We expect too much of the new masters of the universe

For City bankers who once thought of themselves as masters of the universe, these have been bruising years. Financial scandals, shrinking balance sheets and the humiliation of having to rely on state support have sapped the energy of a profession that once seemed indestructible.

Yet at the same time as private-sector bankers have been on the defensive, their official counterparts have been riding high. Central bankers used to be thought of as timid technocrats operating behind the scenes. Now they stride across the financial stage. They have slashed interest rates, pumped vast amounts of money into the financial system and worked with governments to rescue banks and keep them lending.

They are, it seems, the new masters of the economic universe. But we should be wary. We had too much confidence in private sector bankers before the crisis. Are we now too optimistic about the abilities of the financial system’s new overlords?

Central bankers derive their influence over markets from their independence and credibility — sources of power that they acquired in the two decades following the last big financial crisis, in the mid-1970s. The pioneer was the Bundesbank, which in the 1970s pursued tight monetary policies when inflation was accepted as a fact of life in many other countries. The US Federal Reserve under Paul Volcker followed suit in the 1980s, using high interest rates to bring inflation under control.

The UK emulated these policies under Margaret Thatcher, only to relapse in a spell of inflation in the late 1980s. This led to the Bank of England being put in charge of monetary policy as an independent authority. Since 1997, control over interest rates has been exercised by the Monetary Policy Committee.

Independent central banks committed to low inflation held sway as we moved into the 21st century. When the euro came into being, the European Central Bank followed the Bundesbank model. But we now know that, during this period, growth was supported in the west by an unsustainable credit boom. When the economy showed signs of faltering — after the Asian crisis of 1997, and again when the dotcom bubble burst in the early 2000s — central banks reduced interest rates to support economic activity. Financial markets believed in the “Greenspan put”: the US Federal Reserve would act to sustain growth, no matter what.

Central banks now seem ready to do whatever it takes to sustain growth — to a degree that casts doubt on the genuineness of their commitment to price stability. Monetary policy deliberately turned a blind eye to relatively high inflation in 2011-12.

And growth is not the only competing objective that central bankers have taken on. They have worked with governments to rescue banks, too. They are experimenting with new tools — quantitative easing, which entails creating money to buy financial assets, and “macroprudential” policy, which uses regulation rather than interest rates to steer the economy.

This carries risks. The most important tasks for central bankers are to maintain the stability of prices and intervene when there is a severe crisis in the financial system. If they over-reach themselves, there will be conflicting pressures which compromise these core responsibilities. That is a danger to the economy and puts central bank credibility at risk. Central bank independence is also in danger of being eroded. By acting as instruments of government policy, central banks are straying from their own dominion of monetary policy and financial stability into political territory. (For example, the ECB has been drawn into a role in the Troika of institutions supervising the restructuring of the Greek economy). Through QE programmes, central banks have become substantial holders of government bonds — with the result that government spending is financed by money creation rather than issuing debt on the markets. This is justifiable as a short-term remedy to restore confidence but not as a long-term basis for managing public debt.

It is a measure of how much has changed in the world of central banking that the very institutions that won their credibility by keeping a lid on prices now seem to be trying to create inflation, not subdue it. The 2 per cent inflation target served policy makers well as a definition of price stability when they felt that zero inflation was not achievable. But price stability could mean what it says on the tin — somewhere close to zero, perhaps as close as possible. The odd month in which prices fall is not the same thing as the chronic deflations endured by the US in the 1930s and the UK in the 1920s. Maintaining financial and price stability in well-performing economies such as the UK and US requires a gradual rise in interest rates. But today’s central banks are behaving more like pussycats than lions in pursuit of this objective.

We may live to regret their caution. The job of a central banker is to make unpopular decisions when politicians will not. We saw that in the 1970s and 1980s from the Bundesbank and the US Federal Reserve. We have yet to see those actions from the current monetary policy makers. The lions of the financial system need to find their roar.



Andrew Sentance is senior economic adviser at PwC and a former member of the Bank of England Monetary Policy Committee