Thursday, December 13, 2012

Governor of Reserve Bank of Australia lays out limitations of what central banks can do

In a must read speech (hat tip Zero Hedge) on the challenges of central banking, Glenn Stevens, the governor of the Reserve Bank of Australia, laid out the limitations of what central banks can and cannot do.

  • Central banks can and did buy some time to address the problem of excess debt in the financial system that triggered our current financial crisis.

  • Central banks cannot fix the problem caused by this excess debt.

Mr. Stevens then noted that the policies adopted to buy time carry with them their own negative side-effects.

Regular readers know that your humble blogger has been saying that adopting the Japanese Model for handling a bank solvency led financial crisis and its related monetary and fiscal policies was and is a mistake.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  This puts the burden of the excess debt on the real economy and results in, at best, a Japan-style economic slump or, at worst, a depression like Greece is experiencing.

I say the ongoing pursuit of the Japanese Model is a mistake because our modern banking system is designed to support a different model for handling a bank solvency led financial crisis:  the Swedish Model.

Under the Swedish Model, the banks are required to recognize upfront all the losses that they would realize if the excess debt went through the long process of default and foreclosure.  Subsequently, banks retain 100% of their pre-banker bonus earnings to rebuild their book capital levels.

Banks absorbing the losses on the excess debt protects the real economy as it does not take capital out of the real economy that is being used for reinvestment and growth and divert it for debt service.

Why don't policy makers need to foam the runway so that banks can absorb the losses gradually over time?

Modern banks are designed to continue operating and supporting the real economy even when they have low or negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become the banks' silent equity partners.

Since the problem of excess debt in the financial system has not gone away since the beginning of the current financial crisis, the choice to continue pursuing the Japanese Model must be made every day by policy makers.

Since the problem of excess debt in the financial system has not gone away, the Swedish Model could still be adopted and the current financial crisis brought to an end.

That policy measures of any kind have their limitations is a theme with broader applications, especially for central banks. 
The central banks of major countries were certainly quite innovative in their responses to the unfolding crisis. Numerous programs to provide funding to private institutions, against vastly wider classes of collateral, were a key feature of the central bank response to the situation. 
In essence, when the private financial sector was suddenly under pressure to shrink its balance sheet, the central banks found themselves obliged to facilitate or slow the balance-sheet adjustment by changing the size of their own balance sheets. This is the appropriate response, as dictated by long traditions of central banking stretching back to Bagehot.
Your humble blogger has argued that the implementation of the central banks' policy response was and still is inappropriate.

Walter Bagehot, the father of modern central banking, said that in their lender of last resort role, central banks are suppose to lend freely against good collateral at high interest rates.

So yes, central bank balance sheets should have expanded.

However, central banks didn't always lend against good collateral and they didn't lend at high interest rates.
Conceptually, at least initially, these balance-sheet operations could be seen as distinct from the overall monetary policy stance of the central bank. But as the crisis has gone on such distinctions have inevitably become much less clear as ‘conventional’ monetary policy reached its limits.
Bottom line, central bank balance sheets increased from both their role as lender of last resort and also from the use of unconventional monetary policies like quantitative easing.
It was fortuitous for some, perhaps, that the zero-lower bound on nominal interest rates – modern parlance for what we learned about as the ‘liquidity trap’ – had gone from being a text book curiosum to a real world problem in Japan in the 1990s. 
Japan subsequently pioneered the use of ‘quantitative easing’ in the modern era. This provided some experiential base for other central banks when the recession that unfolded from late 2008 was so deep that there was insufficient scope to cut interest rates in response....
Japan demonstrated that quantitative easing doesn't solve the underlying problem of excess debt that occurs with a bank solvency led financial crisis.

Japan also demonstrated that there are limits to how much time central banks can buy to address the problem of excess debt.
For the major countries a further dimension to what is happening is the blurring of the distinction between monetary and fiscal policy. 
Granted, central banks are not directly purchasing government debt at issue. But the size of secondary market purchases, and the share of the debt stock held by some central banks, are sufficiently large that it can only be concluded that central bank purchases are materially alleviating the market constraint on government borrowing....
Having adopted policies to distort the price of government debt in the hope of stimulating demand, central banks have become the market for government debt.
The problem will be the exit from these policies, and the restoration of the distinction between fiscal and monetary policy with the appropriate disciplines. 
The problem isn't a technical one: the central banks will be able to design appropriate technical modalities for reversing quantitative easing when needed.
Who is going to buy all this government debt?
The real issue is more likely to be that ending a lengthy period of guaranteed cheap funding for governments may prove politically difficult. There is history to suggest so. It is no surprise that some worry that we are heading some way back towards the world of the 1920s to 1960s where central banks were ‘captured’ by the Government of the day. 
Most fundamentally, the question is whether people are fully understanding of the limits to central banks' abilities. 
It is, to repeat, not to be critical of actions to date to wonder whether private market participants, and perhaps more importantly governments, recognise what central banks cannot do. 
Central banks can provide liquidity to shore up financial stability and they can buy time for borrowers to adjust. 
But they cannot, in the end, put government finances on a sustainable course and they cannot create the real resources that need to be found from somewhere to strengthen bank capital. They cannot costlessly correct earlier misallocation of real capital investment. They cannot shield people from the implications of having mis-assessed their own life-time budget constraints and as a result having consumed too much. They cannot combat the effects of population aging or drive the innovation that raises productivity and creates new markets. Nor can they, or should they, put themselves in the position of deciding what real resource transfers should take place between countries in a currency union. 
Please re-read the highlighted text as Mr. Stevens summarizes why the Swedish Model needs to be adopted.

As shown most recently by Iceland and previously by the US in the Great Depression, under the Swedish Model,

  • Bank book capital levels are rebuilt through retained earnings and equity sales after all the losses on the excess debt have been realized.  While this is occurring, taxpayers act as the banks' silent equity partners.
  • People are protected to the extent that their debts are written down to what they can afford.  This process does not create equity for the borrowers.  Rather, it attempts to keep families in their homes (after all, who is going to buy and live in all these homes if they go through foreclosure).
  • The real economy continues to produce the innovations that raise productivity and create new markets.  It can do this because the capital it needs for reinvestment, R&D and growth is not diverted to cover the debt service on the excess debt in the financial system.
  • Retirement saving plans can continue without the negative impact of central banks pursuing monetary policies like zero interest rates and quantitative easing.

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