Why Central Bankers should keep you up at night

–Another day, another elegantly crafted article assuring you that the central planners have it all under control. This time it’s Ian Verrender at Business Day explaining how central banks can now save our economy from another 2008 style crash. (The one they caused.) He concludes it won’t work, which contradicts the rest of the article, but oh well.

–As usual, the commentary begins with a long winded introduction, which barely relates to the body of the article. (Does this type of writing annoy anyone else out there?) Then Verrender writes about some specific new provisions in the Basel III agreement. They allow central banks to impose higher reserve requirements onto banks during periods of excessive credit growth.

“Under this option, regulators can force banks to put more of their capital aside at the time they can most easily afford it, but at the very time most would be recklessly chasing market share by lending even more, fuelling asset price bubbles.

It is this measure that makes enormous sense and potentially gives regulators greater power in curbing asset price bubbles, providing them with another tool to regulate the economy.”

–The problems with this concept are so vast and obvious, it’s difficult to cope calmly with the claims Verrender makes. He raises the first objection himself: We know regulators can’t predict asset bubbles.

“Why couldn’t [the central banks] see what was happening in US real estate? How could they not have known that Wall Street’s investment banks were dropping fuel on a raging firestorm?

The answer is that the US Federal Reserve and central bankers in Europe were fully aware of what was happening but chose to let markets behave the way markets do.”

–This is quite outrageous. Throughout the crisis and before, central banks assured us that the economy was rosy. That there were no imbalances and that the crisis was a minor matter. That subprime would not cause contagion. That banks were sound and that monetary policy would solve the issue. They were consistently wrong. These people couldn’t see excessive credit growth or asset price bubbles if one slapped them in the face.

–But more importantly, their ideological beliefs, until recently, held fast to the idea that asset bubbles do not form. That investors were too rational! They have since given up on this.

–The people who did pick the bubble, explained that sub-prime would go contagious and that the US was already in a recession, blame central banks for fuelling the bubble.
The long standing economic theories which were used to predict the crash blame crashes on central banks fuelling a bubble.

–In fact, the 2008 bubble and crash played out in text book fashion if you happened to be aware of the Austrian Business Cycle theory. Many scholars even used housing in their examples of how such a crash can take place! And those theories were rejected by policy makers. They still are!

–Here is a quick rundown on the Austrian Business Cycle theory:

  1. A central bank holds interest rates too low for too long
  2. This fuels excessive borrowing (credit growth)
  3. This fuels an investment/consumption boom
  4. Asset prices get driven up
  5. Interest rates finally do go up (usually when the central bank realises inflation is getting too high)
  6. The borrowed money for investment/consumption cannot be afforded at the higher rates
  7. Crash

–If you take a look at the period 2001 – 2008 this is exactly what happened. Central banks fuelled a bubble. With Basel III we supposedly give them the power to prevent one as well. Why not give them neither, seeing as they can’t even see a bubble they have created?

–Let’s look at Verrender’s next claim: “The idea behind the new Basel III recommendations is that money hoarded during the boom can then be released during a recession.”

–We know that regulators can’t force banks to lend. Central banks have pumped trillions into the world economy, only for banks to sit on it. Why on earth does anyone think that they will lend it if you force them to have even more?

–But wait, this isn’t entirely true. Some regulators can force banks to lend. Just look at G.W. Bush’s affordable housing policies. Certain loans had to be made in certain amounts. Can you guess to whom? Sub-prime borrowers. Yes, banks were forced to lend to people who couldn’t repay their loans in order to achieve Bush’s lofty affordable housing goals.

–So this comment from Verrender is also outrageous: “… every major market crash in the past three decades has been preceded by reckless lending on the part of the world’s biggest banks.”

–They were forced to lend by law. So we know that forcing banks to lend is a bad idea.

–To sum the past few years up, the central bank drugged the banks with cheap money, the regulators forced them to walk the plank with affordable housing policies, then both the central bank and the regulators threw a life ring. The solution is to give the bullies more power!

–But it’s not much of a solution anyway, admits Verrender: “Will these new measures ensure we never see a repeat of the past few years? Absolutely not. There will be another crash. Most of us won’t see it coming.”

–So why bother with Basel in the first place!?

Nick Hubble,
for Markets and Money

Nick Hubble
Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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