GES Session II: Reassessing Central Banking

The participants at this session were:

Edward Lazear, Professor of Human Resources Management and Economics, Graduate School of Business, Stanford University

Assar Lindbeck, Professor of International Economics, Stockholm University

Suzan Sabancı Dinçer, Chairman and Executive Board Member, Akbank

Jürgen Stark, Member of the Executive Board, ECB

Durmuş Yılmaz, Governor, Central Bank of Turkey

The moderator was Wolfgang Munchau, Co-Founder and President; Eurointelligence; Associate Editor, Financial Times

Since this session was off-the-record, I'll report on what was being said, but not who said what. Note that I had posted earlier my interview with Jurgen Stark, one of the participants of the session.

The idea of the session was to reassess central banking in the aftermath of the financial crisis. In this vein, the discussion's objective was to answer the following questions:

1. Will central banking be the same after the "Great Recession" as it was before?
2. Should monetary policy react to housing markets and asset price bubbles?
3. Are two or more pillars (i.e. central bank policy rules) better than one?
4. Are central banks the best banking supervisors?
5. What are the potential tensions between monetary policy and banking supervisors?
6. Are quantitative easing and other unconventional policies adequate instruments during recessions.

This session was one of the most controversial I had attended, as there was much disagreement. In fact, the first question was the only one with "consensus-building": All the participants more or less implied that central banking would not be the same. But their perception of where it was headed differed a lot, as my summary of the answers to the other five questions will attest to:

The second question is really three questions disguised as one: First, we need to determine whether central banks can indeed predict asset price bubbles in advance. According to Alan Greenspan, former chairman of the Federal Reserve, who many see as one of the main culprits of the crisis for not having touched the U.S. housing bubble, we cannot.

Obviously, if you agree with Mr. Greenspan, then your answer to the second question is definitely a "no". But even if you believe that a central bank can identify a dangerous bubble forming in advance, it doesn't mean you think it should prick it.

For one thing, it is not clear whether a central bank would have the adequate tools to prick a bubble. But even if it has, it would run the risk of losing its credibility by creating a downturn by pricking the bubble. It might be true that if the central bank had not intervened, things would have been worse. But the problem is that that state of the world is not observed.

Coming to the question of the pillars, that's where inflation targeting got a lot of of critique from one of the discussants, who thought that one of the lessons of the crisis should be that inflation targeting was not the best central bank policy over the long haul.

The European Central Bank's, or ECB, two-pillar strategy of money and prices were given as an alternative to inflation targeting. In fact, related to the previous question, it was argued that the ECB's consideration of money and credit in its monetary policy strategy had enabled it to lean against the wind in the face of unsustainable financial trends. The argument goes that, since financial imbalances are associated with strong credit and growth aggregates, central banks can use them rather than try to target asset prices directly.

So far so good, but I am missing something in this argument, maybe because I am not a monetary economist. Namely, the critique I outlined is based  on a very canonical New Keynesian model, where money is deemed redundant for the monetary transmission mechanism. However, you can extend this basic model to account for money and integrate money into an extended Taylor rule. For an example of what I have in mind, have a look at this paper.

Note also that there is not a binding "central banker constitution" that prevents an inflation targeter from watching over money and credit. The Central Bank of Turkey, or CBT, does that all the time, and their recent normalization actions, which I summarized in my Hurriyet Daily News & Economic Review column a couple of weeks ago, are partly in response to monetary and credit developments.

But if you'll explicitly target money or credit, you had better have the appropriate instruments to do so. This is the famous Tinbergen rule, which simply states that you need to have at least as many policy tools as targets. For example, if you targeting both inflation and unemployment, you need to have at least two tools. But you can cheat the rule somewhat by having your instrument respond to a linear combination of targets, that's what the Taylor rule mentioned above actually does.

I know I am starting to get boring, so just a small footnote to make this discussion more interesting: Dutch economist Jan Tinbergen, who is named after the rule, won the first Nobel price in Economics back in 1969. Not to be outdone, his brother Niko won the Nobel in Physiology or Medicine a few years after him. They have there more siblings who, surprisingly, did not get any Nobels:)...

Turning back to the matter at hand, a good starting point for the next two questions, 4 and 5, would be the Tinbergen rule. Since central banks' sole instrument in shaping their policies is the interest rate, they would need a second policy tool if they were to target financial stability in addition to price stability. This second set of tools is regulatory or supervisory powers.

So far so good. But there are quite a bit of complications with combining monetary policy and financial regulation at a single body. For one thing, this may produce an inherent conflict of interest. Can a Central Bank having to work with banks for the smooth operation of monetary policy be equally diligent in making sure the balance sheets of the very same banks are strong enough? In fact, a recent column from a Turkish ex-Central Banker illuminated me that this was the exact same worry that led to policymakers at the time for an independent agency for banking regulation and supervision.

But there is a simple way out of this dilemma. It is possible to leave the regulation of individual banks to another agency and have the Central Bank take over macroprudential regulation. But even then, there are serious issues that need to be resolved.

For one thing, what if there is a conflict between price and financial stability? Then, striking the right balance between the two would be a very delicate task, with the danger being that neither would be satisfied and the central bank would lose credibility as a result.

Secondly, combining the lender of last resort with the macroprudential regulator could result in what economists call the time inconsistency problem. In our context, this means that even though a central bank is committed to running a tight ship in terms of macroprudential regulation, that commitment has no meaning, as the bank will have to flush the system with liquidity when the crisis means. But since this is known in advance, the central bank's financial stability arm has no muscle.

By the way, if I am starting to sound boring again, note that Kydland and Prescott won the Nobel Prize in economics for their work on the time inconsistency problem back in 2004, although Odysseus of Ithaca knew the solution to the problem a couple of thousand years before them: He tied himself to the mast of his ship, as he knew that he would be lured by the sirens. In other words, he ruled out beforehand time-inconsistent policy by literally tying his hands.

Coming back to serious (and boring) matters, there is also the danger that the public may not like such great power at the hand of unelected bureaucrats and the politicians may be too tempted to temper with such an all-powerful central bank. Note that even without much power over financial stability, the Central Bank of Turkey has been criticized a lot by ministers in the past couple of years for supposedly keeping the interest rates way too high and the lira appreciated.

These disclaimers on combining monetary policy with regulation necessitate another footnote: As you can see, a lot depends on the credibility of the central bank and the country in question. The three issues mentioned above might not be a big deal for a credible central bank operating in a credible country with a history of price stability, where it is taken for granted that the central bank will not be pressured or meddled with by the government. But they may be the route for permanent loss of credibility and recipe for disaster where price stability and central bank credibility hangs in a dangerous balance. 

So maybe the moral of all this is that there is no single answer to these questions. They should be answered under the context of the central bank and the country in question.

Last but definitely not the least, on the issue of quantitative easing and other unconventional policies: The question of adequacy did not get much attention, as with interest rates at record-lows in the developed world, there is not much else to do. The discussion rather focused to the implementation of timely exit strategies, and here there seems to a difference of opinion between the U.S. Fed's hold-for-longer and ECB's more cautionary approaches.

Now that I have duly reported the session, let me share my single disappointment with this extremely thought-provoking discussion: Most of the discussion was based on developed country monetary policy. The little developing country / emerging market, or EM, discussion focused on Turkey, as two of the discussants wereTurkish.

That was a shame, as EM central banks are dealing with slightly different, but equally challenging, problems. For one thing, a timely exit is much more important for them, as, contrary to their kinsmen in developed countries, they are already starting to see signs of overheating in their economies. Therefore, exiting before the developed world means rising interest rate differentials a flow of fresh money to these countries.

OK, but why worry, you might wonder. The problem is that the inflows to EMs are causing their currencies to appreciate- this is the background of the currency wars theme that has taken so much attention of late, especially during the annual IMF-WB meetings.

The question for the central banks and/or governments is whether they should respond to such currency appreciation pressures and how. Some countries have started to implement capital controls. Others are just buying up foreign currency as if there is no tomorrow. The Central Bank of Turkey introduced quite an ingenous scheme just after the GES meetings. As a longer-term, institutional solution, it has also been suggested that the standard Taylor rule should be enhanced to account for the exchange rate as well. 

This EM perspective is really an interesting angle, but it was disappointingly absent from the discussion. But maybe there is only so much you can talk about just over an hour...