If Only Central Bankers Would Hit Bottom

I’m told that alcoholics and addicts have to hit bottom before they are able to renounce their self destructive ways. Ironically, their personal collapse makes them more capable of change than scientists, who, according to Thomas Kuhn in his landmark, The Structure of Scientific Revolutions, were so incapable of abandoning core beliefs that it would take an entire generation for significant advances to become widely accepted. The old guard literally had to die off before the new paradigm could take hold.

Bear with me in delving deeper into this comparison. The Wikipedia entry on Kuhn’s work gives a sense of the power and durability of existing frameworks:

There is a prevalent belief that all hitherto-unexplained phenomena will in due course be accounted for in terms of this established framework. Kuhn states that scientists spend most (if not all) of their careers in a process of puzzle-solving. Their puzzle-solving is pursued with great tenacity, because the previous successes of the established paradigm tend to generate great confidence that the approach being taken guarantees that a solution to the puzzle exists, even though it may be very hard to find. Kuhn calls this process normal science.

As a paradigm is stretched to its limits, anomalies — failures of the current paradigm to take into account observed phenomena — accumulate. Their significance is judged by the practitioners of the discipline. Some anomalies may be dismissed as errors in observation, others as merely requiring small adjustments to the current paradigm that will be clarified in due course. Some anomalies resolve themselves spontaneously, having increased the available depth of insight along the way. But no matter how great or numerous the anomalies that persist, Kuhn observes, the practicing scientists will not lose faith in the established paradigm for as long as no credible alternative is available; to lose faith in the solubility of the problems would in effect mean ceasing to be a scientist.

In any community of scientists, Kuhn states, there are some individuals who are bolder than most. These scientists, judging that a crisis exists, embark on what Thomas Kuhn calls revolutionary science, exploring alternatives to long-held, obvious-seeming assumptions. Occasionally this generates a rival to the established framework of thought. The new candidate paradigm will appear to be accompanied by numerous anomalies, partly because it is still so new and incomplete. The majority of the scientific community will oppose any conceptual change, and, Kuhn emphasizes, so they should. In order to fulfill its potential, a scientific community needs to contain both individuals who are bold and individuals who are conservative.

We are desperately in need of radical new thinking among the financial elite. We may not simply be at the end of an era, we may be on the verge of a reformulation of capitalism itself. However, the signs are that there are few iconoclasts among the policy elite. Central bankers in particular seem hopelessly stuck in their world views, starting with their conception of their role.

Bloomberg’s story, “Central Bankers at Retreat May See Few Options to Fix Economy,” would normally get me riled up, but I am suffering from central banker fatigue. Railing at them is an exercise in futility, so I’ll just hit the high points and encourage readers to jump into the fray.

Key excerpts:

The world’s top central bankers gather at their annual U.S. mountainside symposium today with a sense there’s not much more they can do to repair credit markets and rescue the global economy.

Reports in the last week showing a surge in inflation reinforce expectations that Federal Reserve Chairman Ben S. Bernanke will have to keep U.S. interest rates on hold. Similar conditions in Europe are paralyzing his counterparts at the Bank of England and the European Central Bank.

“All the central banks can provide now is time for the banking system to heal,” Myron Scholes, chairman of Rye Brook, New York-based Platinum Grove Asset Management LP and a Nobel laureate in economics, said in an interview. “What more they have to offer is now very limited.”….

“There isn’t a lot they can do” now, said former Fed Governor Lyle Gramley, senior economic adviser at Stanford Group Co. in Washington. “The Fed really has to hope and pray that credit markets begin to heal by themselves.”…

The Fed, while leaving the benchmark interest rate unchanged for its last two meetings, says financial markets “remain under considerable stress.” One gauge watched by the Fed, the premium for banks to borrow for three months over a measure of the future overnight lending rate, averaged 0.77 percentage point last week, the highest since April.

The Fed’s rate cuts also have failed to pass through to the housing market. The average rate on a 30-year fixed mortgage was 6.47 percent last week, about where it was a year ago….

Apart from lowering rates, Bernanke has pushed the limits of the Fed’s powers to ease the crisis in credit markets. In December, he started auctioning 28-day loans to commercial banks. He followed that in March with a $200 billion program to auction Treasuries to investment banks in exchange for mortgage-backed securities and other debt. Bernanke also offered cash loans to other bond dealers that trade with the Fed.

With all these programs in place, Fed officials may be reluctant to do more without assurance that it will ease the credit crisis and not do more harm.

“They have done a lot, and at some point they simply have to give the markets the time needed to heal,” said former Fed researcher Brian Sack, senior economist at Macroeconomic Advisers…

Some, such as former Bank of England policy maker Willem Buiter, who will address the meeting tomorrow, argue that the Fed’s actions to date store up trouble for the future.

“There will have to be a lot of soul searching about whether central banks, in their rush to forestall a financial disaster, have created moral hazard and perverse incentives on an unprecedented scale,” Buiter said.

The repeated use of the word “heal” says that the Fed has done a great job of pre-selling its message and the words of realists with Buiter will fall on deaf ears.

So what’s wrong with this picture? Here is a starter list. Readers are encouraged to add to it.

1. There is a remarkable lack of introspection. The Fed (and by extension other central banks) seem to think they performed ably and are victims of circumstance. They seem to see themselves as agents that act on the system, and implicitly deny their role in creating the current circumstances.

2. Part of the lack of introspection is how mission creep worked to their disadvantage. The Fed in the old days understood its job: take the punchbowl away before the party got good. But Congress gave the Fed the dual mandate of price stability and creating full employment. The Fed was effectively given responsibility without having authority, yet over time seemed to develop unwarranted belief in its ability to deliver on these objectives (as opposed to the more modest aim of doing what it could around the margin to help). We recall hearing paeans to the financial authorities almost like clockwork before crises (well, maybe not 1997-1998): “Gee, they have things so well under control, we won’t have a recession.”

That false confidence got worse under Greenspan, who loves scouring data and took an inordinate interest in the stock market, indeed, seemed to regard rises in the averages as validation of his policies (see here for a longer discussion). And this misguided thinking conditioned Bernanke’s reflexes when the crisis hit, His priority became validating asset prices, when the experience of Japan showed what a misguided course of action that was. Indeed, the most successful example of coping with a housing/banking crisis was Sweden in the early 1990s, when the markets were permitted to fall but the authorities moved quickly to recapitalize the banking system. Funny that we never hear anyone in the officialdom mention that model.

The Fed even considers itself to be in charge of the stability of the financial system , even though Congress has not added that to its job description. Moreover, the Fed has direct oversight over only a relatively small subset of market participants. For instance, only 15% of non-agricultural debt in the US falls under its purview.

Now the US central bank could kid itself that it, along with its peers, was doing a good job based on the so-called “Great Moderation,” a twenty-year period that featured more stable growth (although it also came with more frequent financial crises). However, economist Thomas Palley disputes the conventional account of the success of this period and the contribution of central bankers to it:

It is often said that the winners get to write history, which matters because the way we tell history frames our understandings. What is true for general history also holds for economic history…

The last twenty-five years have witnessed a boom in the reputation of central bankers…based on an account of recent economic history that reflects the views of the winners…

The raised standing of central bankers rests on a phenomenon that economists have termed the “Great Moderation.”… the smoothing of the business cycle over the last two decades….

Many economists attribute this smoothing to improved monetary policy by central banks….This explanation is popular with economists since it implicitly applauds the economics profession by attributing improved policy to advances in economics and increased influence of economists within central banks….

That said, there are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost. One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages…rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth….

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending…

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

3. Focus on monetary policy and liquidity and lack of attention to regulatory and structural reform. The credit crisis has been a massive indictment of financial deregulation. Yet the Fed remains a hostage of free market ideology and what Willlem Buiter calls “cognitive regulatory capture.” The Fed is too close to banks and industry, and almost seems to lack belief in the importance of oversight.

A full year ago, a vocal minority recognized the role of structural failings and called for the Fed and other regulators to investigate and develop new approaches. The proponents included Henry Kaufman, Australia’s former Reserve Bank Governor Ian Macfarlane, Steven Roach, and Jim Hamilton. Kaufman in particular has offered some sound analysis and proposals that have languished on op-ed pages (one example here); others over the past year have pondered the need for reform and made recommendations.

But what do we see instead? The Treasury launching a plan to make the Fed into an uber-regulator, with the Fed having no particular idea of what it would do with its new powers. This is the worst of all possible worlds. The current fragmented system allows an ambitious or progressive regulator to take ground, which forces the other to react to protect their turf (Eugene Ludwig, head of the Office of the Comptroller of the Currency in the Clinton Administration end ran the Fed more than once).

Now one can correctly argue the central bank lacks formal authority to do much in the way of regulatory reform. Yet first, Bernanke has been extraordinarily aggressive in going to the limits of, even beyond, the Fed’s charter (it most assuredly did not have the authority to stick taxpayers with the losses that eventually result from the Bear bailout, but Congress failed even to slap the central bank on the wrist for overstepping its bounds). Second, there has been an intellectual vacuum about what to do about the mess. The Fed and other central banks could readily have framed the debate and taken the lead in proposing reforms. But that role instead seems to have been seized by the Treasury, which seems more interested in quick fixes and the appearance of being in charge rather than the harder job of trying to achieve lasting progress.

I’m sure there is plenty to add to the Fed’s rap sheet, and I hope readers will provide input.


Originally published at naked capitalism and reproduced here with the author’s permission.

One Response to "If Only Central Bankers Would Hit Bottom"

  1. bill greene   August 27, 2008 at 9:19 pm

    Scientific revolutions, that require the abandonment of outdated theories, are fairly frequent in the hard-sciences, where observation and tests evaluate results more or less objectively. Unfortunately, economics is not much more scientific than the study of politics and history, and objective observation of results is not widely practiced. For example, three generations of intellectuals supported Russian Communism and many of those still endorse similar central management of not only a nation’s economy, but the lives of its people. Similarly, many economists are wedded to the idea that their job is to direct and manage the nation’s economy. Over the last 30 years, this ambitious and self-justifying role has created as much harm, or more, than benefits, to the economies and people involved. The real job of economists, and most all governmental administrators for that matter, should be to provide security and legal order to the free economic activity of the citizens. Instead of enacting legislation and regulations that encourage bad behavior by financial institutions and individuals, such agencies should allow the victims of their own irresponsibility to suffer the consequences. The federal bail-outs of the past thirty years–of Mexico, the S&Ls, the foreign government debt holders, and now the housing mortgage excess–have roiled the markets and allowed the perpetrators to continue undermining orderly markets. In the current housing mess the regulators are even confused whether it was the borrowers or the lenders who were the “victims.” Instead of letting the victims of their own bad judgnment suffer the normal consequences, the top level regulators will probably bail them all out! This results in penalizing the 97% of home owners who did not get in trouble who will one way or another pay for the benefits parcelled out to the violators of prudence and good sense. Perhaps if we used more common sense, reduced the excessive paperwork regulations that burden all transactions, and punished the wrong-doers, we could restore sanity–and justice– to the financial arena.