. It said extraordinary measures have reduced incentives for politicians and other borrowers to repair balance sheets, and created the illusion that central banks can do much more to stoke growth and redress imbalances. 

Central bank policy “buys time” in the short term for banks and governments to tackle debt overhangs, the BIS said....

This only works if the governments adopt the Swedish model with ultra transparency.

Under the Swedish model, the banks are required to recognize all of their losses today.  Subsequently, they rebuild their book capital levels.

With ultra transparency, market participants can confirm that all the losses have been recognized and exert discipline to constrain risk-taking by the banks while they are rebuilding their book capital levels.

So long as the governments continue to implement the Japanese model and protect bank book capital levels, then all the time that is purchased at great cost by the central bank is used for is to pray for a miracle.