General Douglas McArthur famously said that old soldiers never die, they just fade away.
Central bankers are the generals of monetary policy, because they fight currency wars, combat inflation and defend financial stability. Retired central bankers do not fade away. Like Greenspan, they can write best selling memoirs and retire very comfortably.
Recently, Federal Reserve vice-chairman Donald Kohn, who has decided to retire, gave one of the most frank analyses of where mistakes were made, in a speech: “Many central bankers and economists, myself included, were a little complacent coming into the crisis. We thought we knew enough about the basic structure of the markets and the economy to achieve economic and price stability with relatively minor perturbations. And we thought we had the tools necessary to deal with liquidity shortages and mal-distributions. The reality is that we didn’t understand the economy as well as we thought we did. Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis that resulted in very serious unemployment and loss of wealth around the world. We must learn from our experience.”
Why did such clever people not see the crisis coming? Why is there a tendency of disaster myopia, when policymakers very often react too little too late? Of course, it is understandable that people are complacent or are too cautious. No one likes to disturb the status quo. Almost all of us would like to wait till the next piece of information comes in to confirm our hypothesis.
Californian Prof Frithof Capra, who is a physics professor and also a systems analyst, wrote a book back in 1982 called the Tao of Physics and another important book called the Turning Point. He felt that the academic profession and government bureaucracies had become so specialised and fragmented that they could not see the wood from the trees. No one is looking at the earth from 30,000 ft up and asking why it does not add up.
A famous Harvard professor of business strategy put it another way. We are used to top-down departments and bureaucracies, where orders and strategies are formulated at the upper echelon, and they are supposed to be executed at the bottom layers. However, we forget that most businesses are coordinated and done horizontally, between different departments and arms of a business or government. Coordination of different parts of government or business, with different agendas and interests, is the most complex task of modern governance.
What most economists and central bankers forget is that markets are all about human behaviour and such behaviour is reflexive. Human beings do not stand still – they observe each other, anticipate or predict their competitors’ behaviour and act accordingly. The market is always watching how the government policy is implemented – they make money from regulatory and tax arbitrage.
Once they can predict how central bankers or policy makers behave, the policies begin to lose their effectiveness. This is why legalist Han Feizu said the ruler must be silent and observant, not allowing the public to predict what he will do. If the policy is predictable, it will be negated.
This is like a tennis player. If your opponent knows that you always like to play backhands to a certain corner, he can read you and exploit this weakness.
The best example of the need for central bankers to understand reflexive action is Goodhart’s Law. London School of Economics Prof Charles Goodhart is one of the best monetary economists, who has trained a whole generation of central bankers and financial regulators. He worked in the Bank of England and was also an adviser to the Hong Kong Government on the establishment of the Hong Kong peg. Goodhart’s Law states that every monetary target loses its efficacy, because the market immediately changes its behaviour to negate that policy target. Goodhart’s Law also can be generalised to regulatory policy.
As Donald Kohn admits, the trouble with the recent generation of central bankers is that they think that they know how the market functions. The fashionable thinking is that they must stick to clear monetary targeting or rules of behaviour, such as Taylor’s Rule, named after Stanford Professor and also former US Treasury Undersecretary John Taylor. If the market can read central bank behaviour, they can adapt and change their behaviour very quickly. For example, if there is too tight regulation, then the market moves more business either offshore where there is less regulation or they move into shadow banking, where regulators cannot see what is going on.
It is also dangerous to compartmentalise between monetary policy and financial regulation, as if the lines between the two can be clearly drawn. Monetary policy has implications on financial regulation and vice versa.
There is, however, an elephant in the room that most central bankers and financial regulators of advanced countries have missed. The elephant in the room is the biggest and most important issue that is before one’s eyes, but we ignore it because we do not know how to handle it. Hence, most people tip toe or move around the elephant rather than confront it.
The biggest item that is common to monetary policy, financial regulation and fiscal policy is land and real estate, including fixed investments. The value of land and fixed assets is directly related to interest rates – the lower the interest rates, the higher the value of real estate. Real estate is the biggest collateral of bank loans and often the biggest asset of most households or firms. Land sales are also the biggest revenue for many local governments. Hence, asset bubbles are most difficult to handle because their deflation can kill banking systems and eventually become fiscal deficits.
Recently, it was revealed that US regulators did not see that real estate-related loans of the US banks accounted for 55% of total loans and asset-backed securities accounted for 74% of their debt securities holdings.
Since real estate is 225% of GDP, it was not surprising that a 20% fall in real estate caused the massive melt down in the financial derivative markets and eventually the solvency of banks.
A new generation of central bankers will have to learn new lessons from the current crisis.
Central bankers are the generals of monetary policy, because they fight currency wars, combat inflation and defend financial stability. Retired central bankers do not fade away. Like Greenspan, they can write best selling memoirs and retire very comfortably.
Recently, Federal Reserve vice-chairman Donald Kohn, who has decided to retire, gave one of the most frank analyses of where mistakes were made, in a speech: “Many central bankers and economists, myself included, were a little complacent coming into the crisis. We thought we knew enough about the basic structure of the markets and the economy to achieve economic and price stability with relatively minor perturbations. And we thought we had the tools necessary to deal with liquidity shortages and mal-distributions. The reality is that we didn’t understand the economy as well as we thought we did. Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis that resulted in very serious unemployment and loss of wealth around the world. We must learn from our experience.”
Why did such clever people not see the crisis coming? Why is there a tendency of disaster myopia, when policymakers very often react too little too late? Of course, it is understandable that people are complacent or are too cautious. No one likes to disturb the status quo. Almost all of us would like to wait till the next piece of information comes in to confirm our hypothesis.
Californian Prof Frithof Capra, who is a physics professor and also a systems analyst, wrote a book back in 1982 called the Tao of Physics and another important book called the Turning Point. He felt that the academic profession and government bureaucracies had become so specialised and fragmented that they could not see the wood from the trees. No one is looking at the earth from 30,000 ft up and asking why it does not add up.
A famous Harvard professor of business strategy put it another way. We are used to top-down departments and bureaucracies, where orders and strategies are formulated at the upper echelon, and they are supposed to be executed at the bottom layers. However, we forget that most businesses are coordinated and done horizontally, between different departments and arms of a business or government. Coordination of different parts of government or business, with different agendas and interests, is the most complex task of modern governance.
What most economists and central bankers forget is that markets are all about human behaviour and such behaviour is reflexive. Human beings do not stand still – they observe each other, anticipate or predict their competitors’ behaviour and act accordingly. The market is always watching how the government policy is implemented – they make money from regulatory and tax arbitrage.
Once they can predict how central bankers or policy makers behave, the policies begin to lose their effectiveness. This is why legalist Han Feizu said the ruler must be silent and observant, not allowing the public to predict what he will do. If the policy is predictable, it will be negated.
This is like a tennis player. If your opponent knows that you always like to play backhands to a certain corner, he can read you and exploit this weakness.
The best example of the need for central bankers to understand reflexive action is Goodhart’s Law. London School of Economics Prof Charles Goodhart is one of the best monetary economists, who has trained a whole generation of central bankers and financial regulators. He worked in the Bank of England and was also an adviser to the Hong Kong Government on the establishment of the Hong Kong peg. Goodhart’s Law states that every monetary target loses its efficacy, because the market immediately changes its behaviour to negate that policy target. Goodhart’s Law also can be generalised to regulatory policy.
As Donald Kohn admits, the trouble with the recent generation of central bankers is that they think that they know how the market functions. The fashionable thinking is that they must stick to clear monetary targeting or rules of behaviour, such as Taylor’s Rule, named after Stanford Professor and also former US Treasury Undersecretary John Taylor. If the market can read central bank behaviour, they can adapt and change their behaviour very quickly. For example, if there is too tight regulation, then the market moves more business either offshore where there is less regulation or they move into shadow banking, where regulators cannot see what is going on.
It is also dangerous to compartmentalise between monetary policy and financial regulation, as if the lines between the two can be clearly drawn. Monetary policy has implications on financial regulation and vice versa.
There is, however, an elephant in the room that most central bankers and financial regulators of advanced countries have missed. The elephant in the room is the biggest and most important issue that is before one’s eyes, but we ignore it because we do not know how to handle it. Hence, most people tip toe or move around the elephant rather than confront it.
The biggest item that is common to monetary policy, financial regulation and fiscal policy is land and real estate, including fixed investments. The value of land and fixed assets is directly related to interest rates – the lower the interest rates, the higher the value of real estate. Real estate is the biggest collateral of bank loans and often the biggest asset of most households or firms. Land sales are also the biggest revenue for many local governments. Hence, asset bubbles are most difficult to handle because their deflation can kill banking systems and eventually become fiscal deficits.
Recently, it was revealed that US regulators did not see that real estate-related loans of the US banks accounted for 55% of total loans and asset-backed securities accounted for 74% of their debt securities holdings.
Since real estate is 225% of GDP, it was not surprising that a 20% fall in real estate caused the massive melt down in the financial derivative markets and eventually the solvency of banks.
A new generation of central bankers will have to learn new lessons from the current crisis.
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