The markets today were in a bit of a tizzy because the Dubai World Group, a holding company owned 100 percent by Dubai’s government, and Nakheel, a wholly owned subsidiary of Dubai World, imposed a debt restructuring and debt service standstill - failed to perform on their debt or, in ordinary if not legal language, defaulted on their debt.  The combination of the Islamic holiday of Eid and the Thanksgiving holiday in the US boosted the magnitude of the financial market kerfuffle.

I don’t see what the big deal is.  Dubai has experienced for most of this decade the craziest construction boom seen in the Middle East since the construction of the Great Pyramids.  That boom turned to bust – as booms invariably do.  Property developers tend to be highly geared and very procyclical in their revenue flows and access to the capital markets.  During construction slumps they drop like flies.  Because the property sector is risky (ask Donald Trump), its creditors tend to get better interest rates than the sovereign rate.  Dubai is no exception to this rule.  If you earn a risk premium during good times, you should not moan when the borrower defaults from time to time when the going gets tough.

What is so important about H.R. 1207: the Federal Reserve Transparency Act of 2009 aka the ‘Audit the Fed’ bill? This bill “To amend title 31, United States Code, to reform the manner in which the Board of Governors of the Federal Reserve System is audited by the Comptroller General of the United States and the manner in which such audits are reported, and for other purposes.” may not sound terribly exciting, but in addition to making the Fed accountable for its quasi-fiscal activities, it could well set an important precedent for the enhanced accountability of operationally independent central banks everywhere.

On September 25, 2009, the Commission of the European Communities produced a proposal for EU-level macro-prudential regulation and supervision, “Proposal for a Regulation of the European Parliament and of the Council on Community macro prudential oversight of the financial system and establishing a European Systemic Risk Board”. It looks as though the EU Presidency (Sweden) and the Commission are trying to get this proposal adopted in a hurry.

I recognise the need for EU level regulation and supervision of macro-prudential risk and support EU-level Colleges or Agencies to supervise systemically important cross-border banks, other financial institutions, markets and instruments.  Unfortunately, the design of the proposed European Systemic Risk Board (ESRB) is a shambles.  The composition of the General Board, the Steering Committee and the Advisory Technical Committee, the selection of the Chair of the General Board and the Steering Committee (the same person), the selection of the Chair of the Advisory Technical Committee (appointed by the General Board on a proposal from its Chair) and the nature of the Secretariat are ludicrously lopsided in favour of central banks in general and of the ECB in particular.  It is high time to have a re-think, before the EU adopts and implements a financial and political disaster.

(1) This is it

The European Commission’s proposal is worth quoting at length.  In this Section, all quotes are in italics.  My own comments are in regular characters.

6.1. Establishment of the ESRB

The ESRB is an entirely new European body with no precedent, which shall be responsible for macro-prudential oversight. The objective of the ESRB shall be threefold:

  • It shall develop a European macro-prudential perspective to address the problem of fragmented individual risk analysis at national level;
  • It shall enhance the effectiveness of early warning mechanisms by improving the interaction between micro-and macro-prudential analysis. The soundness of individual firms was too often supervised in isolation with little focus on the degree of interdependence within the financial system;
  • It shall allow for risk assessments to be translated into action by the relevant authorities.

6.2. Tasks and powers of the ESRB

The ESRB will not have any binding powers to impose measures on Member States or national authorities. It has been conceived as a “reputational” body with a high level composition that should influence the actions of policy makers and supervisors by means of its moral authority.

6.2.1. Warnings and recommendations

An essential role of the ESRB is to identify risks with a systemic dimension and prevent or mitigate their impact on the financial system within the EU. To this end, the ESRB may issue risk warnings. These warnings should prompt early responses to avoid the build-up of wider problems and eventually a future crisis. If necessary, the ESRB may also recommend specific actions to address any identified risks.

ESRB recommendations will not be legally binding. However, the addressees of recommendations cannot remain passive towards a risk which has been identified and are expected to react in some way. If the addressee agrees with a recommendation, it must communicate all the actions undertaken to follow what is prescribed in the recommendation.

If the addressee does not agree with a recommendation and chooses not to act, the reasons for inaction must be properly explained. Hence, recommendations issued by the ESRB cannot be simply ignored.

The ESRB shall decide on a case by case basis whether warnings and recommendations should be made public.

Comply or explain, in short.

6.5. The internal organisation of the ESRB

The ESRB shall be composed of: (i) a General Board; (ii) a Steering Committee and (iii) a Secretariat.

6.5.1. The General Board

The General Board is the decision making body of the ESRB and as such, will be responsible for the adoption of the warnings and recommendations described in section 6.2.1 of this explanatory memorandum.

The members of the General Board with voting rights are:

- the Governors of national central banks; (currently 27)

- the President and the vice-President of the ECB; (2)

- a Member of the European Commission; (1)

- the Chairpersons of the three European Supervisory Authorities; (3).

The members of the General Board without voting rights are:

- one high level representative per Member State of the competent national supervisory authorities; (currently 27, assuming there can be no more than one competent national supervisory authorities; we already know there can be at least one incompetent national supervisory authority; if the competent national supervisory authority is the central bank, that central bank gets a non-voting member of its own as well as its voting Governor member)

- the President of the Economic and Financial Committee; (1). This is the committee established pursuant to Article 114 of the Treaty establishing the European Community.

Until the EU expands its membership, the membership of the General Board would therefore be 61, enough to run a small football league.  This is not a body that will do anything useful.

6.5.2. Chairperson

The Chair will be elected for 5 years from among the Members of the General Board of the ESRB which are also Members of the General Council of the ECB. The Chair will preside the General Board as well as the Steering Committee and instruct the Secretariat of the ESRB on behalf of the General Board. The Chair shall be able to convene extraordinary meetings of the General Board on its own initiative. As regards voting modalities within the General Board, the Chair will have a casting vote in the event of a tie. The Chair shall represent the ESRB externally.

What is interesting here is that, because the General Council of the ECB includes the 6-member Executive Board and the 27 Governors of the national central banks (NCBs), it could, in principle & in theory be possible for someone other than the President of the ECB to be the Chair of the ESRB, including a Governor of an NCB that is not part of the Eurosystem.  In practice, because the Governing Council of the ECB (the six Executive Board members plus the Governors of the sixteen NCBs that are also members of the Eurosystem), which is a subset of the General Council, has 18 voting members on the ECB General Board (the President and the Vice-President of the ECB and the Governors of the 16 Eurosystem NCBs), it will always be able to have its way, as the total number of voting members is 33.

6.5.3. The Steering Committee

Given the size of the General Board -which will comprise a total of 61 members-, a Steering Committee will assist the decision-making process of the General Board. The Steering Committee will prepare the meetings of the General Board, review the documents to be discussed and monitor the progress of the ESRB’s on-going work.

The Steering Committee will comprise the Chair and Vice-Chair of the General Board, the Chairpersons of the three ESAs, the President of the EFC, the Member of the Commission and five members of the General Board which are also members of the General Council of the ECB (12 members).

Note that central bankers will dominate the Steering Committee, with seven out of 12 members.  The Chair of the Steering Committee is the same person as the Chair of the General Board, all but certain to be the President of the ECB.

6.5.4. The Secretariat

The ECB will ensure the Secretariat to the ESRB. The Secretariat will receive instructions directly from the Chair of the General Board.

Who was surprised that the ECB will ‘ensure’ the Secretariat to the ESRB?

6.5.5 The Advisory Technical Committee and other sources of advice

The role of the Advisory Technical Committee (hereinafter, referred to as the “ATC”) is to provide advice and assistance to the General Board on the issues that are within the scope of the ESRB, on request from the latter.

The members of the ATC are:

- one representative of each national central bank

- one representative from the ECB

- one representative of the national supervisory authority per Member State

- one representative of each European Supervisory Authority

- two representatives of the European Commission

- one representative of the EFC.

The Chair of the ATC shall be appointed by the General Board on a proposal from its Chair.

Note that, because for quite a few member states the representative of the national supervisory authority will come from the central bank, it is quite likely that the ATC will have a majority of central bankers on it.  Its chair is effectively in the gift of the President of the ECB.

(2) Central banks are wildly over-represented on the proposed ESRB

Six arguments support the view that central banks are greatly over-represented on the proposed ESRB.

(1)   The ECB, the Eurosystem NCBs and the rest of the EU NCBs have not exactly covered themselves with glory in the area of macro-prudential supervision and regulation during the past decade.  Like the Fed, they failed to foresee the financial crisis let alone to prevent it.  Like the Fed, the ECB and most other EU central banks contributed over a period of many years to the unsustainable credit and asset market boom and bubble that turned to bust starting in August 2007.  They did so by keeping interest rates too low for too long, by failing to control the excessive growth of credit and the broad monetary aggregates, and by failing to diagnose the excessive leverage, and the maturity and liquidity mismatch that was building up in the banking sector and shadow banking sector balance sheets.

In Germany, the Bundesbank failed to diagnose the deep rot in most of the Landesbanken, and the excessive leverage of its main cross-border banks; in Spain, the Banco de España, despite being widely admired for its pioneering of dynamic provisioning, failed to recognise the wildly excessive exposure of its regional Cajas to the construction industry, developers and the housing market generally.  The Banque de France missed an epochal fraud at Société Generale.  The Dutch central bank missed the ball completely with the ABN-Amro take-over and the subsequent collapse of Fortis.  The litany of central bank failure is endless.

It makes no sense to turn over control of the task of macro-prudential supervision to a set of institutions that have manifestly failed to do the job properly at the latest time of asking.  They have no track record of competence in macro-prudential supervision.

Clearly, as the ultimate providers of domestic-currency-liquidity of the highest quality, central banks have to be actively involved in maintaining financial stability and in restoring it should it become impaired.  They should not be put in charge of the activity, however.  Arguments to the contrary, including those made by the Fed (in its opposition to proposals for a new council of financial regulators who would collectively rule the financial stability roost, rather than conceding supremacy to the Fed or a to body dominated by the Fed,) have no intellectual merit and are best explained as manifestations of the very human and institutional desire for more turf.

(2)   The central banks in control of the ESRB would be conflicted in the use of their instruments, especially in the setting of the short-term interest rates under their control, by the potentially clashing demands of price stability and financial stability.  This point has been made many times, but does not get any less convincing because of its frequent invocation.

(3)   Macro-prudential regulation and supervision inevitably involves guiding and direction the actions of, and even determining the fate of, large systemically important individual financial institutions.  Such institutional life-or-death decisions involve property rights and other important distributional and wider political dimensions, as well as technical issues.  They are inherently political, even party-political.  The independence of the ECB in the area of price stability could be undermined if it were to play a dominant role in macro-prudential regulation and supervision.

(4)   The proposed construction ignores the central fiscal dimension of financial stability.  Although there was much that was flawed about the UK model of financial stability management, its tripartite nature has to be a feature of any viable system for macro-prudential management.  The key financial stability related competencies are (1) liquidity provision; (2) prescribing and proscribing behaviour of financial actors and (3); solvency support.  These three functions or competencies can be performed by three different institutions, with the central bank engaged in liquidity provision, the Treasury providing tax payer support for under-capitalised systemically important institutions and a regulator/supervisor telling financial institutions what they must do and/or cannot do.  These three functions or competencies can also be bundled in just two organisations (typically the Treasury for the solvency support and the central bank for liquidity support and regulatory and supervisory authority), or even by just one: the Treasury taking over the functions of the central bank and the regulator/supervisor.

Regardless of how these tasks are structured institutionally, the recent crisis has made it clear that without the ultimate support of current and future tax payers (managed through the Treasury), either there is no such thing as a safe bank (or a safe highly leveraged institution with serious asset-liability mismatch as regards maturity, liquidity and currency mix), or safety for the banks can only be assured by abandoning the goal of price stability.

When central banks act on their own to recapitalise under-capitalised banks, as has been done on a large scale in the US and on a smaller but still significant scale in the Euro Area, the UK and Japan, they act in a quasi-fiscal capacity, that undermines important constitutional and legal prerogatives of the legislature.  These quasi-fiscal operations of the central banks (through artificially low borrowing rates for banks, overvalued collateral and outright purchases of private securities at prices above fair value etc.) are in addition often opaque and non-transparent.  They represent an abuse of seigniorage by an appointed, unaccountable authority.  In the interest of good government, quasi-fiscal actions should be rooted out and replaced by explicit, transparent fiscal actions, including fiscal bail-outs.

Before banks are supplied with additional capital by the tax payer, however, the unsecured and secured creditors and other counterparties of the undercapitalised or borderline-insolvent banks should be asked to donate blood.  In inverse order of seniority, haircuts should be applied to unsecured creditors and to secured creditors and other counterparties, or their (contingent) claims on the bank should be converted into common equity.

It is astonishing to have a proposal for a European Systemic Risk Board that does not find a place in the key decision-making bodies for the fiscal authorities – a place that ought to be at least as significant as that of the central banks.  Indeed, a proper tripartite representation, with equal voting rights for central banks, fiscal authorities and regulators/supervisors, has much to recommend it.

(5)   The proposed construction does not allow for the proper representation of the financial industry.  Obviously, we don’t want turkeys to turn up in large numbers to vote against Christmas.  Industry representatives should, however, be present as a matter of course in a non-voting capacity.  The expertise in the central banks, the regulators/supervisors and the ministries of finance concerning complex systems and convoluted financial instruments is quite inadequate as a foundation for effective macro-prudential management.  We must get the banks, hedge funds and other financial institutions inside the tent.

(6)   The proposed construction does not permit external, independent talent, knowledge and expertise to be brought to bear on the decision making process.  There are independent experts outside the central banks, regulators/supervisors, ministries of finance and the (private) financial sector who would have much to contribute to a systemic risk board.  Time to get such experts, be they at universities, think tanks or other research institutes on board.

No substantive accountability

The proposal repeats a feature of the design of the ECB that is most unwelcome: the absence of any substantive accountability.  To the ECB (and to its architects), accountability means reporting obligations – nothing more.  And indeed in the Commission’s proposal it states:

6.6. Reporting obligations

“The ESRB shall be accountable to the European Parliament and to the Council and shall therefore report to them at least annually. The European Parliament and the Council may also require the ESRB to report more often.”

Reporting obligations are part of what is sometimes called formal accountability.  It means that the Agent or Trustee (the ESRB) is required to provide the Principal or Beneficiary (the Council, the European Parliament, the citizens of the EU) with the information necessary to assess how well the Agent/Trustee has performed with respect to its mandate.  Substantive accountability means that the Principal(s) can impose sanctions on the Agent/Trustee if the performance of the Agent/Trustee is unsatisfactory in the eyes of the Principal(s).

Substantive accountability is lacking for the ECB, because it is logically incompatible with the extreme degree of independence accorded by the Treaty to the ECB in the conduct of monetary policy.  That same extreme degree of independence the ECB enjoys in the pursuit of price stability, the Commission apparently also wishes to bestow on the ESRB in the pursuit of financial stability.  This is implied by its proposal for two reasons.  First, because accountability is, as with the ECB, defined purely in terms of reporting obligations, with no sanctions or punishment available to be imposed on the ESRB and its members should their performance not be up to snuff.  Second, because the majority of the voting members of the General Board and the Steering Committee are members of the Governing Council of the ECB.  The Executive Board members of the ECB and the 16 NCB Governors of the Eurosystem are inviolable and untouchable as monetary policy makers.  How could they be fired, demoted, reprimanded, subjected to a pay cut or tarred and feathered and run out of town in their new capacity as members of the General Board and Steering Committee of the ESRB?

The lack of substantive accountability of the ECB as regards monetary policy should not be extended to the domain of financial stability, which is an inherently political rather than just a technical issue.


We need an EU level macro-prudential stability board.  The current proposals for the ESRB are, however, deeply misguided, as they make the central banks the dominant players in the systemic risk game.  Central banks have neither the technical knowledge, nor the tools and instruments nor the legitimacy to dominate the macro-prudential financial stability framework.  Back to the drawing board.

Contrary to what I asserted in the first version of this note, the EFC is not a committee of the European Parliament.  Rather, it gathers senior civil servants from national Ministries of Finance. It is de facto a preparatory forum for the ECOFIN Council. The relevant committee of the European Parliament is called the Economic and Monetary Affairs Committee.  I am indebted to Carlomagno ( for correcting my error.

Unless there is a major change of direction among global economic and financial officialdom, we are at risk of ending up with a world in which liquidity provision is privatised and insolvency risk for banks is socialised.  This would be the exact opposite of what makes sense: solvency is (or should be) a private good and liquidity is (or should be) a public good.

Until yesterday’s defeat of Roger Federer in the final of the US Open at Flushing Meadows, the most disappointing development this year was the performance of president Barack Obama and his administration – and my expectations were modest to begin with.

Science with very few (if any) data

Doing statistical analysis on a sample of size 1 is either a very frustrating or a very liberating exercise.  The academic discipline known as history falls into that category.  Most applied social science, including applied economics, does too.  Applied economists use means fair and foul to try to escape from the reality that economics is not a discipline where controlled experiments are possible.  The situation that an economically relevant problem can be studied by means of a control group and a treatment group that are identical as regards all but one external or exogenous driver, whose influence can as a result be isolated, identified and measured, does not arise in practice.

Saturday, August 1, my family will wing its way, DV, to Boston, MA.  From there we will trek on to Martha’s Vineyard to spend the month of August doing nothing in particular.  The combination of bad airport novels, adequate supplies of white wine (including, tell it not in Gath, vino verde) and the nearness of lots of family I don’t see enough of should enable me to recharge the nigh-depleted batteries.  Safe and sheltered in the company of other effete liberals and pointy-headed intellectuals, I hope to have the time to finally write the bad book (tentatively titled ‘Oi Oikonomiks!’) I have promised my agent. This blog will fall silent (not before time, I can hear you mutter) until September.

The only blight on the landscape of this holiday is that, once again, a US presidential family has decided to vacation on Martha’s Vineyard during the month of August.  From earlier visitations by the Clintons, I know that the arrival of the presidential hordes on the Vineyard represent a massive negative externality for all those who go there in pursuit of the same thing the president and his family seek: peace and quiet.  Whether the local economy gets a temporary or lasting boost, I leave as a project for Econ 101.

The presidential party (or presidential court) that tags along on any presidential journey, let alone a temporary relocation involving the entire presidential nuclear family, looks and behaves like an occupying army.  There are hundreds, if not thousands of persons charged with security, ranging from the secret service to the specially beefed-up state and local police forces.   Communications experts, specialist medical personnel, myriad advisers and countless other presidential hangers-on cause the Vineyard to sink at least a foot deeper into the sea.  The carbon footprint is bigger than that of the yeti.  The press corps and assorted other media camp out all over the island, competing with the presidential staff for first place in the hot air emission stakes.  Roads are blocked.  Traditional rights-of-way are suspended.  Beaches become inaccessible.

Central bank governors should serve one non-renewable term

Central bank governors should be appointed for one fixed, non-renewable term.  The ECB got that one right.  Members of the Board, including the President, serve for one, non-renewable eight-year term.  The Bank of England’s arrangements are deficient in this regard.  The governor is appointed for a five-year term but can be re-appointed as many times as the Chancellor of the Exchequer sees fit.

The Fed’s arrangements for appointments to the Board are also flawed. From the Fed’s website, Board appointments following the following set of rules: “The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate. The full term of a Board member is fourteen years, …. After serving a full term, a Board member may not be reappointed. …

The Chairman and the Vice Chairman of the Board are also appointed by the President and confirmed by the Senate. The nominees to these posts must already be members of the Board or must be simultaneously appointed to the Board. The terms for these positions are four years.”

The chairman of the Federal Reserve Board can therefore at most serve three consecutive full terms as chairman, followed by one two-year term.  This would exhaust the maximum 14 year stint on the Board. [Addition on 29th July 2009: a reader of this blog (yes, I still have some) writes: "If a Board member is initially appointed to fill the remaining term of a member who has departed early, he can then be reappointed for a full term.  So, potentially, one could serve almost 28 years, and be chairman the whole time." ]

Why is the possibility of re-appointing the chairman of the Fed, and indeed the re-appointment of the governor of any central bank, a bad thing?  Clearly, it undermines the appearance and possibly the substance of independence of the chairman.  The incentive to suck up to/please the power(s) that can reappoint you may be difficult to resist.  It is not necessarily the case that the actions and policies most likely to secure the re-appointment of the chairman are the actions and policies that are best from the perspective of the central bank’s mandate – price stability or macroeconomic stability, and financial stability.

In the current worldwide debate about greenhouse gas emissions, the political leaders of the new big polluters (NBPs, especially China and India) attempt to shift the burden of reducing the global flow of new carbon-dioxide-equivalent (CO2E) emissions to the old big polluters (OBPs, mainly Europe, North America and Japan) by claiming the moral high ground, based on two arguments: (1) we are poor, you are rich, and (2) it’s our turn now to pollute.

I will, in what follows, take as given the proposition that (1) global warming is a reality; (2) global warming is a bad thing and (3) that human-made CO2E emissions are a significant contributor to global warming.  The science underlying these propositions is inevitably shaky – as has to be the case for any non-experimental science.  Still I believe that, even if I don’t really know whether my grandchildren are more likely to swim down Oxford Street or to ice-skate down Oxford street, the cost of not doing something about man-made CO2E emissions if they are indeed as harmful as the Greenhouse Lobby argues is vastly greater than the cost of unnecessarily restricting CO2E emissions – an application of the precautionary principle, if you want.

The problem

Further expansionary monetary policy has become rather ineffective in the overdeveloped world because banks are capital-constrained rather than liquidity-constrained and because liquidity spreads in financial markets that bypass the banks have shrunk remarkably.  Remaining spreads between sovereign debt instruments and assorted private securities of similar maturities can now be rationalised quite easily as reflecting just differential default risk.  Until the banks get significantly more capital on their balance sheets, quantitative easing, credit easing and enhanced credit support are examples of pushing on a string.

The banks will take the liquidity offered and redeposit the bulk of it with the central bank again rather than lending it to the private sector or purchasing more risk financial instruments.  Low official policy rates (and the expectation of the official policy rate being kept at a low level for a further significant period of time) will help recapitalise the banks.  So will the quasi-fiscal subsidies most central banks have been channelling into the banking system through the favourable terms offered by the central banks to the private banks in their transactions, facilities etc., but such gradual recapitalisation through wide margins on low volumes of lending is slow and could lead to a re-run of Japan’s lost decade for much of the G7.

Further expansionary fiscal policy is likely to be ineffective in most of the G7 countries (possibly excepting Germany and Canada).  This is, first,  because households are short of capital and overly indebted and, second, because any further increase in short-term fiscal deficits is likely to undermine confidence in the sustainability of the fiscal-financial-monetary programme of the state. 

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