The perils of central banking (I)
It is an occupational hazard. Central bankers believe, with a mix of wishful thinking and empirical evidence, that their own credibility is critical to the success of monetary policy.
There is little room, then, for exhibiting self-doubt, with a tendency for new policies to be grasped with gusto and the old to be quickly discarded. It is not that critical thinking is actively discouraged – central bankers are a conscientious lot. But in practice it is disincentivised. An idea or analysis that undermines an existing policy will battle for survival until it meets a threshold of certainty that rarely visits the practice of policy.
No wonder then, that much critical analysis of central banking comes from those institutions that are close to the issues, but do not determine actual monetary policy – bodies such as the Bank for International Settlements, the International Monetary Fund, national treasuries and ministries of finance. There are also some individuals that understand central banking, often because they previously worked at such institutions, that are outspoken in their comments as they are no longer subject to, or worried by, suspicions of disloyalty. But, in the main, criticism does not come from within.
In some sects, the cult of infallibility leads inexorably to mass suicide. In central banking the consequences can also be severe. Developed-country central bankers got off lightly for their turn-of-the-century love affair with credit derivatives – despite the many warnings. Earlier seductions by the allures of demand management, money supply targets and the focus on inflation targets to the exclusion of asset prices also came to sticky ends; long after warning signs were first dismissed. Central bankers in emerging economies are not immune from this affliction, though their love affairs are habitually with exchange rate regimes.
Quantitative easing (QE) – the purchase of assets with electronically created cash – was the defining policy instrument of the last financial crisis. More than US$3 trillion of assets were purchased in different phases by the Federal Reserve, the Bank of Japan and the Bank of England. While there are important differences, the European Central Bank’s long-term lending (long-term refinancing operations) of more than US$2 trillion of electronically created cash has strong similarities with QE and could be added to the unprecedented pile of money creation. The judgement of history will be less kind on QE than contemporary analysis by central bankers.
The first round of asset purchases, in the wake of the collapse of Lehman Brothers on September 15, 2008, was ad hoc, courageous and effective at unfreezing financial markets. The “ted spread”, a measure of financial stress, leaped from around 100 basis points just before the collapse of Lehman Brothers to almost 500 basis points just after, before falling below 100bp by the second quarter of 2009. Later, more ordered and focused rounds of what was then classified as QE were much less effective in the countries pursuing them, stored up challenges for the future unwinding of the newly created cash and proved troublesome for those countries not pursuing QE.
One reason to avoid financial crises is that in the descending fog, good policy formulation is quickly lost. Frantic to do something to save the financial system from falling into the abyss, desperate to be seen to be doing something to restore vanished confidence, and frightened of what might happen if they stopped the policy prematurely, central bankers appealed to portfolio balance theory to justify the extension and enlargement of the emergency asset purchases.
Japan’s decade-long, uninspiring experience with QE was, conceitedly, brushed under the carpet. The Fed, the Bank of Japan and the Bank of England (the ‘QE-3’) explained that by re-balancing investors’ portfolios out of cash into non-monetary assets such as bonds, equities or real estate, QE would increase the demand for these assets, which would lead to new supply that would finance new investment in the real economy.
The obvious test of QE, then, would be the degree to which investment increased, or the issuance of corporate bonds and equities rose. But in the QE-3 there was precious little new supply of bonds and equities, and no surge in investment from 2009–12. No wonder the velocity of money collapsed. It is in the countries not pursuing QE where there are signs of, in their case, unhelpful spillovers from QE, such as soaring currencies and a corporate borrowing spree. Yet, the QE-3’s own assessment of QE invariably focused on torturing financial market data to extract the announcement effect on government bond yields – with the unimpressive result of approximately 85 basis points.
• Avinash Persaud is non-resident, senior fellow at the Peterson Institute for International Economics and emeritus professor of Gresham College. Part two of this article will be published next week.