In case you’ve missed it, there’s been a credit crisis. A ruddy big one.
Now the initial pain and panic has subsided, the time has come for reflection. How can we make sure this doesn’t happen again?
Paul Tucker, a member of the Bank of England’s Monetary Policy Committee (MPC), turned his attention to this question in a speech on Friday. He kicked off with a brief look at what had caused all the trouble. A long period of ‘peace’ (translation: we weren’t having a crisis) lulled bankers and policy makers into a false sense of security. Bankers enjoyed above-average returns - naturally, they wanted them to continue. So they kept the party going, using leverage. As a result, they risked not only their clients’ money, but the stability of the system itself.
“Credit cycle circuit breakers”. Sound straight-forward? It’s anything but!
So what does Tucker propose? Here’s the part of the speech that grabbed the headlines:
“At a more macro level, we need to debate whether or not it would be feasible to design discretionary levers that the authorities could employ as credit-cycle circuit breakers.”
This would involve the central bank acting swiftly if it suspected banks were getting ahead of themselves. It could step in and adjust, for example, capital or margin requirements.
Not the wording Tucker uses. He’s asking whether or not it would be feasible to design such levers. I draw your attention to it because I fear that this question will be left behind as these proposals gather momentum. An altogether different, though similar-sounding, question will be answered instead – would it be desirable to design such levers.
The answer – predictably – will be yes. And so the powers that be will set about trying to design them, without worrying too much about feasibility.
That is my fear. Because – and this is crucial – I do not believe it is feasible. I believe it will create a big mess. By what criteria do central banks decide when to step-in? How will they know by how much to alter margin requirements?
This would require all sorts of econometric modelling. All sorts of assumptions and value judgments. The idea of creating ‘levers’ sounds oh so scientific and precise. Simple, even. But it’s nothing of the sort.
The world is complicated. Full of uncertainty. Economists get round that by ‘assuming away’ a lot of the complexity. They discount the unforeseen, in order to have a peek at what the outcome would be if everything fit the model.
But then something unusual happens. Too often, people – the media, politicians, economists themselves – forget that it’s all based on assumptions (another word for guessing). They start to think the real world is more like their models than it ever could be. And they start to overestimate the degree of precision with which they can estimate, and therefore control, events.
I believe this is what’s happening here. It’s perfectly understandable, from a psychological viewpoint. We want to think we’re in control – that if we avoid past mistakes we can avoid future disasters. But the idea of ‘designing levers’ should make all of us stop and have a long, hard think about what it is we’re actually capable of doing – and what we’re not.
And yet more complexity – the whole world has to play ball
Also, as Tucker rightly points out, such measures would require huge international co-operation. Because capital flows across borders, there’d be no point in central banks going it alone. Everyone would have to agree on a hymn sheet and stick to it. The scope for things to go wrong would add to, not detract from, systemic risk. And yet, paradoxically, the existence of ‘levers’ would lead all concerned to believe clever innovation had controlled and reduced risk – sound familiar?
Here’s another quote from Tucker’s speech that didn’t make the papers (at least not any that I’ve seen). I quote it because it’s an insight into the mind of central bankers:
“The MPC’s strategy to date has been clear: to offset part but not all of the shock to demand, consistent with an overriding determination to maintain medium-term inflation expectations anchored to the 2% target.”
In other words, the commitment to ride inflation is “overriding”, but they’ll still worry about the economy, but inflation’s most important. Hmmmm. That’s not really that clear, is it?
Here’s something that’s a lot clearer. The MPC will set interest rates with a view to keeping inflation at 2%. That’s it.
Tucker’s closing remarks are another example of how central bankers think:
“Central banks can play a role because they can bring together and synthesise analytical and practical expertise in macroeconomic conditions, financial markets and the financial infrastructure. That synthesis is rather special, and should be at the service of the system as a whole.”
This is a round-the-houses way of saying “We know a lot of stuff. We’re clever. We have answers.”
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It is the nature of central banking to meddle in the markets. That is what setting interests rates is, after all.
But this meddling shouldn’t be encouraged. “Adjusting” margin and capital requirements will play havoc with banks’ ability to plan their commercial strategies. It’s changing the rules while the game is in progress.
And, let’s not forget, central bankers don’t exactly have a stellar record. As Chairman of the Fed, Alan Greenspan was Central Banker Number One. Greenspan was feted by many for keeping inflation down while growth ploughed ahead.
Now everyone recognises that the trick was more luck than judgment. Greenspan is viewed – rightly – as the man who blew up the biggest bubble the world has ever seen.
Preventing future crises is a noble aim. Sadly, it’s also utterly futile. It’s time central bankers acknowledged that fact. Loud and clear, until everyone gets this message:
“Look, the markets are great, but from time to time they can bite you. If we could, we’d fix them – keep the rewards but take out the risks. But, clever as we are, we central bankers are also wise enough to realise that we can never do that. So by all means invest – but do it with the knowledge that you are taking a risk.”
Of course, you and I have known all along that risk is part and parcel of investing. But give us a natty suit and a six-figure bonus, and I wonder how long it might take us to forget…
Happy investing!
Ben Traynor P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.
