Why Central Bankers Missed the Crisis
WSJ November 17, 2018
The lesson of 2008, a top economist says, is that monetary maestros don’t pay enough attention to financial markets. Are they making the same mistake again?
By Joseph C. Sternberg | 1641 words
It’s been a rough decade for most developed economies, as businesses, politicians, policy makers and voters have struggled with the aftermath of a global financial panic and deep recession. So it’s a good time to ask what we’ve learned—especially about the causes and cures of the financial instability that caused so many problems. Claudio Borio’s answer is sobering: We know less than we think we do, and our ignorance could cost us.
Mr. Borio is worth heeding from his unique perch running the economic-research department at the Bank for International Settlements. The BIS is an informational clearinghouse for the world’s central banks, providing data, convening meetings, and guiding debates on financial regulation. So he can draw on the practical insights that come from extensive contacts with policy makers—a distinct advantage over many academic economists. But in contrast to economists who’ve served in governments, Mr. Borio is not politically invested in one policy choice or another.
That allows him to start our conversation on a crisp autumn morning with a startling observation: “The state of knowledge is that we’re all struggling!”
He doesn’t mean that as a criticism of central banks, which, Mr. Borio says, acted quickly and correctly 10 years ago to stabilize the financial system. “The response to the crisis worked very well,” he says. “It was central banks pulling out all the stops and coordinating with each other. That helped at preventing the situation from running completely out of the control, stabilizing the financial system, stabilizing the economy,” and staving off a depression.
The problem is that politicians have come to rely too heavily on central banks to stimulate growth since the crisis. Mr. Borio describes the institutions as “overburdened.” At the same time, central banks are constrained by economic theories that offer little meaningful guidance for how to sustain growth and financial stability.
Here, broadly, is what mainstream monetary economists think they know: Inflation, employment and economic growth change in relation to each other in predictable ways. The central relationship between inflation and employment is described by a concept called the Phillips curve: As unemployment falls, inflation rises. The theory has been poked and prodded, bashed and battered since it was first proposed in the 1950s, but all variations share the belief that deflation is a result of economic slack.
Central banks can’t tolerate deflation because it signifies slower-than-natural growth in which too few people have jobs. Yet they have limited scope to influence the economy, according to the dominant theory. Over the longer term, financial, product and labor markets find their own equilibriums. Central banks can provide only limited jolts by tweaking short-term interest rates.
Mr. Borio thinks there’s a better approach. “Monetary policy has been reduced to very, very simple relationships that are built on a system that is self-equilibrating,” independent of anything central banks do. “Financial factors don’t really fit into it, and therefore monetary factors don’t really fit into it. The only thing you really have is an interest rate, for instance, that in the short run may affect output but in the long run ends up affecting only inflation.”
In other words, the dominant theories of monetary economics omit the most interesting, and important, consequences of monetary policy. When this model “talks about financial aspects like the financial system,” he says, “the only thing the financial system does is to allocate resources, given resources.” Yet financial systems also create resources by extending credit in response to monetary-policy incentives.
Nor can one elide the question of exactly how those resources are distributed. At the heart of Mr. Borio’s work is an insight most contemporary theorists miss: One needs to examine “how resources are allocated across different sectors in ways that may not be optimal.” It’s very different from the orthodox view that a rising tide of new money lifts all boats.
With that point in mind, economists need to go back to the drawing board. Another way of thinking about the breakdown of the Phillips curve “is that there may be longer-term structural forces that are in play here,” he says. “And personally, I’ve always felt that the way in which structural forces may actually be reflected in the failure of the Phillips curve to work has not been given the attention it deserves.” The big structural force Mr. Borio identifies is globalization, under which international competition puts sustained downward pressure on inflation.
Similar observations underlie the next big thing in monetary orthodoxy: “secular stagnation.” A 1930s-era Keynesian theory dusted off in late 2013 by Harvard economist and former Obama adviser Larry Summers as an explanation for the slow recovery, secular stagnation has gained academic currency as a way to revise the Phillips curve by incorporating more variables. Aging populations are consuming less and productivity is growing more slowly, the argument goes, leading to a sustained period of slack demand. But Mr. Borio interprets “structural forces” differently. The main drivers of deflation at the moment “are good forces,” he says. “They improve the capacity of the economy to produce and boost growth. Think of it as a benign increase in supply.”
In a 2015 paper Mr. Borio and colleagues examined 140 years of data from 38 countries and concluded that consumer-price deflation frequently coincides with healthy economic growth. If he’s right, central banks have spent years fighting disinflation or deflation when they shouldn’t have, and in the process they’ve endangered the economy more than they realize.
“By keeping interest rates very, very, very low,” he warns, “you are contributing to the buildup of risks in the financial system through excessive credit growth, through excessive increases in asset prices, that at some point have to correct themselves. So what you have is a financial boom that necessarily at some point will turn into a bust because things have to adjust.”
He describes this as a “pincer movement” in a working paper he wrote with several colleagues this year. On one hand, globalization and other (often benign) factors make it harder for central banks to gin up inflation by cutting interest rates. On the other hand, by slashing rates in pursuit of that hard-to-attain inflation target, they create imbalances in the financial system that lead to crises like the one in 2008.
It’s not that other economists are blind to financial instability. They’re just strangely unconcerned about it. “There are a number of proponents of secular stagnation who acknowledge, very explicitly, that low interest rates create problems for the future because they’re generating all these financial booms and busts,” Mr. Borio says. Yet they still believe central banks must set ultralow short-term rates to support economic growth—and if that destabilizes the financial system, it’s the will of the economic gods.
Mr. Borio thinks monetary economists and central bankers need to take more responsibility—that especially after 2008, such indifference to financial markets ought to discredit an economic theory. If economists think “structural forces” dictate policies that destabilize financial markets, that should be a clue that they misunderstand the forces in play: “How could financial and macroeconomic stability be in tension?”
The financial panic caught experts by surprise because they had assumed that the financial system (and the economy as a whole) would, through the inscrutable workings of the invisible hand, find a sustainable balance of saving, investment, consumption and other variables independent of central-bank policies.
Mr. Borio, in contrast, can explain exactly where dangerous financial imbalances come from: the incentives policy makers accidentally create for bad decisions on Main Street about borrowing and investment. The misallocation of resources during the booms requires a prolonged and miserable process of reallocation during and after a recession.
We should expect any serious monetary theory to explain a financial crisis, Mr. Borio insists. The only time he sounds genuinely dismissive of conventional wisdom during our conversation is on this point: “You know, in many of these models, how do they explain the Great Financial Crisis? They explain it as a meteorite coming from nowhere—it’s an exogenous shock, it’s productivity that all of a sudden for some unexplained reason collapsed, or people all of a sudden decided to save more, but without an explanation. In my most cynical moments, I say ‘shocks’ are a measure of our ignorance, not a measure of our knowledge.”
So what’s a central banker to do? “I think that if I were a policy maker actually in charge of making policy, I would find it extremely challenging,” Mr. Borio says puckishly before offering a few ideas:
Above all, “it’s important to be thinking of these things all the time.” Policy makers should keep a constantly watchful eye on financial conditions, not only in the depth of a crisis or the height of a worrisome bubble. The problem comes when “95% of the time you carry out your policy as if these factors didn’t matter, and then when you see that the economy is running red hot and you see obvious signs of financial imbalances, you start moving.”
Central banks and other authorities have tended to approach financial stability from a regulatory perspective, and this is the thrust of the high-profile Basel standards the Bank for International Settlements has helped craft. Mr. Borio says this is necessary but far from sufficient. There’s a limit to how successfully such rules can row against the broader policy tide. The entire monetary-policy framework needs to be reoriented toward financial stability.
Mr. Borio’s work amounts to an argument that monetary economists need to acknowledge how little they know about the economies they seek to manage. Central bankers themselves have grown more modest over the past decade. If only more economists shared the maestros’ appreciation for the limitations of current theories and the need to rethink them.
Mr. Sternberg, a London-based member of the Journal’s editorial board, is writing a book on millennials in the post-2008 economy.■