Do Central Banks Have an Exit Strategy?

Do Central Banks Have an Exit Strategy?

By :Kennet Rogof

A year into the global financial crisis, several key central banks remain extraordinarily exposed to their countries’ shaky private financial sectors. So far, the strategy of maintaining banking systems on feeding tubes of taxpayer-guaranteed short-term credit has made sense. But eventually central banks must pull the plug. Otherwise they will end up in intensive care themselves as credit losses overwhelm their balance sheets.
The idea that the world’s largest economies are merely facing a short-term panic looks increasingly strained. Instead, it is becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning. Weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigor.
If this is the right diagnosis of the “financial crisis,” then efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Not allowing the necessary consolidation is weakening credit markets, not strengthening them.
The United States Federal Reserve, the European Central Bank, and the Bank of England are particularly exposed. Collectively, they have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated “investment banks.” Many other central banks are nervously watching the situation, well aware that they may soon find themselves in the same position as the global economy continues to soften and default rates on all manner of debt continue to rise.
If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the 1990’s financial crises. But history suggests that fixing a central bank’s balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalization by taxpayers. Both solutions are extremely traumatic.
Raging inflation causes all kinds of distortions and inefficiencies. (And don’t think central banks have ruled out the inflation tax. In fact, inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses.) Taxpayer bailouts, on the other hand, are seldom smooth and inevitably compromise central bank independence.
There is also a fairness issue. The financial sector has produced extraordinary profits, particularly in the Anglophone countries. And, while calculating the size of the financial sector is extremely difficult due to its opaqueness and complexity, official US statistics indicate that financial firms accounted for roughly one-third of American corporate profits in 2006. Multi-million dollar bonuses on Wall Street and in the City of London have become routine, and financial firms have dominated donor lists for all the major political candidates in the 2008 US presidential election.
Why, then, should ordinary taxpayers foot the bill to bail out the financial industry? Why not the auto and steel industries, or any of the other industries that have suffered downturns in recent years? This argument is all the more forceful if central banks turn to the “inflation tax,” which falls disproportionately on the poor, who have less means to protect themselves from price increases that undermine the value of their savings.
British economist Willem Buiter has bluntly accused central banks and treasury officials of “regulatory capture” by the financial sector, particularly in the US. This is a strong charge, especially given the huge uncertainties that central banks and treasury officials have been facing. But if officials fail to adjust as the crisis unfolds, then Buiter’s charge may seem less extreme.
So how do central banks dig their way out of this deep hole? The key is to sharpen the distinction between financial firms whose distress is truly panic driven (and therefore temporary), and problems that are more fundamental.
After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions’ key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit.
In principle, the financial industry can become smaller by having each institution contract proportionately, say, by 15%. But this is not the typical pattern in any industry. If sovereign wealth funds want to enter and keep capital-starved firms afloat in hopes of a big rebound, they should be allowed to do so. But they should realize that large foreign shareholders in financial firms may be far less effective than locals in coaxing central banks to extend massive, no-strings-attached credit lines.
It is time to take stock of the crisis and recognize that the financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans. Certainly better regulation is part of the answer over the longer run, but it is no panacea. Today’s financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future.

The Failure of Inflation Targeting

The Failure of Inflation Targeting

By : Joseph E. Stiglitz

The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.
The answer came in the form of “inflation targeting,” which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation , the best response is to increase interest rates. One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting in one form or another are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.)
Today, inflation targeting is being put to the test – and it will almost certainly fail. Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is even higher and is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?
Inflation in these countries is, for the most part, imported . Raising interest rates won’t have much impact on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, not those in developing countries, should be raised.
So long as developing countries remain integrated into the global economy – and do not take measures to restrain the impact of international prices on domestic prices – domestic prices of rice and other grains are bound to rise markedly when international prices do. For many developing countries, high oil and food prices represent a triple threat: not only do importing countries have to pay more for grain, they have to pay more to bring it to their countries and still more to deliver it to consumers who may live a long distance from ports.
Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially non-traded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now – for example, 20% per year – and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.
So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign. Former US Federal Reserve Chairman Alan Greenspan, it is now recognized, deserves much blame for America’s current economic mess. He is also sometimes given credit for America’s low inflation during his tenure. But the truth is that America in the Greenspan years benefited from a period of declining commodity prices, and from deflation in China, which helped keep prices of manufactured goods in check.
Second, we must recognize that high prices can cause enormous stress, especially for lower-income individuals. Riots and protests in some developing countries are just the worst manifestation of this.
Advocates of trade liberalization touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. Over a quarter-century ago, I showed that, under plausible conditions, trade liberalization could make everyone worse off. I was not arguing for protectionism, but rather sounding a cautionary note that we must be aware of the downside risks and be prepared to deal with them.
When it comes to agriculture, developed countries, such as the US and European Union members, insulate both consumers and farmers from these risks. But most developing countries do not have the institutional structures, or the resources, to do likewise. Many are imposing emergency measures like export taxes or bans, which help their own citizens, but at the expense of those elsewhere.
If we are to avoid an even stronger backlash against globalization, the West must respond quickly and strongly. Bio-fuel subsidies, which have encouraged the shift of land from producing food into energy, must be repealed. In addition, some of the billions spent to subsidize Western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.
Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.