«I think the Fed is pushing the limits of its mandate as far as it can», says William White.
Mr. White, the big central banks seem like a committee to rescue the world.
Central banks have become trapped in a political process – or rather in a political non-process. They first took some very unusual measures in 2007 and 2008, when the interbank market collapsed and Lehman went under. The point was: They did extraordinary things for purposes of financial stability, which is one of their traditional big roles. And they were very effective in doing that.
So the rescue mission has been successful?
Over time and most particularly in the United States with the Fed, the objective of the exercise changed. It became not so much financial stability any more but pursuing an increase in aggregate demand in the face of all of the economic headwinds. And they have continued to do this over the last number of years. The difficulty that I see with this: I don’t think it will work and it certainly has not restored normalcy to economic growth. But I think it has got a lot of side effects.
How did the central banks become trapped?
According to a charitable view, they do this because monetary policy is the only game in town. They are buying time for the governments to do the things that only governments can do. For example, it would be their job to confront the huge debt burdens. The way out is to write off the bad debt and recapitalise the banks where required – the Nordic way from the early 1990-ies as opposed do the Japanese way. But the Politicians basically have refused to face up to the measures they could take to restore strong and stable growth.
How could central banks get free?
Central Bankers recognise that they are in a place where they don’t want to be. But they don’t see how to get out of it. They are trapped. That is the charitable view. The uncharitable view is that they actually do believe these ultra-easy monetary policies will restore strong and stable growth, and that these policies are not having any significant side effects.
The Fed only follows its mandate, which is to try to achieve full employment.
The unemployment rate is now 5,5%, which is not far off what most people would consider to be full employment. In earlier decades, when employment was this low, people would have been worrying very much about prospective inflationary pressures. I think the Fed is pushing the limits of its mandate as far as it can.
Consumer price inflation is low.
Again, to be charitable: They have a dual mandate, and while the unemployment rate looks more or less normal, the inflation rate is indeed well below where they would like it to be, which is somewhere closer to 2%. The Fed is constrained by a mandate given to it by its democratic overseers. It is similar with the European Central Bank. In both cases, the central banks can justify their measures with their mandate.
Is the mandate of the Fed appropriate?
Indeed the question arises: Is it time to take a broader analytical perspective? The Fed seems to be reasonably successful. But the very low interest rates and the decline of the Dollar up until last June had consequences in emerging market countries: lower interest rates, credit excesses, imbalances.
The Fed is totally preoccupied with national developments, but has this huge impact elsewhere, that will in the end feed back on the US economy. It’s just much more complex than the legislators thought it was when they gave the Fed and the ECB their mandates.
Is the mandate overloaded?
No. Actually, I would go in the opposite direction. Up until the crisis began, the problem was that central banks were far too focused on price stability. This was fundamentally rooted in the belief that it’s demand shocks that you have to worry about. What is missing from the analysis in any fundamental way is the incorporation of supply side shocks.
What is the current problem with supply side shocks?
In the run up to the crisis of 2007, the global economy was confronted with very strong positive supply side shocks from Asia. There came a lot of countries back into the world trading system. This additional supply was trying to drag prices down.
The Fed mostly – and everybody else sort of went along with it – failed to see the importance of this supply side shock. As prices were trying to head down, central banks significantly eased monetary policy. Ben Bernanke wanted to prevent deflation.
What is wrong with trying to prevent deflation?
I would contend, as indeed Hayek contended in the 1920-ies, that it was the attempt to resist a good deflation that led to the monetary and credit excesses, that ultimately culminated in the crisis.
This preoccupation with price stability, this analytical failure to incorporate supply side shocks, really led the central banks to turn a good deflation – caused by additional supply – into a bad deflation, with very high levels of debt. There has been an accumulated increase of debt levels, cycle after cycle, until we find ourselves where we are.
Should central banks look at price levels in asset markets and bubbly behaviour in financial markets?
Clearly, they should. But I wouldn’t focus so much on the prices. I think the underlying reality – and you really get down to the fundamentals here – is that we have a fiat money system. Banks create money simply by buying assets or making a loan and writing up both sides of their balance sheet. That’s where it all comes from. We like that because that’s grease to the wheels of commerce.
What’s wrong with a fiat money system?
As has been evident throughout history, this has always been a system that can very easily get carried away. And it was carried away in many instances, and is again carried away now. We ought to look at the basic monetary system, the character of money and credit creation.
Which signs should central banks look out for?
For the symptoms of there being excesses – the boom bust syndrome. The symptoms would certainly include asset prices, but that wouldn’t be the only thing. In all the English speaking countries in the lead up to the crisis, we were witnessing a collapse of savings rates, particularly household savings rates.
This was a symptom of the underlying problem of excessively easy access to credit, leading people to spend spend spend, as opposed to save save save. In China, because of the different character of the financial system, the very easy credit conditions showed up not as consumption, but as investment. Somebody should have looked at all this and said: Gentlemen, I think we are on a bad path here. But nobody did.
Why were central banks focused just on price stability?
After the big inflation in the 1970-ies, there was a sense that price stability was necessary for macroeconomic stability. And then somehow – in the realm of psychology, not in the realm of economics – it morphed into «price stability is not just necessary but sufficient for macroeconomic stability».
Up until 2007, there was a confluence of two unfortunate things: Firstly this theory that price stability was sufficient, and secondly we went through the period of the great moderation. Put these two together and the central banks were of the view that everything was just fine. But it wasn’t. When we will arrive at a new normal, whatever that means, I think that central banks will pay much more attention to things like credit, asset prices, imbalances. This has now almost become conventional wisdom.
If you could design your perfect central bank, what mandate would you give it?
Central banks should be concerned about price stability and financial stability. This would politically be reasonably easy to sell. The difficulty is that even the combination of the two does not guarantee economic stability.
Prices can be stable and the financial system healthy, but there can be huge debt burdens, as in the corporate sector in Japan in den 1980-ies or in the household sector in the US leading up to the financial crisis. Because of the debt burden, there will be headwinds for economic growth for ages and ages.
In addition to price stability and financial stability, should central banks try to provide full employment?
Then the mandate would be that central banks should do what they think is necessary to ensure strong and sustainable growth. The difficulty with that kind of approach is that you would have to give the central banks an enormous amount of discretion. The reality probably is that they need that discretion.
Central banks have been criticised lately. Who should they be accountable to, and how should their independence be organised?
There may be a bit of an illusion about this in Europe, particularly with the ECB. The word independence has been used loosely and wrongly for a long period of time.
In any democratic society, a central bank must ultimately be accountable to democratically elected people. And central banks know that. They are cognisant of the fact that they are not elected. And they are just wielding enormous power. They are not out seeking this power, and it bothers them that they have been put in this situation.
Independence is considered to be key for monetary policy.
It is better to break independence down into three things. Firstly, the mandate should come from the government. Secondly, in the 1980-ies and the 1990-ies central banks were given what I would call instrument independence.
This is the power to move the instruments under their control independently of short term political processes. Thirdly, if you have the mandate and the powers, you can be judged about whether you met your mandate or not – you are made accountable. All of this was done in a democratic context.
Is there no trade-off between independence and accountability?
Going forward, if central banks should have a mandate which is defined more widely than just simple price stability, then we are obviously in a very different world. If they also pursue financial stability, problem number one is that there are an awful lot of other people in the financial stability business. There has to be a much closer relationship between these various arms of government. And you have to confront some interesting questions about who does what.
Recently there has been a tendency to fold more tasks into the central bank. Is this a good trend?
The irony is that the central banks contributed materially to the character of the current crisis, because they had an inadequate analytical framework. So it’s jolly strange to give these guys even more authority.
The fact of the matter is: In the land of the blind, the one-eyed man is king. That is the way you have to look at it. The central banks are used to dealing with many interactive equations, looking at the system as a whole. They are more inclined than others to really understand relationships and unexpected consequences.
Should the central bank be at center stage?
There are various ways in which cooperation could occur. In Britain, the financial policy committee and the monetary policy committee are both now at the Bank of England. A more common model in other places is to set up a committee of the major groups.
In the US it is chaired by the treasury and includes the Fed, the FDIC, the SEC, and so on. There is no convergence on a model where the central bank is really at the centre, and I think it’s probably better that way. Again, you have to be concerned about the magnitude of the powers that central banks have got, and how are they are to be held accountable.
How exactly do you ensure accountability?
I don’t know. People are in the process of trying to think their way through. It is interesting in the UK, where apparently parliament has now taken a much closer look at the analytical frameworks being used by the Bank of England and the processes that they go through, in order to ensure that they have done the best job that they can. So parliament in the UK has become directly involved with the internal workings of the bank.
Does it make sense to have parliamentary hearings, or to publish the minutes of the central banks decision making process?
As part of their accountability they should be responsible to tell people the reasoning behind what has been done. Then people can either accept this as reasonable or they can reject it, in which case I presume that the parliamentary or democratic process would have to go back to the central bank, and say the governor is fired, or his term will not be extended.
Is there a role model for the institutional setup of a central bank and its decision process? Is there a gold standard of central banking?
No, there’s not. The fundamental problem is the question of the underlying analytical framework. Keynes said: «The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.»
The difficulty at the moment is, that there is absolutely no agreement amongst the central banks on the fundamentals of what they should be looking at.
So there is no template at all?
One could ask: Is monetary policy a science? There are just so many different aspects, from the choice of the exchange rate regime to the analytical framework and the mandate. The list of things that have to be decided to contribute to good monetary policy is hugely long.
In addition, there is also a philosophical framework, to which economic theory can’t tell anything at all. How much emphasis do you put on simple prior beliefs, as opposed to evidence from history and history of economic thought. How capable are you to change your views.
Can views easily be changed?
Some central banks are more adaptable than others. For example the Bank of Canada in the middle of the 1970ies did nothing else than say «I’m terribly sorry, it seemed a good idea at the time». Other central banks like the Fed say «we know the truth, nothing changes».
How do central banks decide on how to conduct monetary policy?
With respect to every one of these aspects, central banks have fashions that they think are appropriate. And sooner or later they realise what is not appropriate. Is there a core of monetary policy science? No. It’s constantly changing. And we tend to go round and round.
Could a best practice eventually evolve?
There is absolutely no agreement on the best way to set these things up. In general, I think that for a lot of policies there is no right answer, but there are packages that work. You can have very different packages of policies in different countries, and they can all work equally well. What you can’t do is to take one bit of a package and say: That works here so it will work there.
What would help to improve monetary policy?
I’ve become more and more convinced that the fundamental problem with the central banks – and for that matter with the broader economic community – is this insistence that the economy is a kind of machine that you can describe with many equations.
The reality is, that the economy is a complex adaptive system. Like a forest. The distinction between the monetarists and the Keynesians is nothing compared to this. The difference between all of these models and the kind of insights that you get from working with economies as complex adaptive systems are totally different. That is not yet accepted.
How does a complex adaptive system function?
If you accept this complexity, then you have to accept a number of things that most central banks have not yet fully incorporated into their thinking. One of them is: these systems break down all the time. If the economy is the most complex adaptive system that mankind has ever created, it will break down on a regular basis.
Historically it has broken down on a regular basis. And, like the boy scouts, we should be prepared for it. Fact of the matter is, when we went into this crisis, we were not prepared for it. And it’s not much better now. There was no bank insolvency regime, no deposit insurance, no memorandum of understanding – all these things that should have been in place, but they just weren’t.
The basic philosophy of central banks still seems to be: We can control the system with our levers.
Absolutely. And this is what Hayek once called the fatal deceit: Believing that you understand how the system works and that you can control it. That’s the first thing. At the moment, this is practiced in a false way, as the crisis has shown.
The second thing about these complex systems is that when they break down, very infrequently but not never the results are catastrophic, a total collapse. Recognising that really bad things can happen, we should try to prevent these from happening. That leads you in the direction of taking steps for example to make sure that banks have got more capital. You need to identify the nodes where things really can go wrong and try to strengthen them. I don’t think we’ve done enough on that.
Where have we made progress in understanding the system?
In these systems, you don’t worry about the trigger. If it’s an accident waiting to happen, the trigger could be anything. You want to focus on the systemic instabilities. I think that this is something people are starting to make progress on. Having said that, when you look at Basel III for the systemically important institutions, all they’ve done is to add a capital overlay. This hardly strikes me as adequate.
What should we look out for with a view to the next crisis?
In complex adaptive systems, history never repeats but it rhymes. This means: Don’t look for the source of tomorrows problem by looking at the source of yesterdays problem. Nevertheless, in a sense you should do that, for example regarding credit. But the way the system will fall apart might be very different from where it fell apart the last time.
From 2007 there were problems with bank loans. What happens next time? I’m most worried about loans in Dollars to companies in emerging markets. As the Dollar appreciates, their debt increases in relation to their income in local currency. Anyway, it will be different the next time round. And complex systems are not linear, they are profoundly non linear. You can hit tipping points, like a phase shift.
Accepting that the economy is a complex adaptive system would mean being rather humble.
Absolutely. This is the first word that comes to your mind: Humility.
For now, we seem to be in a world where central banks say: we saved the financial system so we know how it all works.
The central bankers I know are more humble than that. They are doing what they are doing because they have to. They are just buying time.