Black January: what should central banks do?

Black January?

Stock markets are tanking everywhere. In the senile industrial countries (SICs), except for the US where stock markets were closed because it was Martin Luther King Jr. day, broad-based stock market indices fell by five to seven percent in a single day on Monday, January 21 – the largest one-day decline since 9/11/2001 – after an extended period of more gradual weakening. Interestingly, this weakening of stock markets has now also spread to the BRICs and other emerging markets, some of which experienced stock market declines that were significantly larger proportionally than those seen in SICs.

There has been a swelling chorus of requests, indeed demands, for decisive central bank action (i.e. large cuts in official policy rates) in response to these stock market declines. Some of this came from persons and institutions ‘talking their positions’; anyone long stocks knows that a rate cut won’t hurt and will probably help; only those short equity would not like a rate cut. Of course, just because an argument is self-serving does not mean that it cannot be right. Should central banks pay attention? Should they cut because stock markets are crashing all around the world?

Central bank mandates

The mandates of all leading central banks, including the Fed, the ECB, the Bank of Japan and the Bank of England agree on the role of the stock market in the formulation of monetary policy. The stock market has no intrinsic significance. It matters if and to the extent that its behaviour affects the things that do matter intrinsically. This can be either because the stock market is an important component of the transmission mechanism linking initial conditions and exogenous shocks to the ultimate objectives of monetary policy, or because the stock market can itself be a source of exogenous shocks. 

On the macroeconomic stability side the things that matter intrinsically are not quite the same for all central banks. The Bank of Japan has just price stability as a macroecomic objective of monetary policy, although the Bank of Japan Law expresses the hope/expectation that this will enhance the overall performance of the economy as well: "currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy." The ECB and the Bank of England have a hierarchical or lexicographic ordering of macroeconomic objectives: first price stability and, subject to that or without prejudice to that, employment and growth. The Fed has a symmetric triple mandate: maximum employment, stable prices and moderate long-term interest rates. 

All four central banks are in addition mandated to pursue financial stability, something not defined in any great detail in the legislation establishing these central banks. 

What is behind the decline in stock prices?

A decline in stock prices reflects either the bursting of a stock market bubble, an increase in future expected risk-free discount rates, an increase in future expected equity risk premia or a reduction in future expected earnings growth. There has been no obvious sign of a stock market bubble since the end of the tech bubble in late 2000. Market expectations of future risk free rates, as reflected in longer-term sovereign yields have declined recently. Also, the effect of an immediate cut in the short risk free nominal interest rate on the entire sequence of current and future risk-free discount rate that are a component of the equity earnings discount factors is likely to be small. There will be an impact at the very short end, but, as noted by Alan Greenspan, the impact on long rates may well be perverse. So, unless equity markets are even more myopic than I believe them to be, the most likely culprits in the current stock market collapse are a reduction in expected future earnings growth an increase in the equity risk premium. 

Earnings growth
It has been obvious for a long term that the earnings growth projections of most analysts, right up to yesterday’s crash, have been delusional. Even the downward-revised figures for the US and the euro area were still at or above 11 percent per annum. With 5 to 6 percent nominal GDP growth, it is clear that these analysts were still predicting that before long labour’s share of GDP would fall to zero (even after allowing for differences between the definition of earnings used by the analysts and the definition of earnings in the national accounts). Admittedly, because of the entry of China, India, Vietnam etc. into the global economy, and possibly because of a labour-saving bias in technological innovation, labour’s hare has been falling for at least the last 10 years, but the continued decline implied by the earnings forecasts is just gibberish. While the forecasts of analysts (and the guidance given by the firms themselves) are not necessarily what is priced into the equity markets, it is likely that some of the loony earnings growth forecasts did find their way into stock market valuations. If the recent decline means no more than that the penny has dropped, this has to be good news. A cut in the official policy rates aimed as restoring unrealistic predictions of future earnings growth would not make sense.

The equity risk premium
As regards the equity risk premium, while in normal circumstances it is not at all obvious how a cut in short-term risk-free nominal interest rates (which is all that central banks can deliver) would lower the equity risk premium, there may be a link in these far-from-ordinary times. Fear and panic in financial markets and institutions paralysed large chunks of the wholesale financial markets, notably the ABCP markets and the markets for anything associated remotely with US subprime mortgages, and unhinged the interbank markets in the US, the euro area and the UK from mid-August 2007 till the end of 2007. While something close to order has now been restored in the interbank markets and the other wholesale markets, the fear and panic appear to have moved to the stock markets, focused first on the stocks of banks and other financial institutions and now on anything that trades.

The underlying fear and uncertainty are not surprising. It is clear that the underpricing of credit risk since the end of the tech bubble was not restricted to the US subprime markets. It was a global phenomenon and it affected every sector linked to the international financial system. Credit risk premia across the board were ludicrously low from about 2003 till the middle of 2007. Dodgy sovereigns (Italy, Greece) went for tiny spreads over solid sovereigns (Germany). Emerging market sovereign spreads became minute even for countries without infinite foreign exchange reserves, without oil or gas and without solid fiscal and current account fundamentals. The differential spreads between private AAA, AA, A, and lower-rated instruments had become unduly compressed. Junk sold at spreads previously only associated with rated instruments.

This underpricing of credit risk was part of an underpricing of risk more generally: liquidity risk and market risk (price risk).

Now the worm has turned. The markets knows/fears that there are large losses out there, which have not yet been recognised. Their magnitude could be enormous, much larger than the $400 to $500 billion cast around recently (up from $50 to $100 billion in August) as estimates of subprime related losses. As an aside, the subprime-related losses, associated mainly with losses on securities backed by subprime mortgages, are not aggregate wealth losses. Like all derivative instruments, subprime mortgage-backed securities are in zero net supply: there is an matching open short position for every open long position, so a collapse in the prices of these derivatives only redistributes wealth, it does not destroy net wealth. Only if this redistribution itself causes further real economic dislocation does net wealth suffer. The net wealth losses associated with the subprime crisis are the reduction in the value of the properties bought by the holders of the subprime mortgages and the value of the real resources expended in repossessing these properties.

It is certainly possible that many trillions US dollars worth of overpriced derivatives have been issued during the past five years. When the confidence/hubris/irrational exuberance that drove this orgy of underpricing risk vanishes, we see in the stock markets a form of musical chairs where all the participants are blindfolded. They know there are massive losses (and massive gains) out there, but they don’t know who holds the securities exposing the holder to these losses and gains. The fear of the losses dominates the joy at the prospective gains (although the two are arithmetically identically matched), and any institution that could be exposed to these losses gets marked down severely. These are mainly banks and other financial institutions. Bank stocks collapse.

This collapse in bank equity, combined with a serious banking sector liquidity squeeze caused by the need to take on the balance sheets many of the obscure asset-backed securities and cash-flow backed securities held in opaque off-balance sheet vehicles, means that banks are now both liquidity-constrained and capital constrained. Lending to the household sector and the non-financial corporate sector is cut back. This increase in the cost and reduction in the availability of credit to the real economy is the point where a partly irrational financial sector crisis (partly irrational because it involves mainly a repricing of inside assets) becomes a macroeconomic slowdown. 

If the equity risk premium has gone from being irrationally low to being irrationally high, we clearly have a problem. It is, however, not clear what central banks can do about this. The effect of a cut in the short-term risk-free nominal interest rate on an irrationally inflated equity risk premium is not something anyone can be sure of. I hear shouts of ‘confidence, confidence’ in the background, but attribute it to special pleading.  It is in any case not an operational guide to action. 

The stock market and the real economy

Stocks and shares are component of the outside wealth of an economic system – the value of assets that does not net out when all household, corporate and government flow-of-funds accounts and balance sheets are consolidated. Because it is a component of net wealth, it will influence consumer expenditure.

The effect of changes in stock market wealth on household expenditure is, however, small. Much stock market wealth is held by institutions, such as pension funds and insurance companies. While ultimately these institutions hold their assets on behalf of households, it is often difficult for the supposed beneficial owners to pierce the corporate veil and spend their capital gains. Stocks held directly by households tend to be held by richer and other persons who are unlikely to be liquidity-constrained. The typical estimate of the marginal propensity to spend out of financial wealth is of the order of 3.75 percent. So if you wipe one trillion US dollars off the US stock market, you would get a reduction in annual consumption of less than $ 40 billion, that is, less than 0.3 percent of US GDP. It’s a contraction, but not a collapse of consumption.

Stocks and shares are generally a liquid form of wealth that can be used as collateral for loans. This collateral effect could reinforce the wealth effect of a decline in equity prices. However, few stock owners are likely to be liquidity constrained, unlike home owners.

The value of equity can influence investment directly through a mechanism known as ‘Tobin’s q’, the ratio of the market value of ownership claims to physical capital to the current reproduction cost of that capital. When q is greater than 1, the value of installed capital exceeds the costs of production of new capital goods. When it rises further, it becomes more profitable to order and install new capital equipment and investment demand will increase (Why is q called q? When asked this question, Tobin replied: “because p was already taken” – this is as close as economists get to humour). 

A collapse of the stock market will therefore depress private capital formation.  The effect is likely to be delayed. Between the time the news of the stock market collapse arrives and the time the decision to reduce or postpone investment spending in actually implemented, much water flows under the bridge. Not only are the lags long and uncertain, the ultimate magnitude of the effect on investment is highly uncertain. Investment is one of the least predictable components of aggregate demand. 

The stock market and financial stability
The collapse of the stock market should have no material effect on financial stability, unless it causes the demise of a number of systemically significant financial institutions. In our highly competitive domestic and international financial system, it is hard to see how any individual financial institution, including the largest commercial or universal bank, could be deemed systemically significant. Anyway, financial instability is something you try to prevent by having the right institutional, legal and regulatory framework. If prevention fails, as it will and ought to from time to time, mitigation can take place as and when financial instability threatens. Central banks should not cut rates now to lower the odds that financial instability may arise, or to mitigate financial instability that has not yet occurred. You deal with it if and when it happens. 

What should central banks do?

The collapse in global stock markets will have a limited immediate effect on consumption demand and a delayed uncertain effect on investment demand. Inflation-targeting central banks, and central banks that have price stability and support of the real economy as symmetric objectives, will therefore implement a series of current and future policy rates that can be expected to be lower than before this unexpected collapse of global equity markets. Whether this means actual cuts in rates can only be determined on a case-by-case basis.

The ECB, following its most recent rate setting meeting, was still talking as if a future rate hike was more likely than a future rate cut. Even given the ECB’s lexicographic price stability target, this seemed a bit over the top. Had they implemented a rate hike in February or March, it would, even absent the recent stock market collapse, probably have been judged an error before long even by the hawks on the Governing Council. I now expect that talk of future hikes will cease and that the ECB will begin to cut rates during the current quarter. A cut of 25 basis points in February or March is likely and would be the right thing to do. Weaker domestic demand and the likelihood of lower oil and gas prices due to a weakening global economy, mean that is its possible to support the real economy without prejudice to the price stability objective. 

The Bank of England, for the same reasons as those given for the ECB, will cut rates by 25 basis points, possibly as early as February, as the first of a series of cuts. Rates are high by international standards in the UK. It does not want to become the recipient of carry-trade inflows.

Neither the ECB nor the Bank of England will panic at the sight of a large drop in global stock markets. I am less convinced of the sang froid of the Fed when faced with a chorus of Wall Street howls and whines. They could well be panicked into a 50 or even a 75 basis points cut in the Federal Funds target rate at their next meeting, or even arrange to have an interim meeting – a sure indicator of panic football. 

The poor Bank of Japan will no doubt wish it had room to cut rates. With only fifty basis points to play with before the official policy rate hits the zero floor, there is, unfortunately not much they can do. 

Following the global stock market collapse, if central banks act according to their mandates, monetary policy will, all over the world, now be slightly more expansionary than it would otherwise have been. But we are talking 25 basis points, unless and until further information becomes available about the collateral damage cause to the real economy by the stock market plunge. It was the excessive response of the Fed to earlier stock market collapses that, together with global regulatory failures, created the credit boom and bubble that brought us the August 2007 credit crunch and the January 2008 stock market collapse. A repetition of that error of judgement, especially on a global scale, would in due course bring us a financial crisis that would dwarf the one we are trying to escape from now. It is time for central bankers everywhere to put their fingers in their ears and show some backbone. Their mandates are clear (perhaps less so in the US, with its confusing triple mandate, but even there, long-term financial stability considerations argue against giving the junkie his fix). Rates will have to be lower than they would have been based on the information available as of January 20. But the markets are the tail, not the dog in this story.

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