Wednesday, January 20, 2010

Blame the Central Bankers more than the Private Bankers

“I cannot help thinking that the central bankers are escaping very lightly in the post-crisis dust-up. For while incentive structures in banking exacerbated the credit bubble, they were a much less potent cause of trouble than central bank behavior across the world.”

So writes John Plender in the Financial Times this morning (See “Blame the Central Bankers more than the Private Bankers”:

This article should be read!

One point that Plender makes is that maybe we need fewer academic central bankers and “more private sector bankers with a practical understanding of markets.” You mean heading up the Economics Department at Princeton is not enough to be the head of a central bank?

“The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targeting regardless of imbalances arising from easy credit and soaring asset prices.”

The consequence? An asymmetrical approach to monetary policy: “Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.”

This focus gave us the ridiculously low interest rates in the United States from 2002 through to 2004 and the subsequent asset (housing) bubble which accompanied them. This conclusion comes even after and “In spite of the bizarre recent assertion by Ben Bernanke…that the Fed was largely innocent in the matter of bubble creation.”

This mindset, Plender argues, is still around and is present in some of the approaches to fight systemic risk and to provide “macro-prudential” regulation and supervision. The mix of policy that these “academic” officials are proposing “suffers from the single disadvantage that it will not work.”

What Mr. Plender really asks for is central bankers that have less experience with the academic study of banking and financial markets and that have more practical experience in these markets.

The particular approach followed by central bankers, Plender continues, led to the rise in bank leverage which was “a far more important factor” in the crisis than was financial innovation.

How could this be?

Well, the incentive structures in banking placed emphasis on current bank earnings. And, the surest way to increase performance during the 1990s and 2000s was to leverage up the portfolio so as to earn a few more basis points. This behavior had to continue because competitors kept doing it. As “Chuck” Prince, the Chairman and CEO of Citigroup, so eloquently put it, if the music is still playing you must continue to dance. Competition demanded more basis points to keep in the dance for investor’s money.

And, the continued increases in leverage were underwritten by the monetary authorities who followed the philosophy of central banking described above. When the bubble burst, the leverage, of course, worked in the opposite direction.

I would highly recommend reading Plender’s article.

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