Austerity, uncertainty, instability … all problems we associate with Europe today as it cycles from pre-GFC exuberance to today’s austerity. But to put things in perspective, these are minor problems compared what our grandparents endured after World War Two. In Britain many people did not have enough to eat, the government had secret plans for national catastrophe, the Cold War was raging, the colonies erupting, and Sterling was in crisis. In those days there were few policy economists, and macroeconomics was caught in a battle between non-interventionist classical economics and the Keynesian revolution of demand management.
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By David Cobham
The standard arguments against monetary policy responding to asset prices are the claims that it is not feasible to identify asset price bubbles in real time, and that the use of interest rates to restrain asset prices would have big adverse effects on real economic activity. So what happened with central banks and house prices prior to the financial crisis of 2007-2008?
Looking in detail at what the Federal Reserve Board (Fed), the European Central Bank (ECB) and the Bank of England (BoE) thought and said about house prices from the beginning of the 2000s, it appears that the Fed was so convinced of the standard line (monetary policy should not respond to asset prices but just stand ready to mop up if a bubble bursts) that it did not allocate much time or resources to discussing what was happening.
The BoE, on the other hand, while equally committed to that orthodoxy, felt the need to argue it out, at least up till 2005, and a number of speeches by Steve Nickell and others explained why they believed that the rises in house prices were a response to changes in the fundamentals (notably, the much lower levels of inflation and interest rates from the mid-1990s) and were therefore not a cause for concern. But after 2005 the BoE seems to have lost interest in the issue even to that extent.
Bank of England headquarters, London
The ECB was in principle more willing to consider the issue and to think about a response, but developments were very different between euro area countries (with Spain and Ireland experiencing strong house price booms but Germany and Austria seeing almost no change in house prices), and this would seem to be the main reason why the ECB never raised interest rates to restrain the house price booms in the former (which it correctly identified).
Since the crisis the Fed and the BoE have produced analyses suggesting that monetary policy bore almost no responsibility for the house price rises, on the one hand, and that using interest rates to restrain them would have caused sharp downward pressures on income and employment, on the other. The trouble with these analyses is that they consider only the effect of interest rates being a little higher before the crisis, with everything else equal. But of course the advocates of ‘leaning against the wind’ (the minority view which has favoured using interest rates to head off large asset price booms) have always emphasised that the existence of such a policy needs to be known in advance, so that it feeds into the public’s expectations of asset prices and helps to stabilise them. The absence of any such expectations effect in these analyses means that they are wide open to the Lucas Critique, and their results cannot be taken as an argument against leaning against the wind in this case.
What this all amounts to is our conclusion that the failure to adequately monitor developments in the housing markets means that the central banks of the United States and the United Kingdom, in particular, cannot reasonably claim to have done all they could have done to mitigate the house price movements that were crucial to the incidence and depth of the financial crisis.
The main outcome of the crisis for the operations and strategy of monetary policy so far has been the creation of instruments and arrangements for ‘macro-prudential’ policies, which will indeed offer central banks some additional ways of addressing problems in asset markets. However, central banks need to take some responsibility for the debacle of 2007-2008 and its effects. And they need to find some way in the future to incorporate an element of leaning against the wind into their inflation targeting strategies, in case macro-prudential policies turn out to be inadequate.
It is not beyond the wit of man or woman to establish a central bank remit which has a primary focus on price stability but allows the central bank to react to other developments in extreme situations, as long as it makes clear publicly that this is what it is doing, and why, and for how long it expects to be doing it.
Such a revised remit would and should incorporate useful expectations-stabilising effects for asset markets. The transparency and accountability involved would also help to shore up the independence of the central banks (particularly the BoE) at a time when there is so much pressure on them from the political authorities to ensure economic recovery.
David Cobham is Professor of Economics at Heriot Watt University in Edinburgh. He is guest editor of Oxford Economic Papers April 2013 special issue on ‘Monetary policy before, during and after the crisis’, and co-editor of Oxford Review of Economic Policy spring 2013 issue on ‘The economic record of the 1997-2010 Labour government’.
Oxford Journals has published a special issue on the topic of Monetary Policy, with free papers until the end of March 2014.
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Image credit: Bank of England, Threadneedle Street, London. By Eluveitie. CC-BY-SA-3.0 via Wikimedia Commons
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By Richard S. Grossman
The public has been so fatigued by the flood of appalling economic news during the past five years that it can be excused for ignoring a scandal involving an interest rate that most people have never heard of. In fact, the Libor scandal is potentially a bigger threat to capitalism than the stories that have dominated the financial headlines, such as the subprime meltdown, the euro-zone crisis, the Madoff scandal, and the MF Global bankruptcy.
It’s not surprising that Libor has generated less interest than these other stories. It has left neither widespread financial turmoil nor bankrupt celebrities in its wake. It took place largely outside of the United States, further rendering the American media and public more disinterested. It involves technical issues that induce sleep in even the most hard-bitten financial correspondents.
Yet, despite its lower profile, the Libor scandal is potentially more serious than any other financial catastrophe in recent memory.
The subprime crisis can be blamed on poor government management: irresponsible fiscal policy combined with loose monetary policy and poor regulatory enforcement. The euro crisis resulted from one poorly conceived idea: creating one currency when retaining 17 distinct currencies would have been better. The Madoff and MF Global debacles can be chalked up to a few isolated unscrupulous and reckless individuals.
By contrast, the Libor scandal was nothing less than a conspiracy in which a group of shadowy bankers conspired against the majority of participants in the financial system—that is, you and me. And therein lies the danger.
Libor is the acronym for the London InterBank Offered Rate. Previously produced for the British Bankers’ Association, it was calculated by polling between six and 18 large banks daily on how much it cost them to borrow money. The highest and lowest estimates were thrown out and the remainder—about half–were averaged to yield Libor.
Libor plays a vital role in the world financial system because it serves as a benchmark for some $800 trillion in financial contracts–everything ranging from complex derivative securities to more mundane transactions like credit card interest rates and adjustable rate home mortgages.
Since so much money rides on Libor, banks have an incentive to alter submissions to improve their profitability: raising submissions when they are net lenders; lowering them when they are net borrowers. Even small movements in Libor can lead to millions in extra profits–or losses.
Financial conspiracy theories are about as commonplace–and believable–as those on the Kennedy assassination and the Lindbergh kidnapping. This time, however, emails have surfaced proving that banks colluded on their Libor submissions. In one email, a grateful trader at Barclays bank thanked a colleague who altered his Libor submission at the trader’s behest: “Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger.”
Unfortunately, efforts to reform Libor have been insufficient.
In July British authorities granted a contract to produce the Libor index to NYSE Euronext, the company that owns the New York Stock Exchange, the London International Financial Futures and Options Exchange, and a number of other stock, bond, and derivatives exchanges. In other words, the company that will be responsible for making sure that Libor is set responsibly and fairly will be in a position to reap substantial profits from even the slightest movements in Libor. Like putting foxes in charge of the chicken coop, this is a recipe for disaster.
The financial system’s role is to channel the accumulated savings of society to projects where they can do the most economic good—a process known as intermediation. My retirement savings may help finance the construction of a new factory; yours might help someone pay for a new house. Although Goldman Sachs CEO Lloyd Blankfein exaggerated when he called this function “Doing God’s work,” intermediation is nonetheless a vital function.
Intermediation will come screeching to a halt if individuals, corporations, and governments no longer trust the financial system with their savings. Those who believe that the interest rates they pay and receive are the result of a game that is rigged will just opt out. They may not go so far as to stash their savings under their mattresses, but they will certainly keep it away from the likes of bankers they believe have been cheating them. Instead they will hold it in cash or in government bonds which will reduce the amount of money available for productive purposes. The consequences for the economy will be severe.
Rather than handing Libor over to a firm with a conflict of interest, the British government should announce that a year from now, Libor will cease to exist. How would markets react to the disappearance of Libor? The way markets always do. They would adapt.
Financial firms will have a year to devise alternative benchmarks for their floating rate products. Given the low repute in which Libor—and the people responsible for it—are held, it would be logical for one or more publicly observable, market-determined (and hence, not subject to manipulation) interest rates to take the place of Libor as currently constructed.
Only by making this important benchmark rate determined in a transparent manner can faith be restored in it.
Richard S. Grossman is Professor of Economics at Wesleyan University and a Visiting Scholar at the Institute for Quantitative Social Science at Harvard University. He is the author of WRONG: Nine Economic Policy Disasters and What We Can Learn from Them and Unsettled Account: The Evolution of Banking in the Industrialized World since 1800.
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