Saturday, July 4, 2015

Gary Judd: World defenceless against next financial crisis

The world is defenceless against the next financial crisis, warns BIS. Monetary policymakers have run out of room to fight the next crisis with interest rates unable to go lower, the BIS warns

That is a headline in The Daily Telegraph of 28 June 2015. The article commences “The world will be unable to fight the next global financial crash as central banks have used up their ammunition trying to tackle the last crises, the Bank for International Settlements has warned…. The BIS report described the threat of a new bust in advanced economies as a “main risk”, with many reaching the top of the economic cycle.”[1]

The report itself (85th Annual Report published 28 June[2]) doesn’t use those precise words apart from “main risk”. It is written in the restrained language to be expected of such a publication but it is very clear about the seriousness of the situation. Its recitation of the problems created by the policies adopted leave little doubt the BIS thinks the next financial crisis is not far around the corner. It says

For monetary policy, there is a need to fully appreciate the risks to financial and hence macro economic stability associated with current policies. True, there is great uncertainty about how the economy works. But precisely for this reason it seems imprudent to push the burden of tackling financial stability risks entirely onto prudential policies [policies for regulating banks and other financial institutions]….

Given where we are, normalisation is bound to be bumpy. Risk-taking in financial markets has gone on for too long. And the illusion that markets will remain liquid under stress has been too pervasive…. But the likelihood of turbulence will increase further if current extraordinary conditions are spun out. The more one stretches an elastic band, the more violently it snaps back. Restoring more normal conditions will also be essential for facing the next recession, which will no doubt materialise at some point. Of what use is a gun with no bullets left?[3] [Italics added.]

The BIS is the world’s oldest international financial organisation (established 1930, 4 years before RBNZ) and has 60 member central banks representing countries from around the world that together make up about 95% of world GDP. RBNZ is a member.

BIS’s mission is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.

One of its committees is the Basel Committee on Banking Supervision which is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. RBNZ generally adopts Basel Committee recommendations with only minor modifications for New Zealand conditions.

So, if BIS says something in its Annual Report it should command careful attention. Its just published vews surely qualify as “Breaking News”. NZCPR appears to be the first to break the news to New Zealanders at large.[4]

The report should particularly command the attention of directors and managements of banks and other financial institutions. Rules of prudential regulation must be obeyed: directors and managements cannot exercise their own judgement. The extent to which directors and managements can think for themselves is diminished by the imperative to obey commands from on high.

It is most unsatisfactory that those who know the business best are dis-incentivised from responding to market signals directly. The message from the BIS report for directors and managements of banks and other financial institutions is that even though they must obey the rules, they shouldn’t regard them as sufficient on their own and should be devising disaster contingency plans to cope with another and worse GFC.

Underlying much of the BIS Annual Report is that causes have effects — and effects have causes. The report is saying that the causes of the GFC are being repeated and the effects of those causes are likely to be worse. Hence — “the more one stretches an elastic band, the more violently it snaps back”.

The report is saying that central banks have stretched the money creation ‘elastic band’ more this time than they did last time, so the snapback is going to be more violent. Exacerbating the situation arising from central bank activity is the stretching from government stimulus, particularly because it has been debt-financed. Governments are debt burdened to an enormous and unprecedented level, with no capacity to take on more debt.

Neither central banks nor governments have bullets left for their guns. Guns is an apt analogy because coercive powers are used by governments and central banks to impose their wills on the people. The BIS Report shows this has taken the global community to the brink of economic chaos.

That BIS message that the causes of the GFC are being repeated and creating great danger is not breaking news to me. I  talked about it and the pointlessness of prudential policies in an address I gave to an Institute of Directors Chairmen’s Workshop in September 2009 entitled Trying to Be a Rational Banker in an Irrational World[5], I said[6]:

You can't necessarily blame the Federal Reserve and other central bankers for the misjudgements which resulted in the excess money in the system. The problem is the system which permits men to play God with the money supply. They think they know what's best but they don't. A central banker can get something right only by sheer coincidence. Even if he doesn't make a misjudgement of events current at the time, he cannot be responsive to future changes in the financial environment in such a way as to avoid perverse outcomes, because first of all he has to recognise that the environment is changing and secondly he has to use imprecise instruments to try to deal with the change.

I concluded the address with this:

… I … come back by way of conclusion to my thesis that there has been a failure by policymakers clearly to identify and honestly to state the causes of the global economic crisis. As I said, we have been subjected to rhetoric which suits and is aligned with political agendas because it shifts the blame away from the policymakers. Also I believe it to be aligned with a fundamental feature of the political condition which is the desire to be able to exercise control, and an enthusiasm to grasp opportunities to exercise such control.

Instead of saying that the fundamental cause of the crisis was the huge growth in liquidity and credit, as [Dr] Alan Bollard [then RBNZ governor] has correctly identified, and asking what policy prescriptions are desirable going forward to ensure that it doesn’t happen again, the response of the policymakers has actually been to do precisely the same thing, but in spades, and in part in a much more dangerous way by creating primary money [using quantitative easing] and not just by encouraging credit creation. If any consideration has been given to how this cause might be avoided in the future it certainly has not been the subject of public statements….[7]

Instead, the political rhetoric is directed to putting the blame on others. Policymakers and politicians want the public to put the blame on “Wall Street greed”. Policymakers and politicians say they want to try to prevent future problems by things such as increasing regulation, imposing restraints on remuneration and generally increasing government involvement in the financial affairs of economies…               

To draw [an] analogy. It is a bit like engineers deliberately setting off explosive devices to cause landslides into a dam. Landslides which are likely to cause a breach in the dam and to flood the countryside below. Instead of ceasing to generate the landslides the engineers resolve to continue them but to try to build the dam a bit higher….

….[O]f this I am of no doubt: that there would have been a greater likelihood of finding the best response if there had been a clear and honest identification and acknowledgement of the causes of the problem. Instead we have obfuscation, evasion, posturing and politicking.

Even now we would be in a better position going forward if policymakers adopted a rational approach, even if belated.

A rational approach must take account of all causes. Ignoring fundamental causes is a recipe for disaster.[8]

Ignoring fundamental causes is a recipe for disaster: this is what the BIS Report is saying.

My suggestion as to why the policymakers acted as they did has an echo in the BIS Annual Report. Under the heading The deeper causes, the report says.

Why has this happened? One possible answer lies in a blend of politics and ideas. The natural bias of political systems is to encourage policies that buy short-term gain at the cost of risking long-term pain. The reasons are well-known and need no elaboration here. But, as ideas influence policy, their effect becomes all the more insidious because of that bias. Thus, the pressing question is whether prevailing economic paradigms are sufficiently good guides for policy.[9]

Different, but connected, breaking news of high importance for New Zealand is the latest dairy auction where prices fell further. Economists speculate that this may cause RBNZ to again reduce interest rates. Unlike the BIS Annual Report, this news has been well publicised in New Zealand.

In the first quotation from Trying to be a Rational Banker I referred to the system which permits men to play God with the money supply. The usual description of God’s attributes includes that he is omniscient or all knowing (so he knows what is going to happen in the future). Much as they might like to think they have this godlike attribute, central bankers do not.

RBNZ like just about every one else probably thought that dairy prices would not go down and would likely continue to rise. Many are still in a state of disbelief that prices have been relentlessly going down for quite some time now. They forget that in the supply/demand nexus there is not just demand but also supply.

Even with demand all was not as it seemed. It has often been said that of the billions of people in undeveloped and emerging economies many are moving toward the middle class so the demand for foods like dairy will keep increasing. But demand may still plateau or go down especially where prosperity is the result of monetary stimulation and is therefore artificial. In the euphoria when dairy prices just kept going up, this was one of the forgotten things.

Another forgotten factor is that increased prices stimulate supply not just from new producers (such as in Brazil) but also from traditional producers who in the past may have been incentivised not to produce but are now losing those incentives (Europe, including the UK), and from traditional producers who erstwhile produced only for domestic markets because it wasn't worth their while to produce for overseas markets but it became worthwhile (as in the US).

In New Zealand higher prices encouraged more intensive dairy production, increased investment and increased price of land.

Some (including in New Zealand) may now be getting their fingers burnt because prices have dropped. There are countless examples of investments which seemed great at the time turning out to be bad. A topical one is oil. The dramatic oil price reduction has made investment in shale a bad decision. Those with deep pockets may hope to ride out a temporary reversal but it may not be temporary.

With New Zealand dairy, perhaps the lower prices may cause supply from other countries to fall off and/or demand increase to resume, but we don’t know.

Many New Zealand economists are now saying that RBNZ must (and will) reduce interest rates because the downturn in dairy prices exacerbates other factors and is creating a danger of economic activity falling off. Some are now saying that OCR reductions are inevitable. I saw one predicting four interest rate reductions over the near-term.
Much of the work economists do is directed towards second-guessing what RBNZ will do. When they undertake or take account of surveys of employment, business confidence, etc they do so for the purpose of predicting RBNZ actions. They know RBNZ will be trying to influence business and household activity.

Add to that the need to try to work out what the consequence of an RBNZ response will be beyond the immediate change in the Official Cash Rate (OCR) — will it be what RBNZ hopes, will there be a further change in the economic climate in New Zealand or somewhere else in the world which has an impact on New Zealand. Will it turn out to be something of a disaster, like Governor Bollard’s ‘go for growth’ strategy in his initial years as governor?

I can’t help thinking of the ancient practice of consulting the entrails of a chicken before undertaking an important course of action.

There is only one thing RBNZ might do which would be useful. It should abdicate. It should give up trying to influence the money supply because its actions are far more dangerous than anything which might result from the operations of the market.

Unfortunately, there is no market economy anywhere in the financial world. Financial markets are all directly or indirectly constrained from acting as markets by central banks. They have a monopoly on the supply of currency and its electronic equivalent (in New Zealand if someone else tries to do it they are liable to imprisonment for up to 3 years — RBNZ Act 1989, sections 25 and 27).

They also exercise control over the creation and destruction of money created through the operation of financial institutions. Different mechanisms are employed but in New Zealand today the favoured mechanism is the OCR.

But not just that. RBNZ makes and alters capital and liquidity rules and imposes other restrictions and requirements, some of which are motivated by a concern about the stability of the banks and other financial institutions (prudential rules). All have an indirect impact on the money supply.

Most of those things are specialised and not apparent to the general public but Governor Wheeler demonstrated a nascent enthusiasm for visible direct intervention when RBNZ regulated to require that banks could not lend to homebuyers who did not put up a sufficiently large deposit.

The absence of true financial markets globally means that if RBNZ did abdicate, New Zealand would remain subject to the influence of the policies of overseas central banks. The economists would need to ‘read the entrails’ of the Federal Reserve and others.

Abdication would still be worthwhile, nevertheless, because it would at least return some degree of responsibility to New Zealand bank directors and management who might then start focusing on managing risks and their businesses generally without being concerned about the need for second-guessing what RBNZ might or might not do. Instead they would have to try to second-guess what the Fed will do.

The real solution is for the Fed and all the rest of them to abdicate. They won’t realise that before the next collapse comes — they will continue to think that they know best and that they have the power to do something, even though they don’t know what it is. Abdication by RBNZ would set an example. New Zealand has been first before.

The Fed is scared stiff at what may happen if they decide they must increase interest rates. They probably remember that the last time interest rates were increased — in the mid-2000’s —things started to go pear-shaped and the slide towards the GFC was accelerated. Hence present indecision and prevarication.

When the next collapse comes, will that make them realise that it is their policies of intervention which are the problem? Unlikely, but the next collapse may be so serious as to completely undermine global economic order, in which case they will become irrelevant.

There is one glaring deficiency in the BIS Annual Report. There is an underlying assumption that central banks and governments should be able to do something although they don’t say what it is.

What they should say is that their member central banks cause the problems and should cease to be involved in trying to control the money supply, but as BIS is the central bank of central banks, it could hardly say that, even if in its heart of hearts it knows it to be the case!

It is the actions of central banks and governments which create the danger to global economic stability. Although they might not say it directly, this is the clear message from the BIS Annual Report. Returning to cause and effect, if central banks trying to control the money supply is the cause of the effect, surely the answer is to get rid of the cause which in this case is the central banks having the power to play God. Let the millions of individual producers and consumers determine it by their own individual free actions. That is, allow the market to function unhampered by these attempts to exercise control.                                 


Wayne Nicholls said...

Thanks Gary for the extensive article and particularly for its NZ context. When the Bank for International Settlement believes it is necessary to make public the ideas you referenced then it is obvious that a major storm is brewing.

Your article became more meaningful with the claim in the last paragraph that “ Let the millions of individual producers and consumers determine it by their own individual free actions. That is, allow the market to function unhampered by these attempts to exercise control. ”

This is the solution but before this can be understood and applied there needs to be a change in academia to the acceptance of individual judgment and responsibility. As long as it is believed that individuals are not respected to rationally organize their lives then the market will always need controllers and suffocates. This is the challenge to change this mind set.

In reference to this I recommend John Allison’s book The Financial Crisis and the Free Market Cure. John Allison was the retired Chairman of BB and T. From your article I sure you will enjoy this reference. You have much in common.

Wayne Nicholls.

Gary Judd said...

Thanks, Wayne. I got John Allison's book soon after it was published. It is an excellent work and John himself when CEO of BB and T practised what he preaches in the book.

One of the quotes from the BIS report spoke of the likelihood of turbulence increasing. Well, it has — since the publication of the BIS Report and indeed since the publication of my article, with the turbulence in the Chinese sharemarket.

The response of the Chinese government is authoritarian, as you would expect (but not much different to what Robert Muldoon was doing in the 1980s). For present purposes, the important thing to note is that they are once again repeating the causes. Some of the new money created by Chinese monetary policy went into the Chinese stock market (but aided and abetted by the monetary policy of the Fed and others because that's where some of the new money created by the Fed or through its policies went).

Now one of the measures they are taking is to purchase stocks through an agency but apparently funded by the central bank. It is quantitative easing (monetising assets). Whilst the purpose may be different (to meet an emergency situation as compared with attempting to stimulate the economy as in the US and elsewhere), the effect is still the same — injecting new money into the economy which recreates the causes of the problem they are trying to solve.

Who knows what the outcome will be.