Bill Totten's Weblog

Saturday, July 04, 2009

Central banks rewarded for failure with new powers

by Richard A Werner

Special to The Daily Yomiuri (July 03 2009)

As Obama's campaign promise of finally introducing universal provision of basic health care in the United States (and thereby finally catching up with 19th-century Germany) is being quietly shelved, the transfer of power to the banking community is coming close to completion.

The former head of the Federal Reserve Bank of New York - for all practical means and purposes the true central bank of the United States - in his current role as US treasury secretary has proposed to give more powers to the privately owned US central bank. The ostensible excuse is that it should be given the allegedly new brief of ensuring the health and stability of the overall financial system - as the "systemic risk regulator". Apparently the Federal Reserve Board needs more staff, more resources and greater legal powers to do this.

But this brief was precisely why the Fed was founded in the first place in 1914, against much resistance from Congress. It was argued at the time that only by having a privately owned cartel of bankers' interests, which is given the government's prerogative to create and allocate money, can the bankers ensure that their speculative excesses won't create massive recessions, bankruptcies and large-scale unemployment. It was hardly a convincing argument - just as it has hardly been a convincing case that bankers need to be given billions and trillions of taxpayers' money in the past half year or so as soon as some of their big bets went sour, after they had made billions and trillions of profits from their speculative gambling. Then, just as now, the bankers got their way nevertheless. They are a persuasive lot. Their powers of persuasion may have to do with the fact that already at the time (just as today) they were the creators of the majority of the money supply. If money speaks volumes, money creators have a monopoly on the library.

The Bank of England is now also asking for more powers. A similar proposal to give more unaccountable power to the European Central Bank has been signed off in Europe: The ECB will be given new scope to influence the European economy and government policies in an additional role as pan-European "systemic risk supervisor", as if it not already wielded the greatest power concentration in banking history. Central bankers like the ECB, the Bank of England and the Fed talk about little else but "stability" and how they are always concerned with it.

The problem is that this is not what they have delivered. Has that been because they just did not have enough power? The political and legal powers of central banks worldwide have increased dramatically in the past thirty years.

While deregulation, liberalization and privatization have consistently eaten away the former powers of governments and elected representatives of the public, unelected central bankers have managed to amass increasing powers and influence over the economy and people's lives. The ECB is the world's most powerful, unregulated, unaccountable and untransparent central bank since the Reichsbank (which could not be reined in by laws made in the German parliament and was only accountable to external interests, namely the J P Morgan-controlled Reparations Committee - today known as the BIS). Central banks have long had enough power to prevent asset bubbles and banking crises - if only they had put their minds to it. But do they have any incentive to do so?

The powers of former Fed Chairman Alan Greenspan to influence the economy were virtually boundless. He was able to block any regulation of the credit derivatives market and interfered in attempts by other public sector entities to rein in the exploding speculative activities of bankers, loan sharks ("subprime lenders") and second-hand debt dealers. The main constituency of the Fed are its banking shareholders. It has little to gain from restricting the bankers' profiteering. And it has much to gain from erring on the side of laissez-faire.

The fact is that central banks chose to ignore warnings by critics who had argued consistently since the early 1990s that central banks needed to intervene in the inefficient and rationed credit markets to restrict bank credit extension for purely speculative purposes and encourage bank credit for productive investment.

This can be achieved by simply imposing a rule that banks are only allowed to create credit for transactions that are classified as contributing to gross domestic product. Financial transactions don't. This proposal does not directly restrict financial speculation: let there be a free market for speculators to speculate as much as they wish to do so.

However, let them not lay claim to newly created money for their activities and let them raise their funds in the supposedly efficient and deep capital markets or from other nonbank financial institutions that in turn must not receive credit from banks. This simple rule will prevent asset bubbles and banking crises.

Central banks not only ignored this advice (detailed in many of my publications since the early 1990s, as well as in my 2005 book), but took policies that encouraged bank credit creation for speculative purposes.

Predictably, this led to asset inflation and - with mathematical precision - banking crises. Central banks thus were responsible for the biggest resource misallocation in peacetime history. The central banks lobbied to fight the ensuing pandemonium with vast new money injections, for the benefit of the financial sector, and most of which was put on the taxpayer's tab again.

Taxpayers now have to face multiyear belt-tightening programs that will continue the agenda of rolling back useful government activities and exposing ever increasing parts of society to predatory raids by profiteers.

How were central banks called to account for their massive mistakes? Have there been any serious inquiries into the responsibility of central banks? Have any disciplinary or legal measures been imposed or proposed against the responsible central bankers?

Instead of punishment, central bankers are about to be rewarded with new and greater powers. This is at least historically consistent: whenever bankers and central banks mess up on a large scale, they are not punished, but usually rewarded with greater influence and powers. Thus it happened after the Reichsbank's hyperinflation, the coordinated aggressive money printing policies of central banks in the early 1970s which created the high inflation of the first half of the 1970s, the Bank of England's policy to encourage speculative credit expansion since the early 1980s; the Bank of Thailand's catastrophic creation of what grew into the Asian crisis, the Bank of Japan's active propagation of the bubble economy and subsequent unprecedented slump with record deflation. Even the Fed's shocking policy of bankrupting tens of thousands of banks, causing the Great Depression and bringing starvation upon a previously healthy farming sector did not lead to any serious restriction on central bank powers or stricter accountability for central bank failures.

By contrast, the few central banks that had remained prudent and failed to create bubbles and busts were not rewarded with greater powers: the Bundesbank had dared to be the odd one out among central banks and through its refusal to create an asset bubble in Germany was becoming increasingly isolated. It started to make other central banks look bad. It got its just reward: it was stripped of all its powers with the introduction of the ECB.

Rewarding the Fed for its massive failure by giving it yet more powers and control levers will increase regulatory moral hazard. It will not reduce systemic risk, but is the surest way to increase it: When those who mess up don't have to pay up, but instead are being bailed out or rewarded, they have little incentive to change their behavior. To the contrary, the reward is likely to encourage them to take risks and mess up again. As I have warned for the past decade: By increasing central banks' powers, the risk that central banks will do more of what they do best - create massive cycles - is likely to rise; hence since 2001 I have warned of the risk of ever bigger boom/bust cycles and banking crises (what I call "central bank risk").

The plan to give more powers to the Fed, right after it has been responsible for the global financial crisis, is sending a clear message to central bankers across the globe: Messing up on a grand scale is highly advantageous.

Little failures such as some consumer price inflation here or a minor recession there will draw public criticism. But catastrophic blowups have unimaginable potential to further increase the unaccountable powers of central bankers.


Werner is professor of international banking at the School of Management, University of Southampton and author of Princes of the Yen (2003) and New Paradigm in Macroeconomics (2005).

Bill Totten


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