The debate on the functions of a central bank will be a topic of hot discussion for some time to come.
It all started with the bailout of Bear Sterns by the Federal Reserve, the US central bank. The financial crisis got worse with the takeover of Fannie Mae and Freddie Mac, when the US treasury extended government guarantee to private debt worth $5.3 trillion, nearly five times the size of the Indian economy. On Monday, Lehman Brothers filed for bankruptcy and Merrill Lynch agreed to a takeover by Bank of America. Insurance giant, AIG, has also got emergency funding from the Federal Reserve. The financial crisis is getting worse by the day.
The Federal Reserve’s response to the current crisis has led to considerable debate in the popular press. It has been argued that the Fed set a bad precedent by bailing out Bear Stearns at the start of the crisis. Bailing out financial institutions creates expectations of future bail-out, and hence, does little to prevent excessive risk taking, a problem known as moral hazard. Rather, to avoid a future financial crisis, some have called for an overhaul of the functioning of central banks. A prominent advocate of this view is Willem Buiter, a Professor at LSE and a former member of the Bank of England’s monetary policy committee.
In a paper* delivered at the Federal Reserve Bank of Kansas City last month, Buiter criticised the Fed on numerous issues. Since all of his criticisms cannot be covered here, we focus on a few examples. While some of his analysis makes sense, certain assessments remain unproven and some other suggestions are even ridiculous, according to Alan Blinder, an economics professor at Princeton University and the former vice-chairman of the Board of Governors of the Federal Reserve System, who was given the task of discussing Buiter’s paper at the conference**.
Let us first look at the least controversial of Buiter’s suggestions. According to international regulations, the banking sector currently operates with a minimum capital adequacy ratio of 8 per cent. This ratio measures the shareholders’ equity as a percentage of risk-weighted credit exposure. It is, in essence, a cushion against loan defaults and other types of risk. Both Fannie Mae and Freddie Mac merely had a capital adequacy ratio of around 0.5 per cent, which meant they could hardly bear the losses as mortgage defaults began to rise owing to the US house-price collapse. In this regard, Buiter persuasively argues that capital adequacy criteria should be extended to all financial institutions — including those which are considered “too large to fail”. He also suggests that serious penalties should be imposed on existing shareholders and management in case of inadequate capital holding, which should prevent excessive risk taking in the first place.
Elsewhere in the paper, Buiter argues that the Fed has consistently overestimated the fallout from the financial and housing sector meltdown on the real economy, a charge which Blinder strongly disagrees with. Buiter believes that, “The Fed listens to Wall Street and believes what it hears”. As a result of being too close to the financial markets, the Fed overreacted to the financial market turmoil and cut the official policy rate too far and too fast. In the process, the Fed itself may have helped create an inflation problem. It will take some time to see if events prove Buiter right.
Some of Buiter’s suggestions are radical, to say the least. For example, he advocates transferring the responsibility of taking interest rate decisions to another authority, leaving the central bank to focus exclusively on policy implementation. This, according to him would improve the decision-making process as the nexus between the financial sector and the central bank would be broken. To most, including Alan Blinder, this does not make any sense. He asks, “if we take the interest rate setting away from the central bank, to whom shall we give? ... To an agency that will almost certainly be less independent than the central bank?”
There are only a couple of points where Buiter and Blinder agree. For example, both agree that Fed should charge a higher-than-market interest rate for liquidity support provided to troubled institutions. Indeed, in the plan put together for Fannie Mae and Freddie Mac, this is exactly what the Treasury has done.
Overall, the spat between world’s two leading macroeconomists shows that the debate on the functions of a central bank will be a topic of hot discussion for some time to come.
The author is Senior Economist at Crisil
*Central Banks and Financial Crises
http://www.kansascityfed.org/publicat/sympos/2008/Buiter.09.06.08.pdf
** Discussion of Willem Buiter’s Central Banks and Financial Crises
http://www.kansascityfed.org/publicat/sympos/2008/blinder.08.25.08.pdf
