Why central banks need some friction in their models
As central banks struggle with the efficacy of their policies, could it be that their models are in fact to blame?
Most central bank models assume “neoclassical” stable relationships without any financial frictions, and agents who never default.
In a frictionless economy, funds flow to the most productive projects irrespective of who has the money, their risk appetite, patience, wealth or incentives.
In such a world, there would be no need for banks, since everyone would borrow and lend at the same riskless interest rate, nor any need for money, since everyone’s IOU would be instantaneously and perfectly acceptable.
It is, alas, a fantasy world.
As my friend, Charles Goodhart, professor emeritus at the LSE (London School of Economics) and former Monetary Policy Committee member, who turned 80 last week, has remarked: “Default is to liquidity what sin is to holiness in religion.”
In the real world, people default, either if they can do so without penalty, or if they are forced into it. The same is true of banks, but they play a much more central role in our economies.
To ignore that role, and the central functions of banks within our payment and credit system, is neither realistic nor helpful.
The private sector’s demand for loans, banks’ profitability, capital adequacy and risk aversion: all these affect not only financial aggregates but also financial wealth and the real economy, through a variety of channels.
Overlooking how banks function means that the models that central bankers have relied upon are, by construction, overly simplistic fair-weather versions only.
This failure to recognise how banks and other financial intermediaries respond is a key part of why quantitative easing has become “largely a spent force”, again to quote Charles.
Credit has simply not been created despite repeated monetary stimuli.
Take the European Central Bank’s (ECB) recent programme (“TLTRO 2”). So far eurozone banks have drawn less than 5% of the incremental €1.6 trillion despite the ECB offering to pay banks 0.4% to take the money.
The first version of quantitative easing (QE1) proved remarkably effective, not only because of signalling future official rates nor just for portfolio balance reasons, but because it provided lots of liquidity to a banking and financial system that had become scared rigid of worsening default risk.
QE1 reduced risk premia, especially in the banking system, dramatically.
Now that the liquidity needs of the banking system have become effectively satiated, the subsequent rounds of QE have become increasingly ineffective.
If QE is proving less effective, negative rates are a dangerous experiment with diminishing positive impact.
I fear that many central banks overlook the adverse impact of negative interest rates on the profitability and position of banks, insurance companies, pension funds and other intermediaries.
Take the recent troubles in eurozone banking which are among the hardest hit by negative rates.
Or look at Switzerland and Sweden where banks have put up their margins on corporate loans and mortgages to offset the impact of negative rates — contrary to policymakers’ objectives.
The need for Japan to change course in its monetary policy after negative rates in January failed to achieve their objectives is also telling.
Mr Goodhart is perhaps best known for his dictum, “When a measure becomes a target, it ceases to be a good measure.”
At an LSE conference to celebrate Charles’s contributions to economics last week, I proposed a second Goodhart law in honour of his 80th birthday. “When central banks’ policies overlook financial frictions in the transmission mechanism, they will lose traction.”
This should not mean going soft on intermediaries. Rather, it would support a keen focus on the health of systemic banks and clearing houses.
It would also mean keeping a weather eye on which other parts of the financial system could start to pose systemic risk, though mutual funds and pension funds are not systemic in my view.
Viewed through this lens, some of the fancy new ideas about abolishing currency, such as those proposed by Kenneth Rogoff, in order to impose negative interest rates of a much larger magnitude on society, would not work.
Either it would cause a damaging impact on intermediaries or the government would have to proclaim publicly that the purpose of the whole exercise was to make the savings of ordinary people worth less as time went by.
The new law also supports greater emphasis on housing and infrastructure not only for their direct boost to the economy; they support additional lending by intermediaries.
Every monetary policy committee should have members who have a real world understanding of the plumbing of financial intermediaries. It’s time to put financial frictions into macroeconomic models.
This article first appeared in the Financial Times.