Central Banks and the Illusion of Stability
In the 17th century, Sir William Mallery was a well-master who lived on the outskirts of Rutland, England. In the English Civil War of 1648, the town had lost many of its fighting-age men in battle. Legend has it that in the Battle of Worcester, Sir William fled the battlefield while a dozen of Rutland’s men perished. Consequently, he was labeled a coward. According to Sir William, he chased the enemy on foot and reports of his departure were just plain wrong. But nobody believed him. So, the coward moniker stuck with him, and he bristled at his ill-found reputation. He had always felt that his destiny was to be somebody important, but after his disgrace in battle, the townspeople ignored him. Consequently, he longed for recognition and respect. So, in 1655, he hatched a plan to have the town magistrate’s wife, Lady Fielding, kidnapped so that he could publicly orchestrate a daring rescue. He conspired with a friend from a neighboring town, who dressed as the “black knight.” Sir William would be the rescuer, or “white knight,” and they would split the spoils.
The plan was for the black knight to kidnap Lady Fielding and keep her in one of Sir William’s wells on the outskirts of town. The kidnapping itself went off without a hitch. The black knight rode into the town square on his horse and swooped up Lady Fielding in front of dozens of townspeople, including her husband, the town magistrate. Naturally, the townspeople were worried about Lady Fielding. As was customary at that time, they collected 1,000 shillings as a reward for anyone who rescued Lady Fielding. But without any fighting-age men in good standing, they quickly grew desperate. However, when Sir William told the townspeople a story about the deadly history of this mysterious black knight, they grew scared and offered the money in advance to entice somebody to find the “damsel in distress” and return her to safety. In front of all the townspeople, Sir William loudly proclaimed that he would not return without her, collected the money, and rode off on his horse.
But there was a problem. The black knight decided he wanted 80% of the rescue fund for putting himself at risk in the kidnapping, and Sir William decided that he also wanted 80% for himself in case the plot were ever discovered because he would face the penalty and his friend would live anonymously in another town. The black knight insisted that if he didn’t get his share, he would take Lady Fielding with him and make her his slave. Sir William, realizing his plan was failing and not wanting any harm to befall Lady Fielding, fought the black knight. After a grueling exchange of blows, Sir William won. He threw 200 shillings at the black knight and kept 800 for himself.
Unbeknownst to Sir William, the exchange was witnessed by some children who were out hunting pigs and farrow. They discovered the ruse and went back to town to let the townspeople know. Sir William returned with Lady Fielding and shared a tale of his valiant efforts to rescue her and “possibly” mortally wound the black knight before he got away. While he was sharing this tale of gallantry and bravery, the boys from the hunt called him out. They revealed that Sir William wasn’t a hero at all but, rather, the creator of an elaborate ruse to fool the townspeople for pride and money. Even though he did rescue a damsel in distress, she was in danger primarily because of him.
How is the tale of Sir William of Rutland any different from the Fed (and the US Treasury) rescuing the economy from the financial crisis of 2008? If the Rutland Ruse had happened today, the locus of discussion might be on the heroic rescue of Lady Fielding rather than her tragic kidnapping. Likewise, the locus of discussion regarding the financial crisis of 2008 is about the Fed’s rescue and bailout of the banking system, not about the various policies that led to crisis. Of course, the Fed is not solely responsible for the crisis. To suggest otherwise is foolish. However, if we are to move forward, we must talk objectively about all the sources of the crisis and remove people and institutions that led us astray.
The story of Sir William of Rutland is a parable, but the glorifying of the Fed and bailouts is all too real. Recently, Timothy Geithner wrote a book called Stress Test, in which he laid out his justification for the bailouts, painting a picture of himself and Ben Bernanke as the saviors of the markets. Don’t buy it. Over the past several years, we have also heard such justifications from Hank Paulson, Alan Greenspan, and Ben Bernanke. The combination of below-market rates, major trade imbalances, loose lending, fiat money, and perverse incentives helped the crisis spread all over the world. Below-market interest rates pushed the entire marketplace to borrow more than it otherwise would. Major trade imbalances enabled foreign central banks to purchase US Treasuries, which pushed rates down all along the yield curve, again affecting markets worldwide. Today’s persistent trade imbalances are possible only because fiat currency is not backed by gold or specie of any sort, affecting whole countries and markets. Lack of coordination between the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation created large gaps in the regulatory framework, allowing non-bank lenders to lend to anyone and letting banks sell their entire exposure to originated loans to anyone, again affecting whole markets. Lastly, banks not only securitized loans, but they also sold and securitized their underlying interest in the first losses of the loan pools — which created the perverse incentive for lenders to originate without regard to the credit quality of the underlying borrower. Through securitization, bad loans were then sold in the form of mortgage-backed securities, collateralized loan obligations, and so on to investors all over the world. Just as treating Sir William as a hero would only encourage him to create more deceit, treating central banks as saviors only encourages more of the same.
Just as human beings like Sir William should be measured by the entirety of their actions, monetary policy should likewise be judged by the entirety of its effects. In other words, the financial crisis of 2008 did not just happen one day out of the clear blue sky. Bad choices were made by many players, including the Fed. Today, we stand at the 100-year anniversary of the Federal Reserve. Before it was formed, there was a different system in place. What system? What did it look like? How can a country operate without a central bank?
Before the Fed, the US government made rules and regulations for banks that affected lending and credit, so we must not assume that there was a complete void. And for much of this period, banks issued their own currencies. That’s right: Each bank had its own money stock and its own gold reserves or other form of specie. Each bank effectively operated as its own central bank, issuing currency that was backed by the trust of the public based on how well the bank was managed and how much gold (or specie) backed the money. When there were surges in demand for bank notes — and there were — banks issued more bank notes subject to the constraint of public trust (largely determined by the adequacy of specie to back the notes). The weakness of this system was that trust was localized. Bank notes were very valuable in close geographic proximity to the bank where they could be redeemed. The farther a bank note was from its primary issuer, the greater the discount required for another bank to redeem the note. For instance, if I had a $100 bill issued by my bank in Washington, DC, that same bill might be worth only $99 in Baltimore, and $96 in Chicago, and $90 in Los Angeles. However, this lack of trust was due to information asymmetry and a high cost of discovery. Today, because of the internet, the cost of discovery is virtually nil. And a competitive currency framework would encourage the transparency that people need to prudently manage their finances.
During the financial crisis of 2008, correlations between asset classes went to 1.0, meaning that virtually all asset classes fell in tandem. Why? What caused the crisis to be so uniform? Central banks. Some may counter that central banks rescued the financial system from imminent collapse. Although this is true, central banks were major contributors to the credit bubble, whose popping caused so much damage. The public seems to view central banks as the white knight who rode in to rescue the damsel locked in the tallest tower. How would you feel about that white knight if you learned that he was the one who locked her up?
Warren Buffett once famously said that he looks to invest in companies that could be run by a monkey because sooner or later, they will be. Of course, central banks are far more enduring and powerful than individual companies. Even if you agree with a particular approach or philosophy of a particular central banker, sooner or later, you won’t. Why give that power to anyone? It’s hard to imagine life without central banks. We’ve had them in the United States for 100 years. Yet the United States operated for nearly 83 years without one (1831–1913). Putting such vast power over other people’s lives is dangerous. The Fed’s contributions to creating the crisis are far from trivial. Praising their rescue efforts in 2008 is not only misguided; it is downright dangerous because central banks push millions, if not billions, of people to do things that they would not do on their own — be it consumers taking on larger mortgages, businesses buying back stock rather than investing in capital expenditures, or investors shifting their allocations toward riskier assets in search of greater yield. It’s high time for a complete discussion about the role of central banks in our economy.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: ©iStockphoto.com/retrorocket
Thank you, Ron for so well-written article. Your comparison speaks for itself with no doubt. Following up, how do you see the future of central banks, and probably currency backed by gold or silver etc.? Will you have a chance to share your vision on that in your future articles?
I’m encouraged to see this type of commentary.
Most of us would rather not think about these things.
A term to ponder: Dark Pool Liquidity
“Because it is sometimes so unbelievable, the truth often escapes being known.” — Heraclitus (535 — 475 B.C.).
Thank you Ron for one of the best entries in this blog ever. I think one cannot discuss the role of central banks in an economy enough, but unfortunately it is all too often not done at all.
Instead the central banks of this world become heroes once they bail out investors who have taken on too much risk.
I suggest everyone should read Alan Meltzer’s History of the Federal Reserve as an introduction of the many mistakes the Fed has done in the past just to appear as the white knight once things go haywire.
Joachim, thank you for your comments! I haven’t read Meltzer’s piece, but I’ll look at it. Thx for the suggestion.
Thanks John. I also appreciate the quote of Heraclitus. Wisdom for the ages.
We cannot argue that the independence of Central Banks is healthy for economic and financial purposes. The problem seems to rely on those bankers inside CBs and their incapability to control those highly complex financial instruments that the smarter/greedy guys create, being aware of those future consequences. Great article.
Thanks Juan! Central banks are not independent. Rather they are dependent. Consider the case of the United States in the past 6 years. As the federal government ran enormous fiscal deficits, the central bank was forced to deal with that reality. This is not unique. When the Federal government runs large deficits, calling central banks independent simply gives the government cover to do what it wants. Moreover, the average citizen has no understanding of these issues. At the very least, if the deficit funding came entirely from taxation, at the very least the average citizen might be aware of the choices governments are making. As such, they can choose the give or withhold their consent. As it is now, the average citizen can’t associate the impact of the government choices with taxation. Instead, the impact is diffuse as asset prices, consumer prices and various services exhibit inflation at different times and in different magnitudes, which means the average citizen cannot associate the effect with the cause. And how can we blame them, economists have a hard time with this too!
Great article! Unfortunately, I don’t believe that the discussion that you suggest is possible in today’s political environment. Big (real) change just doesn’t seem possible to me. This type of tectonic shift in thinking seems very likely to stall at some point before action is taken, ultimately becoming a nice bumper sticker that makes us smile like, “fair tax.org” or “who is John Galt?”. Hope I’m wrong…
Hi Adam! Many new ideas seem crazy or unattainable before they gain traction. But people need to see the truth for what it is. If they still choose one path over another, then so be it. But from an analytical perspective, it is also important to compare what is with what the markets would do all by themselves. This helps one to separate the impact from underlying supply and demand from policy. Thanks for reading!
The sentiment here is certainly Jacksonian, though I’m not sure whether that’s a good thing. However, I think the article conveniently omits and exaggerates certain facts in financial history. Sure the US technically operated for 83 years without The Central Bank… but that doesn’t mean other institutions didn’t serve similar functions. There were local banks that served as clearinghouses and guaranteed deposits. This was shortly followed by a “national bank” system, primarily to deal with both the Civil War and the fact that half of all banks were failing on a regular basis. However, even that couldn’t deal with seasonal flow of funds that regularly caused liquidity crises like the Panic of 1907. I should note that several people attribute the Panic of 1907 to the very lack of a central bank/ lender of last resort, and they certainly give JP Morgan credit for acting in that capacity to stop the Panic. And even moving to the most recent crisis, sure the Fed probably had something to do with it…. by virtue of controlling a pretty significant driver of the economy. But what’s the criticism? That they kept rates too low for too long? As opposed to looking at outright fraud being committed by mortgage originators (fraud that is much more directly linked to a liquidity crisis or crisis of confidence), it seems irresponsible to point the finger at what is a fundamentally reactionary institution. And we should want them to be reactionary… imagine a Fed that tried to time the market. Besides, we’ve absolutely had asset price bubbles which popped, yet barely affected the fundamental economy (the most recent being the tech bubble of 2000). And again, while one could point to the “too low too long” argument, the isolated nature of the tech bubble certainly points more to a one-off instance of animal spirits than some systematic central bank error. Frankly, I think you could have had a call money rate multiple times higher and people still would’ve been subscribing to Pets.com and piling into Cisco stock. Just like you could have had a fed funds rate that was higher in 2005 but Countrywide would still be originating toxic mortgages, and you’d still get a liquidity crisis.
Hi Mike,
I always love a challenge. Thanks for the collegial criticism while keeping it respectful. Well done!
Your comment covers a huge expanse of history. So, it is difficult to comment on all of it. And certainly you bring up interesting points as there are always many facets to history. So, let me just take issue with a few of your points.
First, during the Laissez-Faire era, there were many issuers of currency – post offices, banks, general stores, etc. The competition acted as a check and balance on each other, as well as government spending. It was very hard for governments to do serious deficit spending back then. Yes, there were bank runs and and other difficulties, but various bank laws prohibited banks from diversifiying their deposit base and they were exposed to high concentrations of risk. If left to their own devices, banks could have better manged these risks. So, even during the Laissez-Faire era, banks were subject to many difficult regulations that impacted their liquidity during a crisis. Of course it wasn’t perfect. It’s a human system. Some banks were terrible and did foolish things. Nothing is perfect. But tell me, have we created perfection in banking today? We have had lots of crises since the creation of the Fed, only now, the system is in effect coordinated to ensure that errors in judgement are replicated throughout the system. Taken in combination, fiat money, low rates, bond buying, etc. is consolidating power for the Federal government at the expense of labor markets, private sector balance sheets and thrift.
Second, to call the Fed a “reactionary” institution is simply inaccurate. What’s your starting point? Even if the Fed is reacting to something else as a “first cause,” its reactions then become a first cause for something else. At what point in history do you begin your analysis? It is not possible to isolate first cause in the laboratory of the real economy. Moreover, the Fed itself is not only the executor of monetary policy, they are the primary regulator for much of the banking system. Their policies (as well as other government policies – i.e. Dodd-Frank) influence the volume of loans, quality of loans, allocation between loans and securities, etc. In recent years, as the Fed has held rates low, it has caused an explosion of capital in emerging market stocks and bonds, high yield bonds and a variety of lower credit quality instruments. Policy also influences how much banks purchase sovereign bonds. Back in the Laissez Faire/classical gold standard era, governments often had lower credit ratings than companies. Policy and government power have shifted the balance of power toward governments. Regarding the seasonal liquidity needs of the banking system in the 1800’s and early 1900’s, seasonality in banking was driven largely by the planting and harvesting cycle of a largely agrarian society. Do you seriously think society is largely agrarian today? My main point is not to suggest that any one system of finance is perfect. It’s not. There are no utopias. Only trade-offs. But the trade-offs under which we live today are poorly understood. Governments act in their own interests and finance deficits in a variety of ways – partly by selling bonds, partly by getting the banking system to buy more bonds than they otherwise would and partly by purchasing bonds with new money on either primary or secondary markets. All of these activities have consequences for markets and do not stand in isolation. Central banks react to both policy and economy, but are not just reactionary. They are also first cause in a chain of events.
Ron,
I’m not quite sure I follow you when you say “the system is in effect coordinated to ensure that errors in judgement are replicated throughout the system. Taken in combination, fiat money, low rates, bond buying, etc. is consolidating power for the Federal government at the expense of labor markets, private sector balance sheets and thrift.” If this is expressing the same sentiment as “During the financial crisis of 2008, correlations between asset classes went to 1.0, meaning that virtually all asset classes fell in tandem. Why?”… well I really doubt the answer is “because of the Fed.” It really does have everything to do with a liquidity crisis, specifically one where every single financial institution held a bunch of paper they thought was AAA… but then everyone all of a sudden realized it wasn’t AAA. So what happens when the entire system needed to raise capital at once to meet losses from instruments that, for all intensive purposes, were not supposed to lose money? They start selling everything to meet the “margin call” and stay afloat. Sure they were borrowing at X rate and lending at Y rate which were influenced by the Fed…. but I can’t see how the Fed is to blame for things like Repo 105 or the originator’s fraud that caused toxic assets to be perceived as AAA. It’s like blaming the Fed for Enron.
With regards to the Fed’s reactionary-ness…. I don’t really take a starting point, but look more at the way the Fed thinks about itself and the economy. Keeping in mind their dual mandate (full employment and price stability) plus the “third mandate” of financial stability, the Fed usually doesn’t act until there is material evidence of the mandates being violated or fulfilled. Of course the Fed is a cause and a reactor to economic conditions (reflexivity pops out as a relevant idea), but that doesn’t change the mindset of conservatism that is present at the institution. In other words, their job is not to anticipate material changes in sentiment, data, markets, and overall economic conditions (although they must make forecasts), in the same way a speculator would. Think about what would happen to confidence and stability in the markets if you all of a sudden had a speculator-central bank that couldn’t bat anywhere near .300. This is why we usually see the Fed lagging behind conditions: they don’t tighten until there is inflation, they don’t ease until a recession has been confirmed, they don’t save banks until they are actually in trouble. The only examples of pre-emptive monetary policy I can think of are Volcker’s rate hike and Bernanke’s creative easing policies. But the typical lag simply happens by virtue of the board system at the Fed, like in all things with democracy and voting. Party X is looking forward, party Y is concerned about the present, and nothing happens until it needs to happen (hopefully). Democracy (or perhaps oligarchy), for lack of a better word, is slow but steady. A dictatorship would clearly be worse, marked by periods of benevolence and incompetence. And the alternative of economic anarchy… well I’m not quite sure what that would look like in today’s day and age. But I do struggle to see how a lack of Fed would have prevented the tech bubble and the banking crisis.
Either way, I can agree with the sentiment that each system is imperfect and has its trade-offs. But I think that maintaining protection from a liquidity crisis is well worth the potential risk of asset bubbles, and the jury is still out on that. Perhaps this article will better explain my sentiments: http://fortune.com/2014/03/27/redeeming-greenspan-dont-blame-the-fed-for-bubbles/
This is very expository of the developments we have in our financial system globally. To even think that the operational and instrument independence of the Central Banks cannot be fully guaranteed as they someway somewhat are influenced by governments, makes one cringe and wonder if we have not mortgaged our very lives and the development of financial systems particularly in jurisdictions with shallow financial deepening, to governments, who by the way appear as the white knight you clearly describe….What will be interesting to know will be the future of these institutions in the wake of future occurrences in the market…
Ron,
Great article, and I love the discussion it stimulated.
A dedicated Fed Watcher for more than two decades and attendee of several Humphrey
-Hawkins testimonies, I can confirm that the most powerful central bankers in the world are, quite simply, human! The course of history has demonstrated that bigger and bigger bazookas serves no greater good than taking an entire bottle of aspirin for a more extreme headache. Central Bankers cannot “plot” the course of human behaviors, actions, reactions: I suppose it’s a start that the post-Maestro Fed Heads, Bernanke and Yellen, will subtly admit their lack of confidence. Unfortunately, those geniuses of academia still follow a path of insanity so well defined by the truly great Albert Einstein as doing the same thing over and over again and expecting different results.
I tried to give Dr. Yellen some advice on the ills of Jackson Hole inspired papers and research and to use an age old econometric tool of a family monopoly game to see how quickly well-intentioned “tweaks to rules” can go awry: http://michaelhakerem.wordpress.com