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The Temptation of the Central Bankers

Mareeg.com-WASHINGTON, DC – The banking system has become most central bankers’ Achilles’ heel.
This may seem paradoxical – after all, the word “bank” is in their job description.
But most people currently at the top of our central banks built their careers during
the 1980’s and 1990’s, when the threat of inflation was still very real, so this –
rather than bank regulation and supervision – remains a major focus of their
intellectual and practical concerns.

Simon Johnson
Simon Johnson

Moreover, a formative experience for many central bankers over the past half-decade
has been the need to prevent a potential collapse of output, including by preventing
prices from falling. They have achieved this goal largely by propping up credit,
regardless of what that may do to the banking sector’s structure or incentives.

It is not surprising that today’s central bankers continue to be deferential to
those who run large private-sector banks. Central banks have a great deal of control
over an economy’s money supply, and they can affect interest rates across a wide
range of loans and securities. But private-sector banks do the lending, while also
bearing responsibility for important dimensions of how financial markets operate.

Thus, keeping global megabanks in business and highly profitable has become a key
objective for policymakers in the United States, Europe, and many other countries.
All too often, however, this means that central bankers defer to these firms’
executives.

José De Gregorio, the governor of the Central Bank of Chile from 2007 to 2011, is an
important exception. In How Latin America Weathered the Global Financial Crisis, he
combines recent history and personal insight to offer a fascinating account of how
to apply a more balanced policy approach – both in emerging markets and more
broadly. (De Gregorio’s book is published by the Peterson Institute for
International Economics, where I am a senior fellow, though I was not involved in
commissioning or editing his work.)

There is plenty of conventional macroeconomics in De Gregorio’s story, including the
value of careful fiscal policy and the advantage of maintaining a flexible exchange
rate guided largely by supply and demand in the market. When countries seem
committed to a fixed exchange rate (say, relative to the US dollar), firms and
individuals feel encouraged to borrow in foreign currency (like the dollar) in order
to lock in what are typically lower interest rates.

But such a perception can easily become a trap. When capital flows out of the
country – as is happening now in some emerging markets – it may be helpful if the
central bank allows the currency to depreciate in an effort to boost exports and
reduce imports. But if the country’s borrowers have a lot of dollar-denominated
debt, depreciation can be ruinous.

De Gregorio covers all of these issues very well – and also discusses the importance
of luck. Chinese growth remained relatively strong in 2009 and after, which kept the
price of commodities high. This benefited Chile – a major copper producer – and much
of Latin America.

But De Gregorio’s analysis of banking is what really stands out. Here the key issue
is leverage, or how much banks are allowed to borrow relative to their equity, and
the temptation that policymakers face to allow banks to borrow more, particularly
when times are good and asset prices are rising.

Big banks’ executives often want to increase their institutions’ leverage, typically
because they have various forms of guarantee – in particular, deposit insurance and
access to central-bank financing on advantageous terms. In addition, the executives’
pay is typically based on return on equity, unadjusted for risk.

The danger for central banks stems from the fact that the implicit subsidies
provided to major financial institutions are not measured in any budget. Moreover,
the build-up of risk in the financial system that accompanies higher leverage is
both hard to measure and likely to materialize only after a few years (for example,
after a governor’s term of office has expired).

De Gregorio’s views differ from those of many of his colleagues in other countries,
because he sees clearly the risks in allowing banks to become bigger and apply what
he calls “clever” strategies that require a great deal of leverage.

Higher leverage creates macroeconomic risk – not least for fiscal balances when
implicit guarantees must be honored. By keeping banks and other private-sector firms
at lower levels of debt, vulnerability to shocks is reduced. In a boom, this may
seem irrelevant; but, as De Gregorio knows, pressure on emerging markets – and
richer countries – arises all too often, and frequently at unexpected moments.

Growth based on high leverage typically proves to be illusory. And yet the illusion
continues to entice policymakers. That is why De Gregorio’s book should be required
reading for all central bankers.

Simon Johnson is a professor at MIT’s Sloan School of Management and the
co-author of White House Burning: The Founding Fathers, Our National Debt, And
Why It Matters To You.

source  Project Syndicate

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