The real battle for the future of finance will be fought after the next crisis
In his contribution to Central Banking’s 25th anniversary issue, Andrew Haldane, chief economist of the Bank of England, describes the “giant steps” that central banks have taken to “reinvent” themselves post crisis. These have involved innovations not only in monetary policies and in market operations but also the development of macro-prudential policies. Central bankers have recognised that inflation targeting, by itself, is insufficient to curb financial cycles. They now believe that policies should “focus on the needs of the non-financial economy.” These sweeping change mean that central banks are “unrecognisable” from the predecessors.
Will the changes over the next 25 years be as far-reaching? Haldane posits two scenarios. In the first, current efforts to increase the resilience of the financial system succeed, reducing the need for discretionary macro-prudential activism. Central banks retrace their steps, dismantling the interventionist superstructure they have built post crisis – or keeping it in reserve, only for occasional emergency use. Monetary policy reverts to “plain vanilla” inflation targeting.
In the second scenario, the financial system also reinvents itself. Innovations threaten to cause more cyclical fluctuations, posing new kinds of systemic risks and even greater challenges to macro-economic stability. This demands ever more active macro-prudential policies:
“It is likely that regulatory policy would need to be in a constant state of alert for risks emerging in financial shadows….In other words, regulatory fine-tuning would become the rule, not the exception.”
Moreover, central banks would be constantly in the market:
“Market-making, in a wider class of financial instruments, could become a standard part of the central bank toolkit….”
In this world, central banks’ role in shaping the fortunes of financial markets and financial firms “more likely would rise”.
Haldane clearly relishes the prospect.
Posing such stark alternatives is a stimulating way of forcing one to imagine ‘plausible worlds’. In this spirit, I suggest an alternative set.
Alternative scenario (1): bureaucracy rules
Here, central banks indeed scale down their active intervention but this is not because the financial system is made more resilient and robust. Rather, it is repressed. In this scenario, current efforts to end “too-big-to-fail” institutions are abandoned as impractical. But in return for state protection, systemically important institutions are brought under the wing of the appropriate official departments. There are extensive controls over capital, credit, spheres of activity, interest rates and profitability. Greater apparent stability is purchased at the price of long-term stagnation.
Alternative scenario (2): a second monetarist revolution
In the second scenario, there is another financial crisis and recession (I note that observers such as Avinash Persaud are already claiming that the new capital adequacy regime “appears more pro-cyclical and not contra-cyclical as intended” – Central Banking, Vol XXV Number I, page 106). Many large financial institutions collapse and cannot be rescued. But this is followed not by repression but rather by a second monetarist revolution. Efforts credibly to banish too-big-to-fail – as a factor in bankers’ decision-making – succeed.
In this scenario, imprudent risk-taking is kept under control by financial institutions themselves competing in a decentralised, autonomous, globally interconnected network under light supervision, leaving room for innovation.
But this second monetarist revolution differs fundamentally from the Friedman-Volcker revolution of the early 1980s. It involves a commitment to global rather than insular monetary stability.
This is where Chris Jeffery’s interview with Raghuram Rajan, governor of the RBI, also in the 25th anniversary issue, is important. Rajan is determined to press on with his call for central banks to pay more attention to policy spillovers and spillbacks. Rajan warns that “we are back to the 1930s, to a world of competitive easing”, which can lead to competitive devaluation. The good news is that views among key policymakers are, in his opinion, shifting. He detects a “big change” from where we were at the beginning of 2014. He believes that his pleas have increased awareness that countries need to take spillovers into account. (page 36):
“I have no doubt that countries will continue to do what is largely in their interest. But over time we need a little more effort looking at the global interest”.
Towards a brave new world for world money
The “global interest”: aye, there’s the rub. At present prospects for realising that look poor. Monetary policy mandates remain defiantly national – except in the national central banks of the eurozone, where they are subordinated to the defiantly regional perspective of the ECB.
Yet, as Haldane vividly shows, historical legacies have been no bar to rapid “reinventions” in the past.
After all, the doctrine of central bank independence was once revolutionary. It evolved as a way of putting into practice monetarist insights into the limits of monetary policy and ending the “time inconsistency” problem. It constituted a major external check on natural democratic pressures.
In my view, a commitment to an international central banking standard will come to be viewed as the modern way to achieve national, democratic goals. Is not international financial stability already a pre-condition of domestic financial stability?
In this scenario, too big to fail is credibly banished and banks have incentives voluntarily to hold adequate capital. Deposit insurance and other forms of state protection are eliminated, along with tax incentives favouring debt over equity finance.
Central bankers are quick-change artists. Now you see it, now you don’t. They will change again. Looking beyond formal mandates, they will appeal to their publics for support: global financial stability achieved through central bank solidarity as the only means to secure domestic stability.
That revolution in finance, together with a return to fixed exchange rates, are the keys to a stable international monetary system
In the process, their individual identities will dissolve. This will be their noble sacrifice for the global interest.
PS This is a revised version of a column published by Central Banking.com.