The consensus view was that the US system was infinitely superior to the European one, that US monetary policy was more symmetric, more democratic, and that the policy process was more transparent due to the publication of minutes and votes. The Fed was also seen as academically more sophisticated, while the ECB was regarded as the continuation of Bundesbank with the same means and different language, an institution in pursuit of some ancient ideological battle.
The credit crisis, which is possibly the defining economic event of our time, is helping us to see a little clearer in this debate – or perhaps get us onto a higher state of confusion. We all know by now that this is pretty serious financial crisis, and it is understandable that the public wants to know how this could have happened, and who is to blame. There is no group out there that looks more guilty than the rating agencies. But are they the real bad guys? I think the really interesting question to be asked to which extent central banks have contributed to, or even caused, this crisis. This is not about Mr Greenspan, or a single monetary policy decision at a particular time, or whether US interest rates were raised too late in the last cycle. This question relates to the longer-term impact of monetary policy during the age of global disinflation, which started in the early 1990s, and which has just ended.
Now I do believe that the long period of negative real interest rates in the first half of this decade had a profound effect on credit growth – in a way that seems perfectly logical. If real interest rates are negative, it becomes rational for agents to borrow as much as they can get their hands on. So we should not fake surprise at the thought that a negative real interest rate produces an unsustainable credit boom. Yes, there are technical factors within the markets that have turned this boom into quite such a toxic event, but this can hardly explain why this crisis broke out at the time when it did.
Here is my list of policy lessons, not approved by the G7 or the Financial Stability Forum, or anybody else: First, central banks should take a very hard look at whether they want to continue to define price stability on the basis of a single narrow price index. This is not a core-versus-headline inflation argument, but about whether any index is fully capable of capturing all the pertinent aspects of price stability. Monetary policy must take a broader view, and that would necessarily have to involve qualitative judgements, which I am aware some people like to avoid.
This leads directly to the question whether central banks should explicitly take account of money and credit in their policy setting. No I am not a monetarist. On the contrary, I believe the arguments for not targeting a monetary aggregate are persuasive. Nor do I mean that central banks should prick bubbles; or that they should target some other silly index; or that we should resurrect the Bundesbank (as a monetary authority, I mean). But it means that central banks should take a greater interest in the transmission channels of monetary policy.
On this point, I agree entirely with the views of Charles Goodhart, who made the point earlier this year that a pragmatic central banker should take excessive money growth seriously when accompanied by excessive credit growth, but not otherwise. (I am simplifying his conclusion. You can read his enlightened exposé on whether a modern central bank should target money here, on the Bank of England’s web site) The fact that some arrogant US central bankers have been boasting about not even looking at money is perhaps a sign that something seriously has gone wrong with monetary policy in the US.
My second point is that we should take a very critical look at the Basel capital adequacy rules, and to which extent the imposed ceilings have provided banks with the wrong incentives. This is macro regulation. When you look at the credit market, and some of the more exotic instruments of structured finance, the most striking aspect is that almost everything that is happening in this field is based on some perverse incentives, not on economic logic. None is more perverse than the origin of this entire process, the Basel rules that encourage banks to shift credit into off-balance sheet vehicles. We should perhaps jump straight from Basel I to Basel III, or preferably to something named after a different European city (though not Lisbon).
My third point is whatever committee we should appoint to investigate this crisis, it should not consist primarily of central bankers. Central bankers are good at blaming governments, but not each other. As a central banker would surely understand, we need true independence.
Forth, and this is only relevant for Europe, we should form a European-level bank regulator within the ECB, rather than rely on the present network-based approach. Three institutions were involved in the bailout of Northern Rock in the UK – the Treasury, the Bank of England, and the Financial Services Authority. Just imagine the institutional mess you get into when co-ordinating banking supervision across 27 EU member states. Germany has the Bundesbank and the banking regulator Bafin, and with lots of duplication between them. It is better if we change these structures before the next crisis hits.
Once we have done all those things, we might as well start persecuting the rating agencies, or someone else in the markets. My guess is that the central bankers will for now escape the wrath of electorates and their elected representatives, who will find it easier to hunt down some scapegoats instead. This also means that central bankers will have plenty of opportunity to repeat their systemic errors. In such an environment, the better monetary governance, though far from perfect, will probably come from the euro area, not the US.