Some advice from an ex-central banker
Central banking has experienced a tremendous change in the last three decades. From “behind the scene” secretive rulers of the world (Plaza accord in 1985), to the period of great moderation, attributed to monetary policy, when central banking was called “boring” (until 2007), to the recent almost celebrity status of some central banks and governors.
Truth to be told some past ones are considered causes of economic troubles and some that are in office nowadays are looked to like modern day saviours, expected to pull the latest trick out of their sleeves to save the economy.
First, where does the criticism of central banking come from? At the end of 2011 (time of writing) the world economy is still in a deep financial, economic and structural crisis and more volatility lies ahead.
The economics profession is unable to clearly identify its causes, but various narratives float around, and some of them “blame” central banks for the mess we are in. Some see the causes of our problems in the neoliberal approach to economics and more specifically the so called light touch financial regulation often done by central banks, which was highly praised only a couple of years ago.
Some are more specific and point to the “Greenspan put” and loose monetary policy with low interest rates, especially after the 2002 dot.com bubble burst, which according to this narrative created the new, real estate bubbles starting in US, then spilling over to the rest of the world.
Others blame financial innovation and in particular derivatives (“weapons of mass destructions” as Warren Buffet called them). Some say it was greedy bankers and their skewed incentive/ bonus structure, which can be described as “heads I win, tails you lose” and regulators/central banks that did not stop them.
And of course there is an almost infinite variety of any linear combination of mentioned factors. The “inconvenient truth” for the economics profession is that: a) we do not know for sure what the causes of the crisis are and b) central banking is often mentioned as one of the causes of troubles. Others look at central banks as the last hope to save the world from a complete meltdown.
The aim of this note is not to judge on the past, nor to offer a clear look into the future. It is too early to make qualified judgments on the past, and rethinking the future of central banking will take a lot of collective effort of experts in this area. This note intends to give some advice from an ex central banker which might be useful during future challenges.
Be aware of cognitive biases. Groupthink and intellectual capture can be dangerous. The challenge is that it is necessary to follow developments in central banking, academic and practical ones. But one needs to think hard what novelties mean for a particular country. For example in the last twenty years inflation targeting (IT) for central banks was fashionable. It was viewed almost as a panacea for all central banks to deliver on their primary goal of price stability.
Yet, even the European Central Bank is using a two pillar approach, which means looking at assets. Another caveat is that pure IT is linked with floating exchange rate regime. In a lot of cases this may not be the optimal choice for a country.
Finally, with time and experience some views change. Several years ago the flavour of the day for IT was to target only core inflation, as opposed to headline inflation, which has a lot of “noise” in it.
Yet, recently, one of the most academic and influential former members of the ECB’s governing board (Mr. Bini Smaghi) stated that headline inflation may make more sense. The lesson I am trying to distil out of it is to use common sense and not just follow fashions or theories.
To quote Yogi Berra: “In theory there is no difference between theory and practice. In practice there is.”
After this crisis we will end up in a brave new world. Brave new world refers to the development of the new normal in financial standards, particularly fiscal ones. The still unfolding euro zone sovereign debt crisis is an excellent case in point.
Fiscal discipline and low public debt to GDP will be the main comparative advantages of emerging countries in the next decade. Look at Estonia. In the last decade (2001-2010) average public debt to GDP was 5.2 per cent. Estonia was recently admitted to the Euro zone. Benchmarks of what constitutes sound fiscal policy are changing.
The original Maastricht fiscal criteria were misinterpreted. The famous 3 per cent and 60 per cent were considered to be “average”, normal numbers and not upper limits.
Plus, this crisis has increased the level of public debts significantly in a lot of countries. So, degrees of freedom for the next round of a crisis, which will undoubtedly come, are very limited.
If this changes, ie if public debt will be decreased in the medium run, this may open more space for monetary policy as fiscal dominance in macro policy mix may decrease.
If anything can go wrong, it will. There is an old rule in central banking: Always take good news as temporary and bad news as permanent. The point here is not to be permabear, meaning you are permanently in a bearish mood. But one has always to take into account downside risks and make plans for the least possible events.
If we have learned anything in this crisis it is that tail events can happen and do happen. Look at the euro. Today we fully realise that at its launch more than ten years ago it was a half-baked product at best. In its design no sovereign defaults were envisioned and no exit from euro anticipated.
How realistic is this today? Again, the message is not to be pessimistic. But all policy makers have to think and have some contingency plans ready even for worst moments.
It can be very costly and dangerous to assume only optimistic scenarios. One is much better off if prepared for negative shocks.
Because of asymmetry of the payoff matrix, it is very relevant to have contingencies and be ready for materialisation of downside risks. That means having sufficient cushions in macroeconomic fundamentals for unexpected external (or internal) negative shocks and having contingency plans.
One should remember the old central banking wisdom: Central bankers are paid to worry.
If something looks too god to be true, it most probably is too good to be true. There are a lot of possible experiences to draw from, but I will mention the Irish economy and in particular its banks.
The Irish model of growth, the Celtic Dragon, was a showcase for many small economies, which looked up to Ireland and its speedy convergence growth (in the period between 1995 to 2007).
Until this crisis Ireland was a success story of what EU and euro membership can do for a small country to speed up its convergence. But it turned out to be a problem country that needed a bailout. One should remember that Ireland had low public debt and deficits until it had to rescue its banks.
During boom years, major banks grew very fast, were overexposed to real estate, financed themselves on the wholesale market so that loan to deposit ratios skyrocketed to 180 per cent. Today we are talking of billions of euros of recapitalisation, deleveraging of banks, skyrocketing of public debt, ie huge amounts are due to be paid by taxpayers (both Irish and EU ones). What is the lesson here?
Miracles do not happen. Real estate prices do not grow indefinitely. Bubbles burst. However, banks were considered too big to fail so the state had to underwrite their liabilities. But let us remember the old economic policy dictum: All problems that are now too big to fail started as too small to bother with.
Overexposure of Irish banks to real estate and the real estate bubble did not happen overnight. And who is to be blamed? According to one report “national mania” or “happy go lucky” attitude in Ireland (Nyberg report) are the culprits.
Some may blame Alan Greenspan and his dictum that central banks should not try to prick asset price bubbles as they are difficult to identify and there is not an adequate “needle” for this (ie monetary policy instrument).
It could have been intellectual capture, as mentioned already, that has prevented central banks and financial regulators from acting sooner, before the bubble burst and created incredible damage.
Which brings me to my next advice.
Be humble and modest about what you know about economics, but don’t forget the simple rules of a healthy lifestyle. We should be aware of the “pretence of knowledge” in Economics.
This is the title of the Nobel lecture of Friedrich von Hayek in 1974. Economies do not (always) function according to models. And in finance, it seems that economic agents were reading more the 1997 Nobel Prize Lecture (Sholes and Merton), than the mentioned Hayek one.
Economies are complex, non-linear, dynamic systems, to a large degree driven by human behaviour and not always predictable. We need to be humble when it comes to our understanding of economic phenomena. We did not master all the risks and we cannot predict all future events.
So are we helpless? My answer is no. Central bankers and policy makers in general can follow a “healthy lifestyle advice”: like prudent fiscal policy, sustainable debt, low inflation, take pre-emptive actions to correct growing macro and financial sector imbalances (including unorthodox measures) to minimise impact of unexpected negative shocks.
“Trust yourself”. Nobody knows your country better than you do at least should not if you are a professional.
That means read and follow what others are doing, be up to speed, but at the end think of your own problems and think what are the main lessons you have learned from all of this.
Prioritise, distinguish trees from the forest and find your own solutions. If this means going against the conventional wisdom (be it the IMF or academics) and you are confident you are right, do it.
For example, Croatian central bank introduced capital controls around 2005 against the IMF advice and has been subject to a lot of criticism from the banking community.
However today the bank is vindicated for its foresight. Capital controls are kosher again. But this requires a lot of professional work and self-confidence.
Finally, the last central banking wisdom: Governors earn their wages when models stop working. In the years to come the remuneration of the central banking community in general and governors in particular will be well deserved.