Economics

In January 2010 I will, DV, start a new career as Chief Economist at Citi.  Unlike my predecessor in that position, Lewis Alexander, who was based in New York City, I shall be based in London.

As a consequence of this career move, Maverecon will be mothballed. That is the logical implication of brand integrity and credibility.  In Maverecon I wrote under the cover of ‘academic immunity’ . Academics have no duty other than to state the truth as they see it – to ‘speak truth to power’.  This gives them the ability to be undiplomatic, blunt, tactless and outspoken in ways that are unacceptable in the wider world – the world of grown-ups.

When I served on the Monetary Policy Committee of the Bank of England (between 1997 and 2000) and during my years as Chief Economist and Special Counsellor to the President of the European Bank for Reconstruction and Development (2000 till 2005), I was constrained in what I could say and write in public by institutional loyalty and the moral and professional obligation not to damage the organisation I served.  Unlike my Maverecon blog, my writings and public statements of those years therefore don’t contain words like ‘complete bollocks’.

The joys of academic freedom and irresponsibility include the ability to participate in public debate using expressive, forceful language, strong metaphors, analogues and similes, to go over the top from time to time, to overstate the case and over-egg the pudding and not to worry about giving offense to the high and mighty.  Because of their sheltered existence, academics can be reckless with impunity in their excursions into the forum of public opinion.

Inevitably, during my years with the MPC and the EBRD, both the form and substance of my public statements were more constrained than during my academic episodes before and after.  The same will be true during the years to come with Citi.

I will continue to write and publish fast and furiously and to speak out in public on the issues of the day.  I plan to contribute regularly again to Martin Wolf’s Economists Forum, to write columns left, right and centre and perhaps even to start another blog.  But it won’t be Maverecon because it cannot be Maverecon.

It’s been fun blogging with you.

Dubai is not systemically significant.  If its troubles open our eyes to the likely imminence of the start of the final leg of the journey from household default through bank default to sovereign default, it may do some systemic good, by alerting fiscal policy makers to the vulnerability of their nations’ fiscal-financial positions, and by educating citizens and voters to the urgency of deep fiscal burden sharing.

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.

Mr Eliot Whitehead sent me the following e-mail message in response to my blog post ‘Gold – a six thousand year old bubble’:

“Regarding your FT article, Gold – a six thousand year old bubble, it would interest you to learn that Rai, somewhat since the end of WWII in the Pacific, no longer has value in Yap: to Yapese, it is, essentially, worthless and disregarded. Ironically, it has fairly great value to foreign collectors, but its export is strictly prohibited by law. In reality, more could be “minted”: a clever entrepreneur with the support of the Yapese government should be able to make Rai in Palau and Guam, transport it to Yap, and sell for a tidy profit to these collectors…but this will never happen.

With the advent of American administration (under UN guise), traditional Yapese cultural practice was undermined to be replaced by contemporary, American style consumer values: building materials, automobiles, roads (a pathetic fate for much, unmovable, Rai lining the original pathways), tin foods, clothing, et al. Of course, Rai had and has no value in obtaining these now necessary items.

I date the seeds of this reversal to the late 1960s and was in full swing by the mid-70s.

I can not imagine the circumstances under which Yapese would ever value Rai again. On a grander scale, could gold follow the same path?

Probably not. In any case, I only put my money in real estate.”

Far be it from me to assert that a fate similar to that suffered by the Yapese Rai will befall gold – another intrinsically worthless fiat commodity.  But the demise of the Rai as a store of value and means of payment, when taken together with the historical experience of pre-columbian native American tribes and nations that attached very little value to the shiny metal, should give the gold bugs some sleepless nights.  More importantly, it ought to discourage investors who are not rich enough to survive a speculative disaster from putting too much of their savings into this frivolous store of value.

Gold is unlike any other commodity.  It is costly to extract from the earth and to refine to a reasonable degree of purity.  It is costly to store.  It has no remaining uses as a producer good – equivalent or superior alternatives exist for all its industrial uses.  It may have some value as a consumer good – somewhat surprisingly people like to attach it to their earlobes or nostrils or to hang it around their necks.  I have always considered it a rather vulgar metal, made for the Saturday Night Fever crowd, all shiny and in-your-face, as opposed to the much classier silver, but de gustibus… .

The total stock of ‘above-ground’ gold is about 160,000 metric tonnes (a metric ton is 2,204 lbs. or 35,264 oz, for those of a non-decimal mind-set).  About 50 percent of this existing stock of above-ground gold is kept as a pure store of value (for investment purposes), most likely somewhere below-ground, for security reasons. The other 50 percent exists as jewellery.  I would argue that most of this jewellery demand is simply small-scale store of value (investment) demand by households, rather than demand driven by aesthetic considerations or other intrinsic sources of joy associated with having gold hanging from your extremities.

There are two reasons why the Fed, or any other central bank, should not act as a quasi-fiscal branch of the government, other than paying to the Treasury in taxes the profits it makes in the pursuit of its mandated macroeconomic stability objectives (maximum employment, stable prices and moderate long-term interest rates in the case of the Fed) and its appropriate financial stability objectives.  The appropriate financial stability objectives of the central bank are those that involve providing liquidity, at a cost covering the central bank’s opportunity cost of non-monetary financing, to illiquid but solvent financial institutions.

Any action going beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury.  The central bank should be involved only as an agent of the Treasury – an expert assistant.  It should not put its own conventional or comprehensive balance sheet at risk.

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.

Conclusion

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 (carlomagno07@gmail.com) for correcting my error.

The difference between data and information has been underlined emphatically by the release on Friday, October 23rd, of the UK GDP data for the third quarter of 2009.  Those who make a profession out of providing point forecasts of future GDP had converged on a figure of +0.2% for the quarterly growth rate.  What came out was -0.4%.  Shock horror!  Never mind that anyone providing point forecasts of anything without also offering at least some information about of the rest of the probability distribution of future outcomes  (variance, skewness, kurtosis, single-peakedness etc) is either a fool, a knave (or both) or caters to an audience consisting of bears of very little brain.  No matter that the first release of a quarterly GDP forecast in the UK bears little if any systematic relationship to the ‘final’ release, which is often provided years later.  Although we hope that successive data revisions get us closer the the theoretical concept of GDP, we have, of course, no practical way of verifying that.  We are like the proverbial blind man looking in a dark basement for a black cat that isn’t there.

The euro has become a currency on steroids.  Its relentless nominal and real appreciation since the end of 2000 was briefly interrupted in the second half of 2008, but resumed with a vengeance during 2009.  The strength of the currency is hurting the exporting and import-competing sectors of the Euro Area.  Unemployment and excess capacity continue to rise.  The euro’s excessive strength is also contributing to a significant and persistent undershooting of the rate of inflation the ECB deems to be consistent with price stability in the medium term: headline HICP inflation in December 2008 was 1.60 percent in December 2008, hit zero in May 2009 and has been negative since then.

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

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