Central banks and governments may have a harder time responding to a crisis, should one strike tomorrow, than they did during the 2008 crisis, warns Andrew Metrick.
The Janet Yellen professor at Yale University says central banks – namely in the US – have lost some of their crisis-fighting tools, and have less political capital to call on the legislature to allow them to take extraordinary measures of the sort seen in 2008.
Nevertheless, he strikes a more hopeful note for the future, speaking to Central Banking in the last episode of the post-crisis podcast series. Ten years down the line, central banks may have recovered some of their political capital, and better absorbed the lessons of the crisis, putting them in a better position to respond.
“We would particularly do better than 2008 if we combined that additional knowledge and regained political capital with some additional tools and flexibility, but that part I think is above my pay grade,” Metrick says.
Metrick has been closely involved with work at Yale that seeks to draw out the main lessons of the crisis. The New Bagehot Project aims to categorise every government intervention during financial crises throughout history – “all the way to ancient Rome if we can”, says Metrick.
The hope is that policy-makers of the future will be able to draw on this information to understand which tactics worked well and what to avoid. “We may at the very least have some very good discussions – and some consensus – about the right technical ways to design things,” says Metrick.
Hello, I’m Dan Hinge, news editor at Central Banking, and you’re listening to CB On Air.
We’ve come to the final episode of our tour of post-crisis central banking. It's the big question: what do we do when the next crisis strikes?
Hopefully you’re familiar by this point with our guest for the series, Professor Andrew Metrick of Yale University. He’s been involved with several projects trying to tackle the crisis-fighting question, so he’s well equipped to guide us through the issues.
Andrew, thanks for joining us.
Andrew Metrick: Thank you for having me.
DH: If a crisis strikes tomorrow, are we ready?
AM: Sadly I would have to say no, but I don’t think that’s a very controversial position. I would say no, both because there has been a focus on prevention since the last crisis, and it is good to do better on prevention, but along with the focus on prevention we’ve pulled back a bit from the tools that we can use actively, and we’ve lost some of the political capital that would be necessary to use the ones we still have.
Between those two things, if a crisis were to strike tomorrow, I think there would be a real challenge to have the level of reaction that we had in the past crisis.
DH: So what sort of measures do you envisage a central bank taking in this hypothetical crisis, and do they have enough tools at their disposal?
AM: Well we have a project at Yale where we’re trying to look at this question, broadly defined. We call it the New Bagehot Project, named for a famous Englishman from the 19th century, who wrote a book called Lombard Street, which gave us the only rule that central bankers, I think, all over the world would agree on, which is: in a panic, lend freely, at a penalty rate, against good collateral.
Bagehot’s dictum was violated on each one of its clauses on the last crisis, often for good reason, but it’s certainly too simplistic and too short to serve as an adequate guide for fighting crises in the 21st century.
So, one thing we have going at Yale is called the New Bagehot Project, where we have a wonderful team of senior scholars and energetic young people that are trying to catalogue all of the interventions of various different types that have been done by governments in crises of the past, starting with the global financial crisis, but going back all the way to ancient Rome if we can, and to synthesise any lessons we can get from those different government interventions.
The types of interventions are actually not that hard to catalogue, because almost all of them will operate on some different part of the balance sheet of financial institutions or the whole financial system. That is, you have activities that target the liability part of the balance sheet, when we say emergency lending or the guaranteeing of lending on the part of banks. You have things that affect the equity part of the balance sheet, which are capital injections. Things that affect the asset side, such as directly purchasing assets either from markets or from institutions. And then things that manipulate the entire balance sheet and reorganise it, such as resolution, restructuring, liquidation-type activities.
So most things will fall into one of those classes, or some catch-all you might call ‘rules’ – things like forbearance, or short-sale restrictions, stress tests, things like that.
Since most things fall into these categories and have since time immemorial, it is possible to go and look and see the types of things that have been done and when they seem to be most effective. From our project, my view now is I’m quite confident we will conclude several things that are clearly errors – that are things you don’t want to do – and we may at the very least have some very good discussions – and some consensus – about the right technical ways to design things like emergency lending programmes or credit guarantees or capital injections, so as to maximise the efficacy of those programmes while at the same time keeping the amount of moral hazard risk to a minimum.
DH: So if a shock were to occur tomorrow that was roughly the same size as 2008, how do you see that propagating through the economy, and do you think the outcome would be better or worse now?
AM: Right now, if it happened tomorrow it would be worse, and it would be worse because the exact tools that we have to fight the emergency panic part of the crisis are weaker, and because I think that the current political climate and political capital that exist wouldn’t enable us to do the kinds of extraordinary things that require legislative approval that we were able to do in 2008–09. So I think it would be worse.
But I think there is some hope that 10 years from now, even without any new statutory changes across the major economies, we could regain some of that political capital. And we could learn enough from things that we have done in the past such that using the tools that we have available we could perhaps do better than we did in 2008. We would particularly do better than 2008 if we combined that additional knowledge and regained political capital with some additional tools and flexibility, but that part I think is above my pay grade.
DH: And if you were trying to spot that next crisis coming, where would you look? What kind of things would you look for?
AM: Well the thing that we know to look for is to look for debt build-ups, and this is no surprise to any central banker today, you look for what’s happening to leverage, particularly short-term leverage, and you look at what is backing that leverage, because it appears that on the housing side there’s often a reason that the housing side gets involved, real estate gets involved, because we’re trying to back things that will be perceived as safe.
So that’s the obvious thing, and I know that people are doing that. I think that the second thing that it’s very important to look at are a variety of measures of what is broadly called the ‘convenience yield’, that is the gap between say what highly-rated government securities yield for, and what somewhat similarly-rated but not government-backed securities have as their yield. That gap, when it gets very large, tends to drive a lot of activity in the manufacture of short-term wholesale finance. I think we should be paying a lot of attention to that, because that, just like interest rates, is a very important measure of the tightness or the looseness of markets that can become dangerous.
DH: OK. It has been quite a rapid gallop through the post-crisis years, but it’s been interesting. Thank you very much, Andrew.
AM: You’re welcome. Thanks for having me on.