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Remove the punchbowl before the party gets rowdy

By John Plender Financial Times Published: January 19 2010 17:18 | Last updated: January 19 2010 17:18 No doubt the flak directed at all those private bankers who dont get it about bank bonuses is well deserved. Yet I cannot help thinking that the central bankers are escaping very lightly in the post-crisis dust up. For while incentive structures in banking exacerbated the credit bubble, they were a much less potent cause of trouble than central bank behaviour across the world. Despite the bizarre recent assertion by Ben Bernanke, chairman of the Federal Reserve, that the Fed was largely innocent in the matter of bubble creation, central banks clearly bear much responsibility for past excessive credit expansion. The Feds gradualist and transparent approach to raising rates in mid-decade also ensured that bankers were never shocked into a recognition that unprecedented shrinkage of bank equity was phenomenally dangerous. Despite the popular perception that financial innovation caused so much of the damage in the crisis, the rise in bank leverage was a far more important factor. The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targetting regardless of imbalances arising from easy credit and soaring asset prices a spectacular case of one-club golfing. This mindset led to the silly belief that bubbles could not be identified at the time and that it was better to clean up after the bust than to lean pre-emptively against the wind in the boom. Monetary policy was thus asymmetric. Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets. It is now blindingly obvious in the light of the deep global recession induced by the financial crisis that the consequences of this asymmetry are catastrophic. It cannot be allowed to continue. Yet nothing in the recent pronouncements of leading central bankers suggests much revisionism on the lean or clean debate, even if their faith in efficient markets has been dented. Their response to the crisis boils down to little change on interest rate management, greater regulatory capital and liquidity requirements, and a commitment to macro-prudential supervision. This mix of policy, while a notable retreat from one-club golfing, suffers from the single disadvantage that it will not work.

The macro-prudential approach addresses systemic risk, inter alia, through dynamic provisioning to counteract the pro-cyclicality of finance. Nobody could argue with the logic. And the joy of macro-prudential supervision from the central bankers point of view, says Sushil Wadhwani, a former member of the Bank of Englands monetary policy committee and a leading advocate of leaning against the wind, is that it allows them to claim that their conduct of monetary policy was beyond reproach, while the root of the problem was simply a lack of adequate policy instruments. But as with the tougher approach to overall capital requirements, it will reliably encourage more regulatory arbitrage and crank up the shadow banking system. Note, too, that in Spain, where dynamic provisioning operated through the past economic cycle, it failed to prevent a monumental boom and bust in property, followed by deep recession. There are tricky questions, too, about how it would meld with interest rate management, especially where dynamic provisioning is overseen by an independent regulator. Monetary policy would have to move in support. So the most that can be expected of anti-cyclical capital requirements is that they might help a bit, but they cannot be expected to solve the problem. At the risk of repetition, we need a return to the old-fashioned central bankerly wisdom of a previous Fed chairman, William McChesney Martin, who said that the job of the Fed was to take away the punchbowl just as the party gets going. In other words, raising rates. This takes guts, since it means tolerating some rise in unemployment now to avoid more unemployment later. It is also likely to anger politicians, posing a risk to central bank independence. Yet it is interesting that Ben Bernanke said in his speech on January 3 that if regulatory reforms prove insufficient to prevent dangerous build-ups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks proceeding cautiously and always keeping in mind the inherent difficulties of that approach. This throwaway line, with its breathtaking suggestion that the Fed had always been open to pre-emptive tightening, implies grudging readiness to take away the punchbowl while a few slops remain. Maybe it is time to bring more private sector bankers with a practical understanding of markets back into monetary policy. Poachers turned gamekeepers might teach the academic central bankers a bit of common sense. John Plender is an FT columnist

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