05 Jul.
Regulators’ dilemma: no one can see the elephant.
Anyone who tries to snatch the punch bowl while the party’s still swinging is going to draw a lot of flak[*]. So financial regulators, who sense trouble but can’t prove it is on the way, are reluctant to move too soon.
Their dilemma was summed up in another allegory by Ben Smit, the director of the Bureau for Economic Research, at a Reserve Bank seminar on Friday.
He described a man standing on the main street of a busy city, blowing a whistle. When he was asked why he was blowing the whistle, he said it was to chase away the elephants.
“What elephants?” he was asked. “Well that just shows how effective my whistle is,” he replied.
The problem for regulators – and central bankers – and the people who rely on them to do their jobs is that you only know whether or not they have done a good job when their failure is revealed by a crisis. In the absence of a crisis, there is no way to demonstrate that, without good policy, a disaster would have occurred.
Moreover, when regulators and central bankers do take action to curb excesses, they are often accused of contributing to the crisis by causing panic among institutions. What banks and other financial organisations do to protect their own health can have dangerous spillover effects on the rest of the system.
Alan Greenspan skirted this problem in December 1996 when, as chairman of the US Federal Reserve board, he spoke of irrational exuberance.
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?” he asked. “And how do we factor that into monetary policy?”
The answer is he didn’t – a lack of action that was applauded at the time. However, once his premonition proved justified and two different asset bubbles burst in the 2000s, he became the target of attack.
The New York Times recorded that, on the day of the speech, the Dow Jones industrial average closed at 6 437.10 points, up 25 percent from the start of 1996. The index went on to top 11 000 by the end of 1999 and on several subsequent occasions. Though it plunged close to 6 500 in March 2009, it was trading at over 12 400 on Friday.
But, while the stock market has rebounded, the US economy is still walking wounded and its return to full health is still a long way away. What would have happened if the US policy stance had been less relaxed all along the way, we’ll never know. And if the Fed had taken a harder line it would never have been able to prove that the elephants had been scared away.
When former Reserve Bank governor Tito Mboweni first hiked the bank’s repo rate from 7 percent to 7.5 percent in June 2006, he faced fierce attacks from critics who said there was no sign of elephants.
The Reserve Bank seminar, however, did not deal with monetary policy. It focused on macro prudential policy and the challenges facing central banks, following the financial crisis of 2007/08. The impact of the crisis was so devastating that the world is still living with its long, long tail.
Regulators have identified the problem – which Smit described as the “fallacy of composition”.
By relying on micro prudential regulation – that is, of individual institutions – regulators failed to spot the dangers originating in the close connections between institutions. In other words, there is an immediate spillover effect from any action.
Regulators are now sitting at the drawing boards – scratching their heads.
Source: Business Report
* Bank of England Governor, Mervyn King argued regulators needed to design additional policy tools to moderate the growth of the financial sector and lean against the impact of the credit cycle on the wider economy.
“Parallel to the long-established role which monetary policy plays in taking away the punch bowl just as the party gets going, so there is a role for the central bank to use macro-prudential policy instruments for financial stability purposes by turning down the music just as the dancing gets a little too wild,”. See related post
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