[PEN-L:30133] CB failure?

["Ian Murray" <seamus2001@xxxxxxxxx>]

Global: The Great Failure of Central Banking
Stephen Roach (New York)



The economic prosperity of the last 20 years, in many respects, can be
attributed to the triumph of central banking. Led by the indomitable Paul
Volcker, America's Federal Reserve was central to this outcome. The
single-minded discipline of monetary austerity succeeded in ridding the US of
the inflationary excesses that had built up during the 1970s. As a result,
inflation targeting became the rage in other central banks around the world,
most notably in Germany's once proud and now marginalized Bundesbank. Inflation
was vanquished from the macro scene and central bankers became the new icons of
the ensuing prosperity.

That was then. In the end, the successes of inflation targeting sowed the seeds
of their ultimate demise. The very process of disinflation unleashed powerful
rallies in equity and fixed income markets that became central to the new
prosperity. Since the inflationary excesses of the 1970s had gone to such
extremes, the road to price stability was long and arduous. That made for an
equally long transition in financial markets that benefited investors beyond
their wildest dreams. As inflationary expectations and interest rates fell, the
vicious cycles spawned by accelerating inflation were transformed into the
ultimate in virtuous cycles that only a powerful and lasting disinflation could
unleash. Yet out of this glorious disinflation a new inflation was borne --
asset inflation. And central bankers didn't have a clue how to deal with it.

They still don't. The Bank of Japan was the first victim of the new inflation.
Asset bubbles in equity and property markets in the late 1980s created enormous
excesses in Japan's real economy and in its financial system. The history of
Japan's pre- and post-bubble period tells us that the BOJ was late in
recognizing the perils of what was to come. Its monetary policy stance was too
accommodative in the late 1980s, thereby nurturing the build-up of the bubble.
And it was too restrictive in the early 1990s, failing to appreciate the
deflationary risks that always get unleashed in the aftermath of a popped asset
bubble. Some 13 years after its bubble crested in 1989, Japan is still picking
up the pieces. An alternative approach by the BOJ could have made a real
difference.

It's different in America -- I guess it always is. But the similarities with
Japan should not be ignored. America's asset bubble created its own set of
distortions in the real economy. Capital spending went to excess as Corporate
America became convinced it could acquire Nasdaq-like multiples through
open-ended investment in new information technologies. Remember the e-based IT
spending frenzies associated with B2B and B2C? The Y2K panic was the icing on
this rapidly rising cake. Consumers also got lured into the bubble, increasingly
viewing outsized equity returns as permanent substitutes for saving the
old-fashioned way -- out of their paychecks. By the end, the very fabric of the
US economy had been transformed -- the bubble had become the heart of the New
Economy.

Like the BOJ, the Fed did nothing to stop it. Sure, there was the December 1996
musing by Alan Greenspan over "irrational exuberance." There was even a 25 bp
tightening some three and a half months later, presumably aimed at addressing
those concerns. But that assault on the bubble -- if you want to call it that --
was short-lived. Facing a torrent of political criticism for tampering with the
democracy of the markets, the so-called independent US central bank did an
about-face. Any further tightening was shelved, and the bubble took on a life of
its own.

But it wasn't just policy accommodation that nurtured the excesses of America's
asset bubble. The rhetorical flourishes of Chairman Greenspan took perceptions
of the New Era to an entirely different level. He became almost evangelical in
his passion. In a January 2000 speech before the Economic Club of New York, he
maintained that "the American economy was experiencing a once-in-a-century
acceleration of innovation, which propelled forward productivity, output,
corporate profits, and stock prices at a pace not seen in generations, if ever."
As the bubble was cresting in early 2000, Greenspan repeatedly stressed that
"(w)hen historians look back at the latter half of the 1990s a decade or two
hence, I suspect that they will conclude we are now living through a pivotal
period in American economic history." This rhetoric -- more than policy -- was
an unequivocal signal that the financial markets took quite seriously. It
depicted a central bank that was more than willing to tolerate open-ended
economic growth, largely because of the extraordinarily unique foundations on
which Greenspan claimed it was built. Since there was no urgent need to fight
inflation in this New Era, there wasn't any reason to worry about interest-rate
risk to financial markets. That was the buy signal every investor and speculator
dreamt of.

Many don't see it that way, of course -- not the least of whom is Alan
Greenspan, himself. His recent speech at a Fed symposium in Jackson Hole,
Wyoming (Economic Volatility, August 30, 2002) offers a strong defense of Fed
actions during and after the bubble. In my opinion, it misses the basic point.
The Fed chairman depicts the bubble as something that can only be identified
after the fact; let the record show, he had it figured out as far back as
September 1996 (see my February 27, 2002, dispatch in the Global Economic Forum,
"Smoking Gun"). Moreover, he went on to stress that there is little that the Fed
could have done to avoid it -- including an increase in margin requirements that
a few of us were advocating at the time (see my March 27, 2000, opinion piece in
Barron's "It's a Classic Moral Hazard Dilemma."). This argument never hinged on
the linchpin role of margin debt per se, but more on the increasingly urgent
need of the Fed to send a signal -- any signal -- that it took the perils of the
bubble seriously. With all due respect to Alan Greenspan, his defensiveness
misses the basic point. By condoning the bubble and the New Economy excesses it
spawned, the Fed had become a lead actor in its own "prisoner's dilemma." Such
deep-seated denial makes it exceedingly difficult for the central bank to come
to grips with the toughest problem it faces today -- the lingering excesses of a
post-bubble economy.

The European Central Bank is currently faced with a variation on this same
theme. And the risk is that it will fall victim to the same syndrome -- a
failure to address the perils of a post-bubble era. While equity-driven wealth
effects never took the Euroland economy to the excesses reached in Japan and the
United States, the legacy of this post-bubble era poses an equally profound
dilemma for the ECB. Fixated on price stability and the unrelenting inflation
fighting that such a strategy implies, the ECB is all but ignoring the perils of
an increasingly deflationary world. After the September 6 meeting of European
finance ministers, ECB President Duisenberg argued that the official policy rate
of 3.25% is "appropriate for the present situation and the foreseeable future."
Never mind if that future includes evidence of a growing shortfall in the
Euroland economy and the risk that the outlook could worsen in the event of an
oil price shock sparked by a US invasion of Iraq. A mandate is a mandate, and
the ECB's single-minded fixation on price stability has never seemed stronger --
especially with a headline inflation rate that is still hovering near the upper
portion of the ECB's 0-2% price stability band (see Joachim Fels' September 6,
2002, dispatch in the Global Economic Forum, "The ECB to the Rescue? Don't Bet
on It!").

Europe's lack of pro-growth policy stimulus is disturbing, to say the least --
especially in the current environment. It's not just the ECB that may be
wrong-footed. The recent strengthening of the euro -- and the likelihood of
further currency appreciation to come -- in conjunction with an inflexible
fiscal policy as dictated by the strictures of the Stability Pact, only adds to
the region's deepening deflationary perils. Yet it doesn't have to be that
way -- the central bank does have the opportunity to change course. The
unwillingness of the ECB to face up to these risks is consistent with the
prevailing mindset of the other major central banks around the world. Fixated on
the inflation targeting of yesteryear, the authorities are unwilling or unable
to give active consideration to the possibility of deflation -- a classic
by-product of a post-bubble world.

In short, central bankers are still fighting the old war while the enemy has
established a new front. This has been the policy blunder that I have long
feared the most. Nearly three years ago in Singapore, I was regaled with the
lessons of what has been dubbed as Churchill's most ignominious military
defeat -- General Percival's loss to the Japanese in the Battle of Singapore
(see my October 11, 1999 dispatch in the Global Economic Forum, "Sinister
Twilight"). Confident that the enemy would come by sea, Percival aimed his fixed
artillery south, encased in concrete bunkers that could not fire in a different
direction. The Japanese, of course, came from the north -- through the swampy
Malay Peninsula, and the seemingly impervious citadel of Singapore fell in a
matter of days. Old wars and old demons haunt all of us. Just like Percival,
today's policy makers don't even know there's a new war. Sadly, that may well go
down in history as one of the greatest failures of central banking.