Inflation Targeting by Central Banks: Is it still appropriate?

Not many have escaped blame for causing the global financial crisis. Some more, some maybe less. Central Banks for one probably fit in the latter category. Martin Wolf of the Financial Times think they deserve more blame:

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

Over almost three decades, policymakers and academics became ever more confident that they had found, in inflation targeting, the holy grail of fiat (or man-made) money. It had been a long journey from the gold standard of the 19th century, via the restored gold-exchange standard of the 1920s, the monetary chaos of the 1930s, the Bretton Woods system of adjustable exchange rates of the 1950s and 1960s, the termination of dollar convertibility into gold in 1971, and the monetary targeting of the 1970s and 1980s.

Frederic Mishkin of Columbia University, a former governor of the Federal Reserve and strong proponent of inflation targeting, argued in a book that inflation targeting allows for all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation. Now that we are living with the implosion of the financial system, this view is no longer plausible.

No less discredited is the related view, that it is better to deal with the aftermath of asset price bubbles than prick them in advance.

Complacency about the Great Moderation led first to a Great Unravelling and then a Great Recession. The private sector was complacent about risk. But so, too, were policymakers.
What role then did monetary policy play? I can identify three related critiques of the central banks.

First, John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule, which relates interest rates to inflation and output. This caused the housing boom and the subsequent destructive bust.

Prof Taylor has an additional point: by lowering rates too far, the Fed, he argues, also caused the rates offered by other central banks to be too low, thereby generating bubbles across a large part of the world. This induced a lowering of standards for granting credit and so a credit bubble.

Second, a number of critics argue that central banks ought to target asset prices because of the huge damage subsequent collapses cause. As Andrew Smithers of London-based Smithers & Co notes in a recent report (Inflation: Neither Inevitable Nor Helpful, 30 April 2009), “by allowing asset bubbles, central banks have lost control of their economies, so that the risks of both inflation and deflation have increased”.

Thus, when nominal asset prices and associated credit stocks go out of line with nominal income and prices of goods and services, one of two things is likely to happen: asset prices collapse, which threatens mass bankruptcy, depression and deflation; or prices of goods and services are pushed up to the level consistent with high asset prices, in which case there is inflation. In the short term, central banks also find themselves driven towards unconventional monetary policies that have unpredictable monetary effects.

Finally, economists in the “Austrian” tradition argue that the mistake was to set interest rates below the “natural rate”. This, argued Friedrich Hayek, also happened in the 1920s. The result is misallocation of resources. It also generates explosive growth of unsound credit. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose. As a result, we now face two challenges: clearing up the mess and designing a new approach to monetary policy.

On the former, we have three alternatives: liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard. That is why we should not have fallen into the quagmire in the first place.

On the latter, the choice, in the short term, is certainly going to be “inflation targeting plus”. “Out” is likely to be the “risk management” approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. “In” is likely to be “leaning against the wind” whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical “macro-prudential” approach to capital requirements in systemically significant financial institutions.

This unforeseen crisis is surely a disaster for monetary policy. Most of us – I was one – thought we had at last found the holy grail. Now we know it was a mirage. This may be the last chance for fiat money. If it is not made to work better than it has done, who knows what our children might decide? Perhaps, in despair, they will even embrace what I still consider to be the absurdity of gold.

Quoted from: "Central banks must target more than just inflation" by Martin Wolf, Financial Times, May 5, 2009.

Unemployment hits multi-decade highs

The inevitable outcome of an economic recession is rising unemployment. By how much depends on the severity of the economic downturn. Well, judging by the numbers this recession is pretty severe. Financial Times reported the following story:

US unemployment climbed to 8.9 per cent in April, its highest level in a quarter of a century, as the economy shed more than half a million jobs, official figures revealed on Friday.

The latest non-farm payrolls data showed that 539,000 jobs were lost in April, making it the seventh-worst month for job losses in half a century. The decline was down from a revised 699,000 loss the previous month and the smallest monthly loss total since last October.

“While it is somewhat encouraging that this number is lower than it has been in each of the past six months, it is a sobering toll,” said Barack Obama, US president. “It underscores the point that we are still in the midst of a recession that was years in the making and will be months or even years in the unmaking.”

Analysts said some slowing in the pace of job losses was consistent with the idea that the rate of decline in the US economy was slowing. However, the jobs report confirmed that the US labour market was still very far from stabilising.

Over the past six months, the US economy has lost 3.94m jobs – the most in any similar period since records began, exceeding even the job losses caused by demobilisation after the second world war.

Analysts said the rate of initial unemployment claims looked to have peaked, suggesting job losses would be lower in the coming months, but that unemployment was likely to rise well into next year.

A painful, but necessary solution to the financial crisis

Professors Matthew Richardson and Nouriel Roubini are of the opinion that no easy, pain-free solution is possible to solve the financial crisis. They wrote the following article that appeared on FT.com:

Joseph Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. The government stress tests on the 19 largest US banks could have facilitated this process. The opportunity looks likely to be missed.

The tests, which measure how viable banks are under adverse economic conditions, have no “failed” category, even if as many as 10 are reported to need additional capital. But, given that the economic environment already reflects the tests’ worst-case scenario and that recent estimates by the IMF of financial sector losses have doubled in six months, the stress test results will not be credibly interpreted as a sign of bank health.

Instead, market participants will conclude that banks requiring extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help.

Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.

Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialised risk. Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?

One possible reason is the “Lehman factor” – the bank runs that would occur as a result of a big failure. But we have learnt from the Lehman collapse and know not to leave the sector high and dry when a systemic institution fails. Just being transparent about which banks clearly passed the stress tests would alleviate many of the fears.

Another reason is counterparty risk, the fear of being on the other side of a transaction with a failed bank. But unlike with Lehman, the government can stand behind any counterparty transaction. This will become easier if a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.

That leaves the creditors – depositors, short- and long-term debt-holders and preferred shareholders. For the large complex banks, about half are depositors. To avoid runs on these deposits, the government has to provide a backstop. But it is not clear it needs to cover other creditors of a bank, as the failures of IndyMac and Washington Mutual attest.

Even if systemic risk were still present, the government should protect the debt (up to some level) only of the solvent banks, not the insolvent ones. That way, the risk of the insolvent institutions would be transferred back from the public to the private sector, from the taxpayer to the creditors.

Suppose the systemic risk problem is solved. The other argument against allowing banks to fail is that after a big loss by creditors, no one would be willing to lend to banks – which would devastate credit markets. However, the creative-destructive, Schumpeterian, nature of capitalism would solve this problem. Once unsecured debtholders of insolvent banks lose, market discipline would return to the whole sector.

This discipline would force the remaining banks to change their behaviour, probably leading to their breaking themselves up. The reform of systemic risk in the financial system would be mostly organic, not requiring the heavy hand of government.

Why did creditors not prevent the banks taking excessive risks before the crisis hit? For the very same reason creditors are getting a free pass now: they expected to be bailed out. For capitalism to move forward, it is time for a little orderly creative destruction.

Stressful times for the banks...

Greg Morcroft of MarketWatch, wrote the following story:

Shares of the country's largest banks rose Wednesday as details emerging about stress test results looked better than expected.

Bank of America confirmed in a published report that a government checkup determined the company needs an additional $34 billion in tangible common equity, and that those needs can be covered by converting existing government investments into common stock. That's less than analysts and investors had been predicting the bank might need.

Bank of America and the others will have various options in raising new capital, including converting current preferred shares held by the government to common stock, as Citigroup has already agreed to do, or by selling assets or securities.

Further aiding bank gains, another report indicated that the tests have determined American Express will not need new capital. The government holds $25 billion of convertible preferred shares of J.P. Morgan Chase, while it has invested about $3.4 billion in American Express.

Wells Fargo & Co will need about $15 billion in capital following a U.S. government-led stress test, Bloomberg reported. Wells currently holds $25 billion of capital from the government, which it got in exchange for preferred shares under the TARP plan.

Bloomberg also reported that Citigroup would need about $5 billion of new capital. The federal government has already invested $45 billion in Bank of America but that investment was in preferred shares and doesn't count toward the type of capital regulators are testing major U.S. institutions for. According to the reports, the bank could convert the preferred into common shares, and the new common stock would count toward the required capital. That would, according to the reports, preclude the need for a new investment from the government.

Bank of America shares, a component of the Dow Jones Industrial Average, traded 10% in the pre-open but recovered and were up about 12% by afternoon at $12.13.
"It is conceivable that Bank of America could convert its existing preferred stock, and put the capital issue behind it assuming the economy does not take another significant leg down," Citigroup analysts said in a research report Wednesday.

However, such a conversion would create its own new problem-- namely, making the U.S. government one of the bank's largest shareholders and diluting the stakes of existing shareholders. "Our analysis shows dilution could range from as low as 20% to as high as 35%," the Citigroup analysts said of Bank of America.

The New York Times report cited J. Steele Alpin, Bank of America's chief administrative officer, as saying, "We're not happy about it because it's still a big number. We think it should be a bit less at the end of the day." Some analysts had expected Bank of America to need up to $70 billion of fresh capital.

On a related note, banks that want to return money received under Washington's Troubled Asset Relief Program will have to show that they can borrow funds without government guarantees, making it less attractive for some to free themselves from the government's clutches, The Wall Street Journal reported late Tuesday.

Some banks are keen to return the TARP funds, partly because of the strict conditions they place on executive compensation, dividend payments and stock buybacks imposed after the investments were made in the wake of the September financial crisis. However, regulators want to make sure that banks are financially strong enough to keep lending before allowing them to return the money.

The recession is gathering momentum...

Jane Croft of the Financial Times reported on the rising figure for personal insolvencies and company failures in the UK; clearly a sign of the times we live in...

It was the worst quarter for personal insolvencies since the 1980s, said Mark Sands, of KPMG professional services. The figure at the height of the early 1990s recession was 38,792 for the whole of 1992. Consumer debt is still at record levels and people are being hit by the recession which is pushing up unemployment and repossessions,” said Mr Sands. He predicts 150,000 personal insolvencies this year.

Pat Boyden, of PwC business recovery services, said he expected the number to increase to between 130,000 and 150,000 this year partly because of the introduction of debt relief orders, a new form of bankruptcy for people with debts of less than £15,000.

“We are now seeing a lot of self-employed people and entrepreneurs and buy-to-let landlords getting into difficulty,” Mr Boyden said. “What may be interesting is that in the 1990s recession, bankruptcies continued to increase for nearly three years after the worst of the recession had passed.

“If that is the case this time, we may be seeing record figures every quarter until 2012,” he added. The rise in bad debts will push up impairment provisions at embattled banks as people default on credit cards, loans and mortgages.

Company failures also rose sharply in the first quarter of the year. Insolvency Service figures show that 4,941 companies went into compulsory liquidation or creditors’ voluntary liquidations.

This is a jump of 56 per cent from the same period in 2008 and a 7.1 per cent rise on the last quarter of 2008.