The Economist On the 'Limitations' of Central Bankers

by: Tim Iacono

What a delightful current issue of The Economist - a special pull-out section with the title "Only Human - A special report on central banks and the world economy" along with a number of other articles on the faults and foibles of central bankers.

It looks like the Northern Rock/Mervyn King debacle has sent them over the edge.

While only having gotten through about 10 percent of the total central banking news and opinion in this week's magazine, the compulsion to share a few excerpts of the portion reviewed so far is just, well, overwhelming...

From the cover-story, Lessons from the credit crunch, comes the following list of central banker limitations that appear to have contributed, rather significantly, to the mess that the world now finds itself in:

Loose monetary policy is partly responsible for the mess the central bankers are now trying to clear up. Other factors contributed to the crunch, including rash lending, securitisation and globalisation: when American subprime loans went bad, banks in Leipzig (which had bought the stuff) and in Newcastle upon Tyne (which hadn't) were caught out. But whichever way you look at it, central banks kept interest rates too low for too long. That is most true of the Fed, which slashed rates between 2001 and 2003, held them at 1% for a year and then raised them in slow, predictable quarter-point steps, fuelling the housing boom. The results of that are plain to subprime borrowers facing the loss of their homes and to investors who ended up with subprime debt.

The other two limitations are both related to central banks' and supervisors' ability to control a much-changed financial system. One has to do with asset-price bubbles. The macroeconomic models used by many central banks focus on short-term influences on inflation; they focus less on the supply of money and credit. Even when they do have the right tools, central banks have preferred to wait till bubbles have burst, before mopping up afterwards by cutting rates. The snag is that this can start off new bubbles (as it did after the dotcom bust).

The last restriction has to do with supervision. Central bankers certainly gave warning that financial risks were being underpriced; contrary to some of their critics, they also had an eye on the off-balance-sheet entities in which banks parked their subprime assets. But they did not appreciate what the impact on the banks would be if those risky assets suddenly lost value. Like most of the people they regulated, the central bankers did not factor in the full effects of a liquidity squeeze.


Interest rates held too low for too long, ignoring asset prices, and failing to regulate lenders - now, where has that been heard before?

Is that something new?

In the "proposed solutions" section of the story comes this jab at the Federal Reserve, an organization that, under the supervision of former Fed Chairman Alan Greenspan for almost two decades, has shown a strong preference to encourage asset bubbles while marveling at low inflation, rather than to ever consider speaking of the two in the same sentence.

Central banks should also think harder about what can be done to head off asset-price and credit booms before they turn into damaging and dislocating busts. One answer would be to consider extending the definition of inflation they already aim at to include property and shares. Alternatively—and perhaps more feasibly—they should be more willing to raise interest rates when credit growth is strong or asset prices are booming, even if consumer-price inflation is under control.

Including asset prices in "inflation" - what are they crazy? That would ruin everything!