Central Banks As Central Planners

by: John Cochrane

Two news items cropped up this week on the general topic of central banks as emergent central planers: a nice WSJ editorial by James Mackintosh on QE extended to buying corporate debt, and the Fed's proposed rule governing "Macroprudential" countercyclical capital buffers. The ECB also has a new Macroprudential Bulletin with similar ideas that I will not cover because the post is already too long. (Some earlier thoughts on the issue here. As usual, if the quotes aren't showing right, come back to the original of this post here.)

The WSJ editorial:

...as the central banks become more desperate to boost inflation and growth, they are starting to break one of the modern tenets of the profession by funneling that cash directly to what they regard as "good" uses.

The Bank of Japan's conditions for companies to qualify for central bank funding include...

offering an "improving working environment, providing child-care support, or expanding employee-training programs"... increasing capital spending, expanding spending on research and development or boosting what the Bank of Japan calls "human capital." The latter means pay raises for staff, taking on more people or improving human resources.

The ECB...

...plans to pay banks to borrow from it for up to four years so long as they use the money to help the "real" economy, meaning that they don't simply pump up the housing markets by offering more mortgage finance.

The ECB is also causing a ruckus by stating plans for which private bonds it will buy and which it won't.

What's wrong with this?

"It's a massive politicization of credit: Here are the legitimate things for lending, and here are the illegitimate things," said Russell Napier... "It's capitalism with Chinese characteristics."

Indeed. But just "politicization" or "central planning" is not the real danger. Our governments do all sorts of highly politicized credit allocation and subsidization - energy boondoggles, student loans, export financing, housing, housing and more housing, community reinvestment act, and so forth. On that scale, it seems hard to get excited about a little more.

But central banks so far don't, at least in well run countries. Why not? Independence. The deal for central banks has been: The bank gets great independence. In return, it accepts sharply limited powers. It handles money and interest rates, but it does not funnel credit to specific borrowers, nor does it target asset prices. Branches of government that handle such political decisions are subject to quadrennial electoral wrath. So, though any expansion of financial meddling is unwelcome, the big danger is the inevitable politicization and loss of independence of the central bank.

And that will happen sooner than you think. Congressional hearings and bills to contain the Fed are already in Congress.

A bit more under the radar, but needing much more attention, the Fed has unveiled rules for implementing "macro-prudential" policy with "counter-cyclical capital buffers."

The proposed rule makes for fun reading. The...

countercyclical capital buffer (CCyB)... is a macroprudential policy tool that the Board can increase during periods of rising vulnerabilities in the financial system and reduce when vulnerabilities recede.

[CCyB? OMG, DC alphabet soup is now case-sensitive?]

The CCyB is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses... Above-normal losses often follow periods of rapid asset price appreciation or credit growth that are not well supported by underlying economic fundamentals... the Board would most likely use the CCyB... to address circumstances when potential systemic vulnerabilities are somewhat above normal. By requiring advanced approaches institutions to hold a larger capital buffer during periods of increased systemic risk and removing the buffer requirement when the vulnerabilities have diminished, the CCyB has the potential to moderate fluctuations in the supply of credit over time.

Decoded into English, this is what they're saying: Replay the end of the boom, 2005-2007. This time we really will see the crisis coming. This time we will force banks to issue more stock, hold back on paying dividends and bonuses to conserve capital during the boom when things are going great. This time we will directly tell banks to stop lending even though customers are lining up at the doors for cash-out no-doc refis. Replay the beginning of the bust, 2007-2008. This time we really will demand that banks get even more private capital, and stop paying dividends and bonuses, in the middle of a crisis, even though the same banks may be screaming of its impossibility.

(And... "to hold a larger capital buffer". This entire document uses the incorrect verb "hold" to describe capital, as if capital are reserves. One hopes the ideas are not as confused as the language.)

Hayek's famous criticism of central planning is that planners can't possibly have the information needed to properly supply toilet paper. Which they didn't. So as you read this gobbledy-gook, you should ask just that question - not whether the Fed is well intentioned or not (it is), but how will Fed officials "assess vulnerabilities," "potential systemic vulnerabilities" or tell whether "asset price appreciation or credit growth" are or are not "well supported by underlying economic fundamentals?"

The proposal lays out the answer:

...by synthesizing information from a comprehensive set of financial-sector and macroeconomic indicators, supervisory information, surveys, and other interactions with market participants. In forming its view about the appropriate size of the U.S. CCyB, the Board will consider a number of financial-system vulnerabilities, including but not limited to, asset valuation pressures and risk appetite...

The decision will reflect the implications of the assessment of overall financial-system vulnerabilities as well as any concerns related to one or more classes of vulnerabilities...

"Valuation pressures" and "risk appetite" are not measurable or even defined quantities. "Classes of vulnerabilities" even less so.

If this sounds pretty wooly, you might be a bit reassured by:

The Board intends to monitor a wide range of financial and macroeconomic quantitative indicators including, but not limited to, measures of relative credit and liquidity expansion or contraction, a variety of asset prices, funding spreads, credit condition surveys, indices based on credit default swap spreads, options implied volatility, and measures of systemic risk. In addition, empirical models that translate a manageable set of quantitative indicators of financial and economic performance into potential settings for the CCyB, when used as part of a comprehensive judgmental assessment of all available information, can be a useful input to the Board's deliberations. Such models may include those that rely on small sets of indicators - such as the credit-to-GDP ratio, its growth rate, and combinations of the credit-to-GDP ratio with trends in the prices of residential and commercial real estate... Such models may also include those that consider larger sets of indicators...

Though they might as well say "we will look at every number that comes across the wires." It is painfully obvious, though, that nobody has any clue how to turn this mass of data into a useful real-time index of "vulnerabilities."

The key is to distinguish a "boom" from a "bubble." In real time. When all the bankers in your "surveys" and "interactions with market participants" are telling you it's a boom. "We'll look at every vaguely plausible number that comes in" is hardly a reassuring tie to the mast.

But in case even this smorgasbord data-dump seems too limiting; in case some congressional committee member says "you looked at the price of barbecue in setting the first bank of Texas' capital buffer, and that violates the regulation":

However, no single indicator or fixed set of indicators can adequately capture all the key vulnerabilities in the U.S. economy and financial system. Moreover, adjustments in the CCyB that were tightly linked to a specific model or set of models would be imprecise due to the relatively short period that some indicators are available, the limited number of past crises against which the models can be calibrated, and limited experience with the CCyB as a macroprudential tool. As a result, the types of indicators and models considered in assessments of the appropriate level of the CCyB are likely to change over time based on advances in research and the experience of the Board with this new macroprudential tool.

Translation to English: We will be shooting from the hip, but we will cover up the communiques with a lot of numbers and models and mumbo jumbo to give the illusion of technical competence.

To be clear, I'm all for capital. Lots and lots of capital. Capital issued or retained, not "held," please. I'm for so much capital that the precise amount doesn't really matter.

And that's the point. By pretending that the Fed will set capital ratios down to the second decimal point, and then pretending to be able to adjust that ratio up or down by a few percentage points in response to a Rube-Goldberg model, the Fed pretends there is a very important cost to demanding too much capital, that it knows exactly where the cost-benefit optimum is, not just on average, but with great precision vary it over time. All of this is not just false, it is completely pie-in-the sky. How can anyone with a straight face claim such an absurd level of competence?

So my objection really is the effort to dress this up with the aura of technocratic competence, or pretend the Fed is putting in rules that it will follow. (The link is, after all, a rule-making proposal.) It would be far more honest to issue one line: "The Federal Reserve will adjust capital requirements as it sees fit." Period.

The result is easy to foresee. "Counter-cyclical capital" and "macro-prudential policy" will become one more completely discretionary and judgmental policy tool for the Fed to command the banks. It will be subject to intense political forces. The Fed will get it wrong, and feed the flames. The fallout for the Fed, for good monetary policy, and for the economy will not be good.

While we're on gobbledy-gook language and the revealed confusion by our aspiring technocrats, the "real economy" language is sad. From WSJ, the ECB...

will cut the interest rate to as low as minus 0.4% - the ECB paying the banks - if the banks lend more to the real economy than a benchmark amount linked to their recent loans.

Here we are in 2016, and our central bankers are peddling the medieval distinction between "real" and "financial" investment. Yes, ordinary Joe can be excused from this fallacy. But people with economics Ph.Ds are supposed to understand that every asset is also a liability. Individually we can "buy paper, not real things." Collectively, we cannot.

"The market would much rather companies take the ECB's cheap money and use it to buy each other," said Robert Buckland, an equity strategist at Citigroup Inc.

OK, so even private sector equity strategists can get it wrong. But central bankers are supposed to understand accounting identities. I hope these are journalistic misunderstandings and not an accurate reflection of thinking at the ECB.

Oh, and on negative rates:

German reinsurer Munich Re said it plans to store more than €10 million ($11.3 million) of physical bank notes in vaults to test the feasibility of avoiding negative rates.

The ECB may have to get going on Miles Kimball's plan to devalue currency relative to bank reserves!