Three Thought-Provoking Central Banking Reads

I have three recommendations for readers interested in central banks and monetary policy. First, my classmate Jeremie Cohen-Setton has started a new blog (together with Tishani Dorfmeister) called ECB Watchers. This blog is great for anyone who watches the Fed too, because the comparative analyses of ECB and Fed policies are quite illuminating. In particular, they have good insights into why the ECB and the Fed will each face serious but different challenges with forward guidance. They explain how the differences stem in part from the Trichet doctrine, which basically holds that non-standard monetary policy measures can “be determined largely independently” from conventional measures. They add:

The intellectual case for such a separation became more fragile, however, as the ECB introduced another set of non-standard measures (LTROs, covered bond programme, Securities Markets Programme and, should it be implemented, the Outright Markets Transactions), which implicitly addressed the second category of problems. By and large, the ECB has remained very shy with measures affecting the structure and risk premia problems (which it consistently saw as bordering fiscal policy) in comparison to the Fed and other central banks.

This relative timidity for touching the risk and term premia can be understood in a multi-country context where monetary policy would inevitably have important distributional consequences. But ECB officials often overplay this aspect. The ECB has eventually been forced to venture in this field and is nervously attempting to rationalize and justify these interventions ex post by explaining that the specific set up of the euro area and in particular the risks of financial fragmentation justified such an approach (see speech by Benoit Coeure at the Banque de France). But this argument is anachronic, because the ECB’s non-standard measures largely predates the financial fragmentation along national boundaries or redenomination risks (covered bond programme, SMP) and because the institutional set up cannot be a sufficiently good reason for the ECB not to undertake what its mandate and its fiduciary duty towards European citizens call for.

My second recommendation is a speech by Fed Governor Sarah Bloom Raskin called "Beyond Capital: The Case for a Harmonized Response to Asset Bubbles." Unfortunately, since she gave the speech on the same day as Chairman Ben Bernanke's testimony on July 17, the speech was under-covered. The bit of coverage that the speech has had mostly just notes that she thinks regulation can stem asset bubbles. But it actually has quite a bit more content. The mechanics of asset bubbles-- why and how they form and grow-- is not clearly understood. But Governor Raskin provides a much clearer and more coherent discussion than I have seen in any previous central banker speech (and I have read quite a lot of them!) Here's a long excerpt-- I'm thrilled to see a central banker actually putting this many words into explaining precisely what they mean by an asset bubble before saying what they want to do about it.

It used to be believed that asset bubbles emerged spontaneously, or perhaps came from sunspots or other mysterious causes. Now we know more and we know better, and, while we may not be able to predict bubbles, we understand them to be a product of particular actions and choices by financial institutions and their regulators.

Here is one way a bubble might start. And, to approximate current economic conditions, we'll assume an environment of interest rates that have been low, and continue to be low, for a long time. To start, retail investors may become dissatisfied with their low yields and begin to seek higher yields by purchasing some specific higher-yielding asset. If investors have access to credit, they might try to raise the return on their money by funding a greater portion of their purchases with debt. The asset purchased could serve to collateralize their loan. If many investors employ this strategy and they borrow to invest in the same asset, the price of that asset, and perhaps the prices of closely related assets as well, will increase noticeably faster than the historical trend.

At the same time, increased demand for credit to finance these asset purchases could lead lenders to increase their reliance on less expensive, unstable short-term funding, such as uninsured deposits, commercial paper, or repo transactions, in order to fund the loans.

Besides meeting customers' growing demands for credit, financial intermediaries may themselves decide to "reach for yield" and take on additional risk in a low interest-rate environment. Banks suffering compressed net interest margins because of low long-term interest rates, money market funds facing an earnings squeeze, insurance companies that had promised minimum rates of return on their products, and others may all begin to take on higher interest rate risk, market risk, liquidity risk, or credit risk in search of higher returns.

If these conditions seem likely to continue, an initial rise in the asset's price leads to expectations of further increases, which adds to investor demand, spurring further borrowing and credit growth and increased household and financial sector leverage, which, in turn, could drive asset prices still higher. Rising asset prices, in turn, would increase the value of borrowers' collateral, allowing still further borrowing.

For loans collateralized by an asset whose price is rising, lenders believe they can rely for repayment more on the appreciation of the asset and collateral and less on the borrower's repayment ability. Lenders relax their underwriting standards, such as minimum requirements for borrower down payments, credit scores and credit history, or required maximum debt-to-income ratios. To compete for loans to buy or to hold the appreciating asset, or financial assets related to it, financial institutions could also decrease the margins and haircuts that usually protect them from asset price declines.

Financial institution decisions to relax underwriting and impose less-stringent margins and haircuts will further increase the pool of potential borrowers and their borrowing capacity, further increasing credit growth and supporting still higher asset prices, but, at the same time, will also increase lenders' credit risks and exposure--as secured creditors--to a decline in the asset's price. Ultimately, the asset becomes severely overvalued, with its price untethered from economic fundamentals. We would then have on our hands a full-blown, credit-fueled asset bubble.

And, as we experienced in the financial crisis, when a bubble involving a widely-held asset bursts, the consequent plunge in asset prices can seriously impair the balance sheets of households and firms. Indeed, a dramatic decline in the price of a significant asset can reduce household wealth, spending, and aggregate demand. When such effects on wealth, credit availability, and aggregate demand are large enough, the real economy can suffer a significant recession. And, of course, lower employment and incomes further depress asset prices and borrowers' ability to repay loans, with further adverse effects on financial institutions and their ability to extend credit.

At this point, some financial institutions may have become nearly insolvent. And this, coupled with their increased reliance on potentially unstable short-term funding, could make them more vulnerable to sudden losses of public confidence.

Such a loss of confidence, in turn, makes it impossible for affected institutions to roll over existing debts or extend new credit, and may force deleveraging that requires selling illiquid assets quickly and cheaply in asset fire sales, resulting in further declines in asset prices. Such developments further threaten the solvency of financial institutions and intensify credit contraction, depriving households and businesses of financing. A loss of confidence that is institution-specific could spread, causing other institutions to experience their own heightened solvency risks, liquidity problems, and need to de-lever through asset sales.

My third recommendation is an old (in blogosphere terms) post by Nick Rowe called "Is money a liability?" I came across it because I'm teaching undergrads about the central bank balance sheet this week (as Rowe was too when he wrote the post.)