Another interesting point, originally made at The Economist, concerning central banks. Like Waldo, where are they?
In a crash, their inability to influence things might exacerbate things. On the other hand, perhaps free financial markets, and their instinct toward preserving the status quo, might actually be better at protecting it than the CBs. I don't find the Iceland and Latvia examples compelling - like saying that a bankruptcy of a badly run small town bank in North Dakota is going to bankrupt Citigroup somehow.
usmarket.seekingalpha.com
Many Wall Street optimists believe that when the going gets rough -- yes, even some Pollyannas accept that the party will eventually end, though the day of reckoning always seems to be sometime far away in the future -- someone, somewhere will ride to the rescue.
Whether it is the nation's central bank, the SEC or other regulatory overseers, stock and commodity exchanges, the president and his cabinet, industry leaders, the so-called Plunge Protection Team, or maybe even Spiderman, the complacent types expect that if push comes to shove, some or all of these interested parties will prevent the worst-case scenario -- and maybe even a less-than-disastrous turn of events -- from occurring.
Unfortunately, few of these wishful thinkers realize the hard truth about today's financial world: that even during the seemingly benign times of recent years, policymakers have, for the most part, been followers and passive observers, rather than trendsetters and master croupiers overseeing all the action.
Instead, modern finance has been dominated by a variety of influences -- markets, players, and innovative developments -- that often march to an entirely different beat than the will and wishes of those who are ostensibly in charge. In "Vanishing Vigilantes," The Economist explores one aspect of this disconnect: Why the markets may be undermining central banks.
>Whatever happened to the bond-market “vigilantes”? In the 1980s and 1990s, they patrolled the world, punishing governments or central banks that were soft on inflation by pushing up their borrowing costs.
But we have heard a lot less about these debt-market disciplinarians in recent years. Instead, bond yields have been puzzlingly low, a conundrum that taxed even Alan Greenspan, the former Federal Reserve chairman.
Perhaps the globalisation of financial markets has had a perverse effect. The markets are no longer populated by vigilantes but by 1960s hippies with a “make loans, not war” philosophy. They may be forcing some countries to enjoy far laxer credit than their central banks would like.
In a new paper, Carsten Valgreen, the chief economist of Danske Bank, highlights the cases of Iceland and Latvia. Each has embraced financial globalisation in its own way: Iceland has a free-floating currency; Latvia has pegged its currency to the euro. Iceland's banks are homegrown; Latvia's largely foreign-owned. But both countries have racked up enormous current-account deficits, running at a remarkable 25-30% of GDP. And both have escaped the kind of currency crisis that a vigilant bond market would traditionally have imposed.
Iceland's companies have been in an acquisitive mood in recent years, borrowing heavily to buy abroad. The country has also used foreign finance to build some large aluminium smelters. As a result, its gross foreign debt is more than five times the value of its GDP. The Central Bank of Iceland has tried to slow the process, raising short-term interest rates to nearly 15%. But its efforts have, if anything, backfired. High rates have made Iceland the beneficiary of the “carry trade”, where investors borrow in a low-yielding currency and invest the proceeds in a higher-yielding one. This trade offends economic theorists, who assume the juicy yields Iceland offers will be offset by an eventual plunge in the value of its currency. But so far the trade seems to have worked. Meanwhile, Icelandic consumers have taken the opportunity to borrow cheaply abroad, bypassing the punishing interest rates imposed by their central bank.
In Latvia, credit growth has exploded, hitting 50-70% in each of the last three years, while wage growth has reached an annual rate of 25%. Latvia's fixed exchange rate stops the central bank raising rates to counter the boom. Nor have foreign investors sounded the alarm; indeed, Mr Valgreen says foreign banks are responsible for much of the lending spree. There is not much the Latvian authorities can do.
The travails of Iceland and Latvia are part of a wider trend. New Zealand is also struggling with the conflict between its domestic aim of controlling inflation and the impact that higher interest rates have on international capital flows. All three countries have unusually small and open economies. As such, they are the first to register any change in the wind.
If globalisation has weakened the hand of central banks, so has financial innovation. The growth of derivatives, for example, has made it harder for central banks to control the supply of money and credit. According to the Bank for International Settlements, the face value of outstanding derivative positions on over-the-counter markets is some $400 trillion. These instruments give investors a claim on a large chunk of assets, with only a small down payment. When asset prices rise, speculators can then borrow against their increased wealth, helping to drive prices even higher.
If the world's largest central banks tightened monetary policy aggressively enough, they would bring this process to an end. But tightening in Europe and America has been steady and Japan has barely taken part.
As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes.
If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system.
Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it. |
