How to restore stability to the ‘North Atlantic zone of financial instability’

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I would like to use this blog to post a rather lengthy reply to comments of  Mr. Krzysztof Rybinski on an earlier post of mine to the Financial Times’ Economists’ Forum, on the 12 December announcement of non-coordinated liquidity management policy changes by the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank.

I agree with Mr. Rybinski, that the very fact that the five central bank governors who made their simultaneous announcements on Wednesday December 12th did try to make this look like a substantive coordinated action, shows how worried these central bankers are about financial stability and the risk of regional and global recession in 2008 and beyond. The point of my blog was that because the substance of what was announced was a list of five disjoint liquidity interventions, in the Euro zone, the USA, the UK, Canada and Switzerland, it was both strange and rather worrying that the central bank five governors tried to make their simultaneously announced individual actions look like more than they were. This was a set of actions where the whole was no more than the sum of the parts.  To try to make it look like more than it was in unwise. When those in charge of price stability and market liquidity in much of the industrialised world engage in ‘spin’ of this kind, I get concerned.

A swap between the Fed and the ECB of X US dollars for Y euros  for 1 year, say,  is equivalent to  the ECB borrowing X US  dollars for 1 year and the Fed borrowing Y euros for 1 year, provided

                                                           X = eY(1+i)/(f(1+i*)) 

where e is the spot euro-US dollar exchange rate (number of US dollars per euro), f is the one-year forward exchange rate, i is the one-year dollar interest rate and i* is the one-year euro interest rate. The authorities chose to present their reciprocal borrowing of each other’s currency as a swap rather than as two loans. The private sector likes to do this because swaps are off-balance sheet transactions, unlike loans. Surely the desire to keep their mutual support (and mutual exposure) off-balance sheet cannot have been a factor in the three central banks’ decision to proceed through swaps rather than through explicit borrowing of foreign exchange?

More importantly, there was no need for either official swaps or official borrowing to alleviate the liquidity crunch.  All that was required was for the ECB to make euro liquidity available in the Euro zone (through OMOs in euros) and for the Fed to make US dollar liquidity available in the US (through OMOs in US dollars.  Because the foreign exchange market for the euro and US dollar has remained spectacularly liquidity throughout this crisis, Euro-zone banks who had obtained euro liquidity from the ECB could have bought or borrowed US dollar liquidity through the foreign exchange markets without any problems. The could (indeed probably would)  have used swaps to  obtain the necessary US dollars, if they believed the need for dollars in the Eurozone was likely to be short-lived.  So the Fed and the ECB  did not materially improve the terms and other conditions of access to US dollar liquidity for Euro-zone banks through this swap.  This was financial window-dressing.  Why?  Spin always ends up cutting the mouth that spewed it.

I agree also agree with Mr. Rybinski that the monetary, regulatory and fiscal authorities have to do more in the future to prevent the recurrence of speculative excesses than they have in the past, including the most recent credit orgy – that of 2003-2006.  I believe, however, that the preventative measures that are required will have to be designed and implemented mainly by the regulators /supervisors of financial markets and institutions and by the Treasuries/ministries of finance. Central banks will not play a major part, unless they happen to also be regulators/supervisors for the banking system and/or other financial institutions or markets.

In a world with unrestricted international financial capital mobility, central banks have only one instrument with which to pursue their primary objective, price stability.  That instrument is either the short risk-free nominal interest rate or the nominal spot exchange rate. Central banks have additional instruments for influencing liquidity at various horizons, ranging from overnight to one or at most two years.  There liquidity-oriented instruments include open market operations (collaterlised and non-collateralised or outright) at a range of maturities, reserve requirements and discount window operations.  Both OMOs and discount window operations are multi-dimensional.  The central bank defines the set of eligible collateral, eligible counterparties and the term of the loans. Foreign exchange market intervention is a special case of (outright) open market operations and included in it.

If monetary policy, defined as the pursuit of price stability in the medium term, is entrusted constitutionally and institutionally to an operationally independent central bank, it makes sense to dedicate the short risk-free nominal interest rate (say the target for the overnight interbank rate) entirely to monetary policy.  This is not because the short-run risk-free nominal interest rate (the official policy rate) does not have any effect on liquidity.  Nor is it because the other instruments of the central bank (OMOs, discount window operations and reserve requirements) don’t have an effect on price stability in the medium term.  The reason is a practical political one, grounded in the need for institutional accountability, and reinforced by an appeal to Mundell’s ‘Principle of Effective Market Classification’, which prescribes a division of labour between policy instruments, or an assignment of responsibility for policy objectives to instruments, based on a law of comparative advantage.

Clearly, the policies announced by the five central banks last Wednesday will lower the spreads between the official policy rate and Libor at the maturities for which interventions were announced (mainly one- month and three months), relative to the levels they would have achieved without the announcement.  Since many loans to households and non-financial firms are priced off 3-month Libor, this means that monetary conditions will be less restrictive than they would have been without the announcement.  The central bank will have to allow for this in their setting of the official policy rates, which as a result will be higher in the future than they would have been without the announcement.  They may, of course, still be lower in the future than they are today.  The effect of current liquidity policies on the level of the path of official policy rates most likely to achieve price stability in the medium term is likely to be small, because the price level effect of interest rate changes is subject to long, variable and uncertain lags and of uncertain magnitude. 

Likewise, although cuts in the official policy rate are an inefficient way to boost liquidity under disorderly market conditions, it will have some positive effect on liquidity.  The five central banks, in their open market operations, discount window policies and reserve requirements will have to allow for the fact that the liquidity crunch will be eased a little by cuts in the official policy rates. 

But the regulators and the fiscal authorities will have to do most of the job of (1) making a recurrence of destructive credit cycles less likely, and of (2) minimising the damage to the real economy caused by such episodes of financial manic-depressive illness as are likely to occur despite the best efforts of the authorities.  Without more effective international cooperation and coordination of regulatory standards and of the fiscal treatment of international mobile financial institutions, instruments and their owners, the risk of future credit booms and busts will increase.  Creating a single financial regulator for all of the EU (not just for the Euro zone) would be a valuable contribution from the Eastern rim of the North Atlantic zone of financial instability that has emerged this s century.  This nefarious contribution of the world’s most developed national and regional financial sectors – Wall Street, the City of London, Zurich and Frankfurt – to global financial and macroeconomic instability is in part due to the race to the bottom of regulatory and supervisory standards driven by regulatory and tax arbitrage. The sooner this trend is halted and reversed, the better.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website