The fall and rise of central banking

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Romesh Vaitilingam interviews Howard Davies for Vox

June 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5204]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Howard Davies, director of the London School of Economics. Howard and I met in June 2010 at his office in London, where we spoke about his new book, co authored with David Green. It's called "Banking on the Future: The Fall and Rise of Central Banking." And I began by asking Howard to what degree he felt that central banks were responsible for the financial crisis.

Howard Davies: Well, I think they have to take their share of the responsibility. This complex crisis has many fathers, but I do think that if it were a car crash and we were ascribing percentage blame, we would have to ascribe some percentage to central banks. In the book we do, I think, accept the force of the argument that the Fed, in particular, pushed interest rates down to cope with the dot com boom and bust and 9/11. And that was a successful exercise at the time, but that rates were held down for too long and the tightening phase was a bit too late. But more generally, I think that the case for saying that central banks said that they were interested in financial stability but didn't do a great deal about it is the strongest case, I think, rather than arguing about the technical, when the tightening could have occurred, et cetera.

And it's pretty clear that the central banks all did say, "Yes, we're responsible for financial stability." And what they did was right about it. And we point out that there was a great increase in the numbers of financial stability reviews which were published, but with no consequences whatsoever. Those reviews didn't change market behavior, they never influenced prices, and they didn't seem to influence central bank behavior either.

So I think the strongest charge, if you like, against central banks is that they did not invest in intellectual capital to understand the changes in transmission mechanisms, the changes in mechanisms of credit creation, and the threats to financial stability, and did not respond to that.

There's a big argument about how effective an interest rate response is, whether the interest rate response is the only one. We tend to think that central banks do need another weapon, the macro prudential mechanism, if we could talk a bit in that sort of shorthand. But it's quite interesting that although central banks are frightfully enthusiastic about that now, they never mentioned it before. Although, actually, the term has been in existence for about 30 years. It was originally invented in the 1970s, in the Bank of England, we understand.

So I think there is quite a strong case for saying that central banks could have done more before the crisis. They could have argued that capital requirements should be tightened. Only one or two of them, the Spaniards perhaps, chose to do that. And I think, also, in most places, a bit of preemptive tightening would have made some difference.

So, yes, we think that there is a case. It's not the only case. There are clearly regulatory failures. There are kinds of failures in financial firms themselves. But there is the germ of an argument about central banks, and I think, increasingly, that is accepted by many of the central banks themselves.

Romesh: How much of it do you think is a problem of the separation between monetary policy and financial regulation in a number of financial systems around the world? You, personally, were involved in the separation in this country. I wonder if you had misgivings about that separation at the time...

Howard: No, I don't think that it was really that at all. In fact, if you look at the relationship in this crisis between regulatory structure and, as it were, relative success or failure, then, frankly, it's impossible to identify any correlation at all. Which I don't find is particularly great news, from my point of view, because I was rather in favor of a simple regulator thing and I would have hoped it would have worked better. But what I certainly don't think you can do is identify that central banks, in order to be effective in their financial stability function, need to be hands on line supervisors. Take the Fed, for example, which is a hands on line supervisor of some institutions. And frankly, you cannot say that the Fed performed better, let's say, well, than the Bank of England, frankly, because of having hands on supervision. I mean, there's no argument whatsoever.

If you look at the countries that appear to have done relatively well, you can perhaps point to Spain, at least in the build up to the crisis and at least in relation to their commercial banks. The cajas are a different issue and perhaps haven't been grasped as early as needed. But they did have this dynamic provisioning, which only worked to a certain point, actually, but it was a recognition of the problem.

But the other countries which did well, the Canadians, for example, who managed to avoid contagion from the United States, which was quite an impressive performance the central bank in Canada has never been a banking supervisor. In Australia, similarly a good performer in this crisis, the central bank lost banking supervision to the prudential regulator at almost exactly the same time as the FSA was created here.

So, frankly, you cannot see a relationship. We don't think that central banks, in order to perform this key financial stability function, focusing on credit bubbles, et cetera, need to be individual line supervisors. They do, however, need some purchase on macro prudential tools, if you like, and some purchase on the overall level of capital requirements in banks.

But let's not forget: they've always had that, through the Basel Committee. They are all members of the Basel Committee. The Bank of England is not a line supervisor here. But what's crucial in the crisis, what is now increasingly understood on the regulatory side, what was the problem is there was too little capital, too little capital in the trading book, and the quality of capital wasn't high enough. I think those points, pretty much, are generally agreed. Who decides that? The Basel Committee. Who's on the Basel Committee? The Bank of England, amongst others. So the bank has been involved in the key bit, which is the policy.

Romesh: What about this leaning versus cleaning debate? The consensus before the crisis was that you wait to clean and you can't see a bubble in advance. Is the consensus shifting now? Are we going to be leaning in the future?

Howard: Consensus, I don't know. We're certainly leaners, because we think that the cost of the cleanup has been so massive that surely it must be possible to do better than we've done. I think, until this crisis, it was possible to say, along with Alan Greenspan, "Look. Forecasting, bubbles. You might get it right. You might get it wrong. You might damage growth by tightening too soon. And therefore, let's just ride the cycle, and then, when we need to respond, we'll respond effectively and decisively and aggressively, and we will prevent the deflation of the bubble having too many consequences on the real economy." Well, it's clear that they couldn't do that. The cost of lost output is massive. So, clearly, you've got to look again at that trade off. And I think there are, although not everybody, but increasingly, people in central banks are saying, "Well, there are clearly risks on both sides of this, but surely taking out a bit of an insurance policy on occasion against a credit bubble and an asset price bubble and the real nasty consequences of a deflation may be worth doing."

So I think there's a re-centering. But frankly we've still seen, not that long ago, a speech from Bernanke, which appeared to be quite unrepentant actually, and not at all persuaded of the argument. So I think that there's still a big debate to be had. Of course, at the moment, it's all a little bit theoretical because we're not quite there. We're still struggling to get the economy off its back. But I think this debate should continue further. And there are some people, like Bill White and Stephen Cecchetti and others, who are strongly arguing this case, and I think they need to carry on doing so because there's still quite a few in central banks who just still haven't got the message.

Romesh: Can we talk a little bit about how different central banks responded to the crisis, the different policies they used, how effective they were, how quickly they acted, where you had the Fed doing its credit easing, you had the Bank of England doing quantitative easing, you have the ECB with their enhanced credit support. How do you see these different approaches?

Howard: Well, if you look at the response, it appears that the ECB were quite prompt actually. They were pretty quickly in with a big liquidity support operation, beginning in early August of 2007. And I think it took a while for the Bank of England to appreciate what was needed on the liquidity front. So I think if you'd been talking a snapshot in the autumn of 2007, you'd have said the ECB kind of grasped the problem earlier than the Bank of England. The Fed also saw it coming and operated primarily through banging interest rates down, which is the kind of traditional Fed response. And it took a while for them to see that actually that wasn't going to be the solution and that other interventions were needed. As for the differences between these interventions and the relative success of them, I think the prudent man's answer is that it's far too early to say, because it will be a fascinating thing for economists to explore in the future, I believe, whether there was that much difference.

I mean, my feeling at the moment is probably that these are three different ways of skinning the cat, but the outcome is relatively similar at the moment. You know that they have operated somewhat differently. But they have eased credit conditions and they have eased liquidity conditions, and probably the endpoint is not that different.

And some of the reasons for the different approaches, I guess, are to do frankly there's a different situation of a federal central bank without a treasury behind it in the Euro zone, and the Bank of England here and the Fed in the US which has. And the ECB I think finds itself much more constrained about the way in the way it can manage credit markets, if you like.

Romesh: Well can we talk a little bit more about that because you have a chapter specifically on Europe and the challenges for s central bank operating in a currency area that takes in a number of countries. I mean there are a number of issues hat have come up recently with their interventions during the European sovereign debt crisis, if you like. I'm interested in your reflections on how the ECB has approached the crisis, and right into the recent days.

Howard: Well, we point out in the chapter that the ECB and, you know, the monetary unit is unfinished business. And we take that phrase, in fact, from a speech by Commissioner Almunia, who was then the Monetary Commissioner. It's something he may slightly regret, because he said when the euro was 10, at their 10th birthday conference, "The euro is still unfinished business." And gosh, we've seen that in spades. And we do point out in the chapter although I can't say we forecast the Greek crisis in quite this form, but we do point out that it is a very unusual construction, and that the supportive mechanisms that you would need to make this durable have not been put in place. And we point to the fact that the stability and growth pact had fallen into disuse by 2003 when it was the French and Germans who couldn't meet the criteria. And that without that, there is a great vulnerability in the system.

This a point that Otmar Issing has made many times, that this is a big gap in the system.

Secondly, I think there's a gap in the form of, you might call European Monetary Fund as people are now talking about it. Well we've now put one in place, but it's a three year, limited life, special purpose vehicle. Can you imagine that being wound up? I don't think so. So I think we no have the germs of an EMF, if you like, in Europe. We're still trying to reconstruct a fiscal policy.

So I think, in those two areas, I think it's pretty clear that even if we get over this current crisis there still needs to be a fiscal policy that's much, much more tightly controlled at the center, and there will need to be a support mechanism in the form of some kind of European Monetary Fund.

The other thing that we draw attention to, which I think has now become quite serious, is the peculiar voting structure of the ECB. If you look at the ratio between central decision makers and regional decision makers and compare the Fed and the old Bundesbank and the ECB, you notice a very remarkable difference. In the Fed, there are 12 decision makers on the FOMC. Seven Federal Reserve Board people appointed to take a pan US view, the New York Fed president, who has a permanent vote, and then four of the other 11 who vote on a rotation basis. So the ratio of central to regional votes is one to 0.7.

Under the old Bundesbank, there were the Bundesbank presidium, the directorium, and then there was the Landesbanken. And the ratio was one central to 1.1 regional. So pretty much balancing. In theory the regions could have outvoted, collectively, the center, but the idea that the regions would all vote together is not quite plausible.

The ECB is one central vote to 2.5 regional votes. And although they have agreed a rotation mechanism for new members. So if Estonia and Lithuania and people join, they won't always have a vote. Nonetheless, the rotation they've agreed to does not alter his one to 2.5 balance.

Now, up to now you may argue this is a sort of theoretical thing. There have been some interesting academic papers which we quote in the book which have drawn attention to this misrepresentation if you like. But now it's real. Because we know there's been a majority vote. And we know that Axel Weber voted against buying Greek bonds and that has thrown the whole thing open. So every time Trichet stands up now after a meeting people are going to say "What was the vote?" and so the genie is out of the bottle here.

And if you then look at that and say "Well, what could happen?" It's perfectly possible in the EDB that the whole of the six member Directorate of the ECB, plus France and Germany, could be easily outvoted by a combination of Malta, Cyprus, Greece, Portugal, Italy, Spain, et cetera. And I think that's a rather dangerous thing. Now I'm not saying that there is some nascent conspiracy here, but it would be really peculiar. And other federal systems have thought about that. And even in a place like the U.S. where states' rights and everything have been very strong in the U.S. Constitution, they devised a Fed which specifically rules that possibility out.

And I think this is a fundamental flaw in the ECB and does raise the possibility that you could have monetary policy decisions being made by a series of small countries on the periphery of Europe which were unsuitable for the central and dominant economic mass of the Eurozone. And I think that's risky, and I think as the market focuses on that people are going to start to get worried about it. Because they're going to say "Well, what is our guarantee against a resurgence of inflation? How reassured can we be by saying, well, the ECB is the Bundesbank writ large?" Well it actually is not, And the voting system makes it absolutely clear that it isn't. And I think that needs to be reformed.

Romesh: That's an issue we should probably come back to on another occasion. Well let's move on to another part of the book, I'd like to if we may Howard, and talk about a chapter which I found particularly fascinating, and something not talked about that much, which is about the efficiency of central banks, how cost effective they are. And there are some extraordinary differences.

Howard: You know if you have a licence to print money then on the whole your incentive to be efficient is perhaps a little bit lesser. And the differences in numbers of central bankers by population is astonishing around the world. And particularly even within the Euro zone. There are just masses more central bankers. Now it might seem sort of slightly counter intuitive to say at a time when financial institutions are still collapsing around our ears, and we argue elsewhere in the book financial stability should be more dominant, et cetera. But nonetheless those are not highly labor intensive activities. You need, sort of, 15 really good economists or financial analysts to do a bang-up job on financial stability and identify stresses and strains in the system and perhaps a few other people to be talking around the market. You don't need thousands and thousands of people engaged in note distribution or foreign exchange bureaus or whatever. And many of the central banks are still carrying out functions which are no longer really necessary and carrying them out in a rather expensive and rather inefficient way.

And I think this is going to be particularly true in an environment where public spending across the globe and certainly across all of Europe and North America is going to be under the microscope. I don't think the central banks can say, "We're out of that." Everybody, universities are going to be looking hard at the way they do business, every part of the sector is. And central banks are in that.

We've drawn attention to the remarkable ranges of costs per head of population. Actually, some of this was work done interestingly by the Danish central bank and the Swedes have shown some interest in it. But many others haven't shown any interest in it whatsoever.

I remember when I was in the Bank of England. I was the deputy governor and I better do some work efficiency and make sure we're doing it OK. And I said, "Well, what comparative statistics are there?" I found that there were some, collected in Basel, on things like basic stuff like cost per thousand notes issued in circulation. Or, what does the central bank cost for that and transactions costs, and the central banking market-making function, and all that kind of thing.

I then had to ban them in the Bank of England because the Bank of England was more or less off the map apart from Canada in terms of being cheaper. And so, this would have been terrible message for the Bank of England staff if they had known just how good they were. But I'm afraid in some other places there's a real job to do on efficiency.
Governors of central banks typically are not terribly interested in management. That's a terribly broad generalization and they are not appointed for that. Therefore, what they need to do I think is ensure that below them they have a Mr. Efficiency. I think this would be a really good time for them to do that because they're going to need to find resources to invest in the financial stability function, which we agree with. But I don't think it's going to be very attractive for them to go to governments and say we actually want to keep more of this spending regime, just spend more at a time when every other public sector is contracting.

And therefore what they've got to do is to focus on efficiency and I really hope that this chapter which explores and lays bare some of these differences will create a bit of impetus for that to happen.

Romesh: We're getting here into the culture of central banks which is the subject of your final chapter which I found particularly interesting. You talk about the central banker's club. You talk about the particular characteristics of central bankers and central banks, I guess. There's been a huge change in that over recent decades I know in terms of the secrecy of these organizations and becoming more much interested in communication.

Howard: It always has had the characteristics of a priesthood. And Carl Bruno wrote about it rather entertainingly about it. Willem Buiter has as done so, as well. And there are still... There is still an ancestry of that. And still instinctively--we've got what Robin Leigh-Pemberton when he was the governor of the Bank of England called “decent obscurity” and some of what central banks do needs to be done behind the scenes. And I don't dispute that. We don't dispute that there are times when covert market intervention is necessary, at least in the very short term. You have to disclose that happened, what's happened here in the crisis and some of the support given to Lloyd s and to certain point was not disclosed but it subsequently has been. So we're not saying that there aren't times when you can do good by stealth, but the general culture in public decision making is just radically different from what it was 20 or 30 years ago.

The expectations of transparency and clarity of objective and understanding of due process is just pervasive across the public sectors. It's slightly different in different countries but central banks I think have got to catch up with that. There's a voting and disclosure of voting, et cetera, is one important dimension of it I think.

Gradually they are being dragged kicking and screaming into a more transparent way of doing business, and I hope that some of what we have in the book about culture and about transparency and accountability will help people move further in that direction.

Romesh: Can we talk specifically about governors of central banks. I think in the final sentence in the book is, “Taciturn autocrats need not apply.” What are the characteristics of an ideal governor?

Howard: I think that probably if you describe the ideal characteristics you probably describe something which is an empty set. In that, I think you need to be these days an excellent macro economist. You need similarly to be someone who has a feel for and an instinct for financial markets. Those two are by no means always go together. Thirdly I think you need someone who does have an interest in management or at least an interest in structuring management below them so that they do manage an efficient ship. You need someone who has a very international outlook because we know that no financial system is an island. You do need to be able to understand the interconnections. And you need increasingly to be a good communicator.

The days when the central bank governor would be seen but not heard have clearly gone. And at the moment you know people evaluate Jean Claude Trichet certainly, to a large extent on how he communicates in those press conferences and in speeches and how he explains and articulates about what they are trying to do. I recognize in the book that very few people are going to tick all of those boxes completely. It's quite hard to find that sort of person but we do so as you say that the taciturn autocrat ticks none of them. None of those boxes.

Like in many jobs you have to be aware of what you're strong at and aware of what you are less strong at and then try to support yourself in those areas. So people who don't have a strong instinct for financial markets, perhaps haven't been brought up in financial markets, you know, need to equip themselves with the sort of eyes and ears around the marketplace who will help bring them that knowledge. The ones who are not as good communicators will need to strengthen their communications function in the banks.=

So I think the key is to self awareness on the part of governors on the part about what elements of the job they are good at and where they need help.

Romesh: Final question, Howard, you note the increasing dominance of central banks by academic economists, throughout the organizations and at the top. Do we have too many economists in central banks these days?

Howard: I wouldn't say too many economists, too poor, if you like. I do think however that, as you perfectly well know, all economists are equal. But some are more equal than others. I think you need economists who have a good understanding of the financial system. And I think one of the strongest criticisms which Charles Goodhouse has made is that if he looks at some of the central bank analysis of what's going on in the economy, Charles said memorably the other day that it “Excludes everything I'm interested in.” And that all of the analysis of financial markets and the transmission mechanism, procreation process, etc. have somewhat been pushed to the sidelines. So I'm not worried about the dominance of economists as long as those economists themselves are not people who begin by assuming away all of the complexities of financial markets and the transmission mechanism.

So I think it's a question of a balanced portfolio of people who are sort of financial market economists, if you like, and the pure macro people. But also some micro people who are understanding some of the frictions in the economy, as well.

I'm not worried about the trends towards economists as governors. But I do think there is a worry about some of the DSG models and how they have excluded a lot of complexity. I have quite a bit of sympathy with this Soros-type... I mean, I don't think he's got the answer but I think challenging some of these previous assumptions and this new economic thinking is I think important.

Romesh: Howard, thank you very much.

Howard: You're welcome.

Topics:  Financial markets Monetary policy

Related research here [1]. [1] http://press.princeton.edu/titles/9154.html

Non-Executive Director, Morgan Stanley

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