The Hindu Business Line : When central banking must be thrown to the winds

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When central banking must be thrown to the winds

Intervention to check asset bubbles seemed to be a remedy worse than the disease.

S. Balakrishnan

Do central banks have wider responsibilities than just setting interest rates? It is the big question engaging the best minds in the academic and financial worlds.

In a dramatic transformation, in the space of just a couple of decades, it is financial markets which drive economies and not the other way round. Asset price booms (starting with the stock and property boom of eighties Japan) create equity more or less out of thin air. This fuels credit expansion far above the needs of the real economy and also has a sort of ‘feedback’ effect on the latter (both in forward and reverse gear as the present crisis shows).

Whether all this is for the good or bad has been the theme of practically every gathering of central bankers and economists in recent years. In the end, they could only worry about it. Intervention to check asset bubbles seemed to be a remedy worse than the disease. And even if you decide to intervene, how and when do you do it?

If actions speak louder than words, the US Federal Reserve has clearly come down in favour of an active (if not proactive) role for central banks after an asset bubble bursts. Do what is necessary now, worry about consequences later, is the approach. The test seems to be whether a distressed financial institution’s collapse will cause the financial system to collapse (and bring the economy down with it).

In tackling the present crisis, the Fed Chairman, Mr Ben Bernanke’s knowledge of monetary history certainly helped. The Great Depression, in his view, was precisely because the Fed stayed passive at a time of deep financial turmoil and perversely increased interest rates and reduced liquidity when the economy and markets were desperately crying for help.

It is not as if the Fed’s bailout of Bear Stearns in the current crisis is new. Mr Bernanke’s predecessor, Mr Alan Greenspan, did the same thing for Long-term Capital Management (LTCM), which was not even a bank, when it went under about a decade ago.

Fortunately, the dominant opinion, in these turbulent times, supports the present Fed actions. Except for two, the vast majority of the members of the Federal Open Market Committee (FOMC), which decides US interest rates, went along with the steep rate cuts of recent months. They have respected voices, like billionaire Warren Buffet’s and the conservative economist, Martin Feldstein’s (adviser to Republican Presidents) on their side.

A number of now hard-learnt lessons make another similar crisis less probable. The most important of these is credit re-pricing, both in origination and securitisation, to reflect risk. Deadbeat borrowers will not qualify for loans. Assumptions of ever increasing asset (collateral) prices will be questioned. No longer will (or should) credit rating agencies equate corporate and retail obligations. Investment and trading in financial markets will not be as highly leveraged, providing a better cushion if things go suddenly wrong. In other words, the real economy will count for more than it did pre-crisis.