Central banking as partisan politics

As long as the financial stability role of central banks remained in the background, the notion of central bank independence appeared to have something to recommend it.

Setting the official policy rate is, by the standards of other political interventions in the economy, a relatively ‘technocratic’, non-political or at any rate non-partisan and non-party political act.  Like any interest rate change, it hurts those who are long the official policy rate (or other rates linked tightly to it) and it helps those short the official policy rate.  But as the official policy rate is an overnight rate in most countries, the distributional effect of this change in the inter-temporal relative price of money is likely to be minor.

Changes in the current official policy rate get leveraged through expectations of changes in future official policy rates.  This feeds through into longer-maturity rates on all kinds of financial instruments an on asset prices, including exchange rates, stock prices and house prices.  Through such interest rate effects, asset price effects and other expectational effects is monetary policy transmitted to spending decisions, production and employment decisions and price and wage setting.  As soon as interest rate policy has an appreciable effect on real variables, such as employment and production, it becomes political, even if these real effects are only temporary (as New-Keynesians believe) or only present if the policy action is unanticipated (as the New-Classicals believe).

With a bit of effort you may be able to continue to view interest rate setting as an essentially technocratic, a-political exercise as long as the long-run Phillips curve is vertical, that is, there is no permanent trade off between inflation and unemployment or inflation and the output gap. But once central banks get their hands dirty with financial stability issues, as inevitably they must, the direct distributional cat-fight aspects of policy grow mightily in importance relative to the technocratic, non-partisan aspects.  Financial stability policy is ‘political’ with a very small ‘p’.  Central bank independence cannot possibly cover the central bank’s responsibilities and actions in the field of financial stability.

Once central banks get involved in lender-of-last resort operations, recapitalisor-of-last-resort operations and other rescue operations of banks and other financial institutions deemed to big, too complex, to international, too interconnected or too politically well-connected to fail, centrals banks and central bankers become normal political actors, indeed partisan political actors.  They should not be surprised to be treated as such.

A classic example was the grilling, often hostile, given Chairman Ben Bernanke of the Fed, on Thursday 25 June by the House of Representatives’ oversight committee on his role, and the role of the Fed, in the acquisition of Merrill Lynch by Bank of America.  The initial agreement by Bank of America to acquire Merrill Lynch was subject to a material adverse change (MAC) clause.  A material adverse change clause is a clause in a merger or acquisition agreement that gives both parties remedies, or the right to cancel the merger or acquisition, in the event that prescribed negative events occur. Negative events may be a sharp decline in sales or in profits, or a regulatory change or problem that would seriously impair the ability of the merged company to function.

With reported losses at Merrill Lynch mounting sharply between September 2008 and the end of the year, it would have been sensible for the chief Executive of Bank of America, Ken Lewis, to call off the acquisition of Merrill Lynch, as it was likely to make the combined Bank of America-Merrill Lynch entity insolvent.

The cancellation of the Merrill Lynch acquisition would have meant the immediate insolvency of Merrill Lynch.  To prevent this, the Treasury Secretary, Hank Paulson and the Fed Chairman, Ben Bernanke, jointly and severally took Ken Lewis into the basement and beat him with a rubber hose until he promised not to invoke the MAC clause.

The legal issue is whether the Fed Chairman and his staff overstepped their authority as bank regulators when they kept the acquisition of Merrill Lynch by Bank of America on the road.  Did they (and Hank Paulson and his Treasury officials) force Bank of America to go through with the deal, even thought it was no longer in the interest of the shareholders of Bank of America; did they hide key facts from other regulators, and did they threaten to fire Ken Lewis should he try to cancel the deal?  It seems pretty obvious that, factually and morally that is exactly what they did. The question as to whether they violated laws and regulations in doing so is not for me to decide, fortunately.

The exercise of political and regulatory power to force a merger between two banks or an acquisition of one bank by another to prevent a bank failure is always bad economics and bad politics.  We saw this in the UK when Lloyds-TSB, a British bank that had not been fatally damaged by the crisis, was nudged and flattered into swallowing a large cyanide capsule by the prime minister Gordon Brown when it agreed to buy HBoS, a bank that was kept from insolvency only by past and anticipated future government support.

It is bad economics for a number of reasons.

First, such mergers and acquisitions re-inforce the survival of the fattest syndrome that has turned banks and shadow-banking institutions into monsters of perverse incentives for excessive risk taking.  Throughout the north-Atlantic region, concentration and monopoly power in the banking sector will be higher after the crisis than before it.

Second, there was a superior alternative.  The special resolution regime (SRR) for commercial banks administered by the FDIC should have been made available to Merrill Lynch.  Merrill Lynch was an investment bank for which no SRR existed.  That itself was a scandal and a major failure of regulation, expecially since the authorities must have become aware of this when Bear Stearns went belly-up in March 2008.  Some day the history will have to be written of the collective dereliction of duty by regulators, government officials and legislators, that resulted in the absence of quick and efficient mechanisms for putting banks and other highly leveraged, systemically important institutions through an insolvency process lasting no more than a weekend.  Later in 2008, the two remaining large independent investment banks were transmuted into bank holding companies.  That could and should have been done for Merrill.

Merrill could, through the SRR, have been put through a Chapter 11-lite, in which some or all of its unsecured creditors could have been forcibly converted into common stock holders (in inverse order of seniority).  Its board and top management could at the same time have been fired without golden parachute.  Merrill Lynch as a legal entity would have ceased to exist.  New Merrill, the same organisation except for the old leadership, would have re-emerged with a sound balance sheet containing lots of equity and little, possibly no, unsecured debt.

The mandatory debt-to-equity conversion should have gone up the seniority scale until Merrill was properly capitalised.  The whole exercise (conversion to commercial bank status and debt-to equity conversion) should have taken no more than a weekend.

Instead, the regulators and the Treasury decided to cut an opaque deal of questionable legality to save the skins of the unsecured creditors of Merrill.  By doing this they created a merged entity (Bank of America + Merrill) that would fail without government support and, if prevented from failing by a tax payer bail-out, would become a zombie bank: alive but doing very little new lending.

In addition, this bail-out of the unsecured creditors upgraded the already high degree of confidence of parties buying bank debt that such debt was effectively sovereign-guaranteed, to near-certainty.  The future incentives for excessive risk-taking by banks are therefore bound to be even worse than the ones that brought us the great financial implosion of 2007-2009.

It is unavoidable, indeed desirable, that this shambolic mess has become a major political issue.  We are no longer talking about technocratic interventions by disinterested guardians of the public interest.  We are talking interest group politics, capture and partisan behaviour.  When the cake is made smaller and its distribution made more unfair by the actions of regulators, central bankers and unelected government officials, accountability is required.

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