Wanted: paranoid and unpopular central bankers

Panel says central bankers must look for risk everywhere and be prepared to implement unpopular policies to prevent the next crisis

A higher degree of paranoia and risk aversion should form a crucial part of central banks' post-crisis toolkits, Daniel Gros, the director of the Centre of European Policy Studies, said on Tuesday.

Speaking at the inaugural CentralBanking.com web seminar, Gros said: "The key element [of preventing future crises], ultimately, is paranoia. You need to have an institution that dislikes risk and sees it everywhere, even during a boom."

Gros added: "We need an institution that says: ‘We don't believe that this time it's different.' And that is the key for having all these things which look perfect on paper actually implemented when the next good time comes."

Charles Goodhart, a professor at the London School of Economics and another of the web seminar's panellists, concurred: "After this discussion it's very clear you should only appoint paranoid central bankers." However, he acknowledged that it was very difficult to "take away the punchbowl just when the party gets going". "That means, I'm afraid, that central banks will have to adopt presumptive rules of tightening when credit expansion exceeds some perception of normal rates," Goodhart said.

Hans Blommestein, the head of the OECD's bond market and public debt unit, and Luigi Speranza, the head of inflation economics at BNP Paribas, a bank, joined Goodhart and Gros.

The four panellists broadly agreed on the need to develop a coherent macroprudential strategy to deal with the fallout from the crisis.

Goodhart said that central banks would find it hard to set tight policy in boom years, but could not afford to shirk from it. Gros added that, at least theoretically, the European Central Bank had the right target "if they had substituted the word ‘money' with ‘credit', in their objectives. "One hopes that they keep that in mind the next time this happens, and act accordingly, however unpopular they might be," he said.

Making a case for a strong, independent body to assume that role, Gros said that supervisors or regulators who were too close to the market inevitably became part of it. "That's why it's key to think not only about the technical details of these counter-cyclical measures, but to think about the institutional setup which is most likely to deliver risk aversion and tight implementation even during good times," he said.

Blommestein added to this list the need for a better metric to understand systemic risk. He said, however, that we must avoid falling into the trap of relying on overly complex models in the misguided belief that they offer a full, accurate picture of reality. "We have to have a healthy dose of scepticism - it's not just a matter of mechanical, statistical methods in the macroprudential approach," Blommestein said.

Goodhart outlined a three-pronged explanation of what a macroprudential approach would involve. He said banks would need a mechanism to raise capital in good times, either through a shift in regulator's capital adequacy requirements, or through insurance measures such as reverse convertibles (revertibles). He emphasised the need for greater control over banks' liquidity management. "Banks ran down their market liquidity out of the belief that they could always raise funding liquidity in wholesale markets. That belief has been shown to be wrong," he said.

He also argued for wider controls over the pro-cyclical features of housing markets. "Shifts in loan to value ratios have been wildly pro-cyclical, and we need some regulation to prevent that happening again and indeed to reverse it," he said.

Goodhart remarked that it would have to fall to central banks to ensure macroprudential stability, pointing out that they already serve as lenders of last resort, a crucial feature in the approach. Agreeing with Gros, he said that the proposed European Systemic Risk Board had insufficient authority to ensure stability.

Speranza said that in the short term, deflation remained the greatest threat. "I wouldn't say with confidence that we're over this crisis yet. There's no evidence of a sustainable path in terms of growth, and there is the risk of going down into excessive low inflation or even deflation in the short term," he said. But Goodhart disagreed, pointing to the results of quantitative easing which was started in March and had resulted in equity and commodity markets soaring ever since. Speranza responded that inflation remains a distant concern, to be dealt with only once the financial system has been fixed.

Gros suggested that the worries about inflation and deflation were obscuring the true concern of whether financial markets can survive independently, given the support they've received from central banks and governments. "That's the calibration I would really worry about these days, not whether we'll have inflation ten years down the road," he said.

Blommestein added that the discussion about exit strategies needed visibility. "Markets have to see that central banks are monitoring this - it's very important that the debate is as transparent as possible," he said.

Click here to view the web seminar



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