Charles Bean, Professor of Economics, London School of Economics; former Deputy Governor for Monetary Policy, Bank of England; former Chief Economist, Bank of England.
Has the experience of the crisis changed your view of the central bank policy toolkit?
Former Deputy Governor Bean: Most certainly. First, the natural real safe rate of interest has been persistently depressed by a combination of high savings, weak investment and portfolio shifts in favor of safer assets. That means prolonged periods when policy rates are at their (near) zero lower bound are more likely, necessitating greater reliance on unconventional monetary policies instead.
I think the experience in both the United States and the United Kingdom during 2009-10 suggests that large-scale asset purchases (quantitative easing) can have a material effect on the term structure of interest rates, though the efficacy of such policies is likely to be less when markets are functioning well than when then are dysfunctional, as was the case after the collapse of Lehman Brothers. However, there is no doubt that the repeated use of such policies does blur the line between monetary and fiscal action. That potentially also makes it harder for the central bank to pursue an independent monetary policy, especially during a tightening phase when the central bank may be selling assets.
The academic literature puts rather more weight on forward guidance as a way to inject further stimulus at the lower bound. The inability of policymakers to tie the hands of their successors means, however, that a promise to pursue a time-inconsistent “low for long” rate path is incredible for more than a year or so ahead. Moreover, practical experience with forward guidance has been somewhat mixed. For instance, the forward guidance introduced by the Bank of England in August 2013 tied the policy rate to the evolution of unemployment (and therewith to the path of productivity, a key uncertainty). Press and market commentary, however, focused excessively on the associated central expectation of when the conditions for considering a rate increase would be satisfied, i.e. they translated state-contingent guidance into date-dependent guidance. When unemployment fell faster than expected, that was somehow regarded as being a failure of the guidance, resulting in some damage to the reputation of the Monetary Policy Committee.
Beyond the extension of the monetary policy toolkit, there has also been a notable expansion in the role of central banks in containing financial stability risks through the application of macroprudential tools (i.e. regulatory instruments deployed with an eye on containing and reducing systemic financial risks). The new conventional wisdom is that such tools should be the first line of defense against building financial stability risks, rather than monetary policy. I think this is right: such tools can be tailored to dealing with the pertinent risks (e.g. raising risk weights on types of lending where excesses are appearing) and thus have a comparative advantage in mitigating financial stability risks relative to the use of monetary policy. However, one needs to recognize that these tools are somewhat unproven, and there may be times that they need to be backed up by monetary policy actions, i.e. monetary policy may need temporarily to be tighter than justified by macroeconomic conditions alone.
Where should we be looking for financial stability risks?
Former Deputy Governor Bean: Almost by definition, risks are going to creep up where one doesn’t expect them. If you take the United Kingdom in the years leading up to the crisis of 2007-8, it wasn’t the case that we were overly complacent at the Bank of England. We spent a lot of time fretting over whether U.K. house prices were overvalued and that we might undergo a repeat of the housing bust of the early 1990s. We also spent a lot of time fretting about the consequences of the correction of what appeared to be exchange rate misalignment. But we didn’t fully comprehend the implications of what was happening in U.S. housing finance and the associated fragilities that were building up not only there, but here in Europe too as a result of European banks’ holdings of what turned out to be toxic U.S. assets.
Having said that, whenever there appears to be high, or rapidly rising, leverage, alarm bells should ring. My guess is that the next round of financial vulnerabilities will turn out to be down to private businesses (not sovereigns) in emerging economies that have taken advantage of low interest rates and ample liquidity in the United States and other advanced economies to borrow in foreign currencies, especially dollars. In many cases the other side of their balance sheets will be in domestic currency. That currency mismatch leaves them exposed if exchange rates change (in particular if the dollar continues to strengthen).
What do we need to do to preserve the benefits of global finance?
Former Deputy Governor Bean: There is no doubt that the financial crisis and recent scandals, such as the manipulation of Libor and Forex benchmarks, have badly damaged public trust in finance (and, indeed, in capitalism more generally). The most important thing is to put an end to the “Heads I Win, Tails You Lose” feature of financial markets, whereby participants walk away with exorbitant rewards, not only in good times but even when things go wrong, with the taxpayer bearing the costs. So ending “Too Big To Fail” is central. We are in a better place than we were: banks have bigger capital buffers; there are arrangements for bailing in more of the debt stock; and resolution regimes are closer to being fit for purpose. Even so, I think regulators, central banks and finance ministries might still struggle to deal with the failure of a multinational SIFI.
One thing I wouldn’t do is place too much faith in regulation to curb excesses. Regulators are always likely to be one step (or more) behind financial institutions, especially when the latter can see profitable opportunities. Moreover, I am concerned at the complexity of the post-crisis regulatory environment, some aspects of which reflect the favoring of particular national interests. Such complexity makes it easier for financial institutions to find and exploit loopholes to circumvent the intent of the regulation.
Far better, in my view, is to ensure that there is plentiful loss-absorbing capacity in the form of equity capital and convertible or bail-in-able debt. That provides shareholders and bondholders with plenty of incentive to monitor and contain the risk-taking activities of managers and employees. And when things do go wrong, as they surely will, governments must be prepared to resist the special pleading which will no doubt come from those who are expected to bear losses.