Central bankers must have the courage to act before a crisis: Don Pittis
Are our bankers-in-chief always condemned to crisis management?
Are central bankers always destined to be too late?
This weekend, two of that august fraternity were strutting their stuff. Former U.S. Fed chairman Ben Bernanke was busy promoting his new book called The Courage to Act. Meanwhile, Bank of Canada governor Stephen Poloz was giving speeches titled Integrating Financial Stability into Monetary Policy.
And in different ways, the two tread the same ground: how difficult it is to rein in a housing boom before it turns into a crisis.
- Stephen Poloz says Bank of Canada not responsible for record debt
- The Current: Ben Bernanke's insider's account of a financial meltdown
The title of Bernanke's book has already been pilloried for its hubris.
Voices had been raised for years that U.S. interest rates were too low and that it was driving house prices too high, distorting the economy. But as Bernanke admitted in an interview that played Tuesday on CBC Radio's The Current, he didn't act until it was far too late.
Greater than housing
"It wasn't until August of 2007 that we began to appreciate that the ramifications of the losses on sub-prime mortgages were going to be much greater than just the housing market," Bernanke told The Current host Anna Maria Tremonti.
Of course by that time, there was really little the U.S. central bank could do to prevent the bubble from popping, setting off a global financial meltdown and necessitating a multibillion-dollar bailout of the banks that had contributed to the crisis.
Years of low interest rates had allowed consumers to borrow recklessly. After they had access to that money, they used it to overinflate the entire economy, buying consumer goodies and bidding up the price of real estate.
By then, it was too late to raise interest rates. It could have been done several years previously, slowing the boom before it became dangerous. So why didn't Bernanke, or his predecessor Alan Greenspan, act then?
There may be clues from listening to our own central banker's speech this week.
"It is not the role of monetary policy to protect individuals from making bad choices," Poloz said in both Washington and to the IMF World bank meeting in Peru.
If it were merely a case of individuals, it would be a smaller problem. It is like the classic insurance case of discrete versus connected risk.
If a local company insures individual homeowners against fire, it is inevitable that some houses will burn down. But everyone else's insurance premiums will cover that occasional eventuality. But if a forest fire sweeps through or a plague of arsonists set a city-wide conflagration, the local insurance company could go broke.
A widespread property meltdown is much more like the second case. As in the U.S., a crash in the Canadian property market, should it happen, would likely have an impact much wider than a few individual homeowners.
Interestingly, Poloz does not deny that such a connected risk may be dangerous.
"It is possible that the sum of those bad decisions could threaten financial stability or the economy as a whole, and so we monitor the situation as a matter of course," said Poloz. "But there is no reason to assume that, in all circumstances, equilibrium will devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis."
For now, Poloz puts his faith in "macro-prudential policy," that is, rules for and advice to borrowers to discourage them from running up excessive debt.
Hands are tied
But when it comes to raising interest rates to prevent a crisis from happening, he insists it's too early. The central bank is bound first by its instructions to hold inflation at or around two per cent as its single criteria for altering interest rates.
As a policy for holding inflation down, that has proven to work well. When inflation rises, higher and higher rates have been clearly shown to, eventually, get rising prices under control.
But when, as now, inflation stays stubbornly low despite the rising costs of housing, the central bank finds it difficult to act.
Some might say the bank's method of calculating inflation is the wrong one. Others might point out that its overarching mandate is to "promote the economic and financial welfare of Canada," which could be seen as overriding any restriction on rates and inflation.
Certainly after a crisis happens, banks are willing to throw out many rules in an effort to end it. In the U.S. and European and Japanese cases, they pumped trillions of dollars into the economy to rescue their banks and restart consumer demand.
However, we have seen the damage of firefighting after the fact rather than prevention. It can create huge economic distortions that continue to plague the world.
Not only have developing countries — like Canadian homeowners — run up dizzying loans that they may have trouble repaying, but Bernanke also admits the financial medicine created domestic distortions.
"What you've seen in the United States is that in this recovery that a lot benefits of growth have gone to the higher income, higher wealth part of the population," Bernanke said.
In the current Canadian election, the danger of a teetering housing sector facing the risk of collapse has been an unpopular point of discussion. No politician wants to be the messenger bearing bad news.
It may be that whether politicians or central bankers, no one wants to risk the wrath of homeowners and investors for ending a boom too early. It's safer to blame bad consumer decisions and unpredictable market forces for a popping bubble. Then after the fact, they will have the courage to act.
Follow Don on Twitter @don_pittis
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