Satyajit Das on Central Banks: Loose Lips Sink Economies
Some recent statements from central bankers risk destabilizing a very fragile financial system.
US Federal Reserve Chairman Ben Bernanke has introduced the term "taper" to the lexicon of central banking. European Central Bank President Mario Draghi's stated strategy is "whatever it takes." Economic Commissioner Olli Rehn recently clarified that European policies were directed at "diluting" not "breaking" the link between banks and sovereigns.
But the statements by the Fed Chairman were hardly surprising. The Fed's unprecedented monetary expansion was always temporary. Confirmation that the measures would continue would admit to failure of policies designed to create a self-sustaining economic and financial recovery. The Fed Chairman also has to manage constituencies within the Federal Reserve uncomfortable with the increased role of the US central bank and foreign nations concerned about the impact of US policies on their currencies and economies. Like ECB President Draghi facing an existential crisis of the euro, Chairman Bernanke, in reality, had little choice.
On one hand, Chairman Bernanke may have been careless and loose in his language. On the other hand, he was deliberating testing the market reaction to the eventual end of central bank support.
Spoken about in the past tense by the US president, Ben Bernanke may also not actually be the Chairman of the Fed at the relevant decision time.
Also, nothing has actually happened. Chairman Bernanke has not halted purchases of Treasury bonds nor increased interest rates.
Despite the confusion about meaning, the statements had a significant impact on prices and rates, leading to large real changes in wealth. "Taper" lived up to at least one of its meanings: a long wick for use in lighting a fire.
With bond and equity markets increasingly volatile, Fed officials have sought to calm unsettled markets, suggesting that the message has been "misinterpreted" or "misunderstood," causing financial markets to be "quite out of synch" with policy. Recognizing the global economy's monetary morphine addiction and also the difficulty of reversing policy, the US central bank officials have even suggested that existing measures could be continued or even increased if necessary. ECB President Draghi and the Governor of the Bank of England have provided guidance that the regime of low interest rates is likely to remain in place for some time.
The reliance on guidance and actual actions of policymakers is troubling:
First, it highlights the fragility of global economies and the financial system, which are now extremely reliant on government support.
Second, the need to "jawbone" exposes the lack of potency of policy tools, which in some cases may be approaching their limits of effectiveness or creating unintended toxic side effects, such as asset price bubbles.
Third, it illustrates the difficulty of international policy coordination. The Fed announcement coincided with a decision by the Chinese central bank to tighten liquidity, exacerbating the market reaction. Given different domestic agendas, the risk of individual action becoming destabilizing is high.
Fourth, it creates uncertainty and volatility, undermining the policies themselves.
Fifth, it points to the excessive influence of governments on markets. Successful investing now requires anticipation of official policy actions rather than traditional analysis of fundamental factors. In this environment, price signals are misleading, distorting resource and capital allocation.
Sixth, the process is undemocratic. Unelected officials, with limited accountability, can, by their words or actions, trigger large changes in prices and rates, affecting millions of citizens and businesses domestically, and in some cases, internationally. These policies can result in massive transfers in real wealth, redistributing employment, income, investments and savings between individuals in a country and between nations.
Seventh, it undermines crucial trust in institutions and policymakers.
Reliance on aggressive policies to resuscitate the global economy always risked blowback. In its 2012 / 2013 annual report, the Bank for International Settlements, the banker to central banks, highlighted the problem:
What central bank accommodation has done during the recovery is to borrow time -- time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth.
Regrettably, the purchased time may have not been used productively, creating new dangers for the global economy without having dealt with existing problems.
The global economy and financial system cannot escape the debt overhang and structural problems, at least without pain. Policymakers are now trapped between existing policies of decreasing efficacy and increasing toxic side effects and withdrawing these measures with uncertain consequences, potentially a complete collapse. The required balance sheet repair and simultaneous correction of public finances would result in a sharp fall in aggregate demand, exacerbating not solving the problem.
Given the current "sea of troubles," the high stakes, and limits to their power, central bankers, unable to confront reality, have lapsed into political spin and word games. In wartime, populations were warned that loose lips could sink ships. As recent events highlight, central bankers would do well to heed that warning, as loose talk may sink economics and destabilize a fragile financial system.
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