TCA Srinivasa-Raghavan Talking heads that do not listen

LINE & LENGTH

Central banks and markets have learnt to communicate with each other, but not central banks and governments.

In March this year the European Journal of Political Economy devoted an entire issue to central banks' communications strategy. The online abstract said: "Central banks now tend to attach greater importance to communication with the public...(but) it is not clear what constitutes an optimal communication strategy."

But were the editors of the Journal a little behind the curve? Even if one assumes that the term "public" is euphemism for the great movers and shakers of the financial markets, the nature of the problem appears to have changed. It is not the "public" that needs to be communicated with so much as the politician "" or more precisely, the finance minister or treasury secretary.

This is because communication between financial markets and central banks "" actually, for 99 per cent of the time it is a one-way thing "" has improved hugely. Mostly this has happened because central banks have learnt not to deliver nasty surprises to the always-skittish creatures that constitute financial markets and who operate mostly (as always through history) on private information.

But while communication between the markets and central banks has improved, a similar improvement has not taken place in the communication between finance ministers and central banks. That part continues to be dogged by problems. (If this is not the case, the problem is even worse: the two still manage not to listen to each other!)

However, although the degree may vary from country to country, this appears to be a universal problem. In democracies it is sufficiently acute for it to become worthy of examination by forensic economists and, yes, psychologists because often the personae of the finance minister and the central bank head can make all the difference.

It is possible to cite several instances of how central bankers and finance ministers don't agree with each other but just one should suffice. In his 19 years as the head of the US Federal Reserve, Alan Greenspan and the US Treasury Secretary almost never agreed on the one issue on which agreement was needed: timing. This is usually the case. Disagreement is not on what, or even how. It is on when.

This happens because central banks are charged with maintaining monetary stability but finance ministers have to ensure that they do nothing that would make their party lose the next election. This lesson has been driven home most strongly in the US, not once but twice. The first was in 1980 and the second in 1992. On both occasions the US Fed "" or Paul Volcker the first time and Alan Greenspan the second "" did things that cost the ruling party the election. The same thing has happened in other countries also but not in quite the same stark fashion.

The problem thus seems to be purely one of very different objective functions. Central banks prefer to act before the problem arises so that it can be prevented from arising. Finance ministers prefer to take their chances, and act after the problem has arisen. Indeed, many don't think there is a problem at all. That, I think, includes the Indian finance minister as well.

But there is something else that needs pointing out: a central bank has a higher probability of success in achieving its goal than a finance minister. The latter's objective function "" of not doing anything to make his party lose the election "" is more constrained because of actions by other ministerial colleagues and events than the objective function of a central bank, which is simply not as multidimensional.

In spite of this, the subordinate role of the central bank to the government or the finance ministry can compound the problem. This is why spokespersons for the financial markets have made out such a strong case for independent central banks and why, barring one or two countries, most governments have resisted the demand. Who wants to hand over such crucial power to a bunch of traders who can't think beyond their own profits?

Conceptually, therefore, the communication problem has become one of transitivity. If good communication exists between A (the central bank) and B (the financial markets) and also between B and C (the finance ministry), how can this be leveraged to improve communication between A and C?

The American answer was to appoint, for a quarter of a century, persons from Wall Street or thereabouts. But it didn't really work as the 1980 and 1992 elections showed. The British, too, have done pretty much the same and there also, politically, it has worked only somewhat. So governments are now seeking different solutions to the transitivity problem. Ben Bernanke, for instance, is not from Wall Street. (But that does not mean it has to be someone from the government because that creates its own problems.)

It is also necessary to ask if the problem of poor communication between a central bank and the government is solvable at all. That is, whatever you do and whomsoever you appoint, will it go away if the agendas "" for example growth vs inflation "" differ so much and diverge as elections approach?

If not, as seems most likely to be the case, the challenge is to minimise the differences. But this is only possible if prime ministers and finance ministers behave with the maturity that is expected of them in the larger national interest.

Jimmy Carter did. George Bush Sr did. Both lost the election. But America prospered.