Financial Stability for Central Banks (Part I)
How can central banks be made more accountable?
October 27, 2009
This financial crisis has unmasked some of the most serious policy blunders by central banks since the 1930s.
While the so-called sub-prime crisis and the severe global recession it spawned have many culprits, none has been more derelict in carrying out their responsibilities than the custodians of the financial system.
In the case of the U.S. Federal Reserve — the most powerful central bank in the world — it was even worse.
The Fed allowed the bedrock of monetary policy discipline to be supplanted by the ideology of self-regulation — the very last thing that increasingly complex financial markets and asset-dependent economies needed. Any post-crisis fix must address this glaring fault head on.
In my view, the best step forward would be to add a "financial stability" provision to the policy mandates of central banks. That one initiative will go a long way in avoiding this type of problem in the future.
Notwithstanding a predictable outbreak of post-crisis remorse, central banks cannot be relied upon to break bad habits on their own. With the U.S. Fed clearly in the lead of condoning and nurturing the Era of Excess, experience suggests that they have a hard time saying "no" to the siren song of the latest untested theory that is invariably concocted to explain away asset and credit bubbles.
This temptation can only be avoided by a financial stability mandate that is hardwired into the legal obligation between central banks and the body politic.
While other central banks have reason to be more cautious, no institution has as much re-thinking to do as the Fed. Despite its so-called political independence, the Fed has had a long history of going with the flow — and doing so at great peril to the system in whose stewardship it has been entrusted.
The U.S. Congress has intervened on several occasions to refocus America's monetary authority, and now needs to do so again.
For example, Fed policy blunders are widely viewed as central to the Great Depression. In response, the Employment Act of 1946 was enacted. It required the Fed to aim its policy arsenal toward avoiding a repetition of the massive unemployment that occurred in the 1930s.
Then came the double-digit inflation of the 1970s — another outgrowth of poor monetary policy — and the U.S. Congress passed the Humphrey-Hawkins Act of 1978, which added price stability to the Fed's mandate. Now, after a decade of asset bubbles and related savings and current-account imbalances, the Congress needs to step in again — this time adding "financial stability" to the Fed's existing dual mandate.
How would this work? Like full employment and price stability, the concept of financial stability is very much open to interpretation. One thing it should not entail would be setting price targets for key asset markets.
Instead, financial stability criteria should reflect a combination of quantitative asset valuation metrics and an assessment of asset-related linkages to the real economy.
There were little doubts of an equity bubble in the late 1990s, or more recently of a confluence of property and credit bubbles. Nor were there any doubts that such bubbles had important spillover effects into the real side of the U.S. economy.
Should such situations arise in the future, as they undoubtedly will, a financial stability mandate would require the central bank to "lean against the wind" — in effect, setting its policy rate higher than price stability and/or full employment mandates might otherwise require. In such frothy climates, the monetary authority would also be required to exercise greater regulatory discipline to manage capital adequacy of financial institutions and leverage of return-seeking borrowers.
Central bankers typically object to this approach — arguing that the policy interest rate is too blunt an instrument to deal with asset bubbles. These objections are unfounded.
The point is not to prick every bubble that arises, but to intervene when excesses in asset markets give rise to dangerous distortions to the real side of asset-dependent economies.
And that, of course, was precisely the case in the period leading up to the sub-prime crisis, when bubble-dependent U.S. consumption and homebuilding activity ended up surging to nearly 80% of total GDP. In such instances, using the blunt instruments of monetary policy to arrest the excesses of bubble-prone economies is both appropriate and desirable.
Yes, such pre-emptive moves could well entail a "growth sacrifice" — an economy that would grow slower than a more free-wheeling approach might otherwise suggest. But the growth that is being sacrificed was artificial from the start.
Moreover, if handled correctively — namely, early enough — such a sacrifice need not entail a recession. The resulting growth shortfall would be far preferable to the severe downside of wrenching post-bubble adjustments in financial markets and asset-dependent economies such as those that are now playing out.
Editor's Note: This feature is adapted with the permission of the author from his essay entitled “The Financial Stability Imperative for Central Banks,” published on October 22, 2009.
Read Part II here.
The U.S. Congress needs to step in again — this time adding "financial stability" to the Fed's existing dual mandate.
Adding a "financial stability" provision to the policy mandates of central banks will go a long way in avoiding global financial crises in the future.
Despite its so-called political independence, the Fed has had a long history of going with the flow — and doing so at great peril to the system in whose stewardship it has been entrusted.
Stephen S. Roach
Former Non-Executive Chairman of Morgan Stanley Asia Stephen S. Roach is a senior fellow at the Jackson Institute for Global Affairs, Yale University, and a member of the Yale School of Management faculty. He was previously the Non-Executive Chairman of Morgan Stanley Asia (a position he held after serving as managing director and chief economist […]
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