Sunday 23 July 2017

Huge policy shift on the way as central banks flounder

European Central Bank President Mario Draghi addresses the European Parliament’s Economic and Monetary Affairs Committee in Brussels
European Central Bank President Mario Draghi addresses the European Parliament’s Economic and Monetary Affairs Committee in Brussels

FAITH in central banks may be running out. The only reason it has lasted so long may be that, in many places, faith in governments ran out some time ago.

The near-collapse of the global banking system undermined one of the main reasons for central banks to exist. They are now failing in another - the avoidance of price stagnation or deflation.

There was an intriguing sign of how patience is running out in the proceedings of the European Parliament last week. The European Central Bank is famously independent: infamously independent in the view of some who complain about its being accountable to no-one.

I have never quite been clear about the distinction between independence and accountability.

They look more like contradictions of each other. Certainly it is a fine line between them. The Oireachtas learnt that independence, according to the ECB, means it does not give an account of itself to national parliaments and the only formal accountability is its reporting to the European body.

Last week, the parliament delivered its verdict on the ECB's annual report for 2015. According to some MEPs, the degree of criticism of ECB policies was unprecedented, but you would have to take their word for it.

Poor, benighted Europe. The verdict, in the form of an agreed motion, is unintelligible to all but a parliamentary draftsperson. Even though this is one of the parliament's most important tasks, its website lists a film award as the main story of the week.

Summoning the will to live, I waded through the unprecedented critique. It does indeed point out the weaknesses and dangers in the ECB's "quantitative easing"; creating cash to buy loans (many of them loans to governments) from banks.

The MEPs zeroed in on the rather generous requirement that banks do not have to return the cash - on which they pay no interest - even if they fail to use it for lending elsewhere in the economy.

The parliament "deplores" a situation where banks have been able to access funding at virtually no cost but the size of this subsidy is not monitored and published and there are no conditions on whether or how it is invested.

It also takes up - perhaps rather late in the motion - what is surely the central banks' Achilles heel in the present policy; that low, or even negative, interest rates must lead to higher prices for any asset which does provide an income stream - of which property will always be the most popular.

Which brings us right back to Dame Street. The bind for the Irish Central Bank is, while it has those controversial mortgage lending limits in place to curb property prices, low ECB rates, along with those of the Fed and BoE, mean it makes sense for investors with cash to bid up prices until the annual rent is a few per cent of the purchase price.

It's not easy being a central banker these days. Sympathy is limited, since it is a mess of their making which it has fallen to them to clear up. Where sympathy may be warranted, it is because what they are trying to do may not be possible. At least not without help.

The dilemma was neatly summed up by Sweden's Riksbank, itself a veteran of a 1980s banking crash. Its own base rate is negative, charging banks half a per cent to deposit money with it. Even so, inflation has not risen to the targeted level, but borrowing and asset prices are racing ahead.

Swedish households' debt to income ratio is 180pc and almost a third have mortgages worth more than four times their income. These are Irish-style statistics and, unlike ours, still rising.

The 2008 crash made not a dent in Swedes' taste for borrowing. In a sign of the times, the krona reversed a six-month decline against the euro when the Riksbank deputy governor suggested QE might be coming to an end.

We may be at the beginning of an enormous policy shift. With both Donald Trump and Theresa May talking of something more extreme - less QE accompanied by more government borrowing, markets have been turned on their heads, with the value of government debt falling and that of shares rising.

The three main US stock markets reached record highs together last week, for the first time since 1999. The Federal Reserve and the Bank of England could be facing another great challenge. The standard response to bigger government deficits would be higher interest rates. The markets are betting on just that, but the politics could be poisonous.

Never mind that such policies would have spooked markets a few years ago, and look even spookier now. In many of the advanced economies, government debt as a proportion of annual output has reached levels never before seen in peacetime, but everybody - not just electorates but markets too - seems weary of the current situation.

Change, any change, is seen as preferable to staggering on as in the last five years. Such attitudes are, of course, illogical. To be justified, change has to be for the better. Perhaps altering course will produce better outcomes but the ECB, for one, is not convinced.

In its carefully coded comments last week, it warned of the dangers of a switch from cheap money to more money, in the form of higher government borrowing and spending. Given those current record levels of debt, there is force in the ECB's fear that, if the policy switch goes wrong, "vulnerable sovereigns" (such as Ireland) could come under pressure again.

All highly speculative of course. In the world we do know about, the ICB looks likely to be disappointed in its hope that the Government would reduce debt faster and monetary policy is in the hands of the ECB. It is left with just direct intervention in the shape of the lending limits which made the news last week.

We may already be seeing the difficulty with this kind of macro-prudential policy. It all too easily becomes micro-economic policy. Guarding the banking system cannot be separated from issues like the supply and price of houses or the consequences for potential growth which come from shortages and soaring prices. Safe banks always lend less than customers want.

Last week, as we saw, the central banks relaxed the limits on first-time buyers. But it has no handle on those who do not need to borrow to buy to let.

Nor has it a handle on institutions big enough to borrow at ultra-low rates and convert the money into properties yielding 5pc.

Given their failure to achieve any of their main objectives of the last decade, from safe banking to modest inflation, the general loss of faith in central banks is bound to feed into more hostility to Dame Street's risk management.

Oh well, at least if there are no houses for their staffs, the central bank will be spared having to tell the London investment banks to take their thousands of jobs elsewhere, because it is just too risky to have them here. Now that really would be a row.

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