It is a grave error to ascribe the credit crisis to greed. Financiers will always cut corners to make a quick buck. Investment and commercial bankers, hedge fund managers, the staff of ratings agencies and just about anyone else employed in the financial world may be worthy targets of our criticism. But their behaviour was predictable. The real responsibility lies higher up. Central bankers are the appointed guardians of the credit system. Yet not only did they fail to predict this crisis, their mistaken policies are directly to blame for the mess we're in.
The greatest error of central bankers has been their failure to understand the dangers posed by asset price bubbles. Former Chairman of the Federal Reserve Alan Greenspan led the central banking community in claiming that it was impossible to identify bubbles in advance. In fact, it's pretty easy to spot a bubble forming—many analysts, including Robert Shiller of Yale University and Andrew Smithers of Smithers & Company, correctly identified both the technology and real estate bubbles of the last decade in advance. Only the current Fed chairman Ben Bernanke and a few excitable property speculators or "flippers" were caught off guard when the property bubble burst.
Furthermore, our financial guardian angels gravely underestimated the damage inflicted by the collapse in real estate values. Yet it should have come as no surprise that the solvency of the banking system could be threatened by such an event. That's what happened in Japan in the 1990s. Nor was it a secret that real estate crashes inflict great damage on the economy. Both the Japanese and the Scandinavian property crises of the early 1990s were followed by severe economic downturns.
The policy of addressing a bubble's aftermath appeared vindicated by the economic recovery that followed the collapse of the stock market in 2002. But now it's clear that the low interest rates of that era ignited the real estate boom. Greenspan adopted an asymmetric approach: ignoring bubbles as they grew but cutting rates as they deflated. Anticipating that the central bank would bail them out when trouble struck, speculators blithely took on more risk. Financial institutions responded to the "Greenspan put" by increasing their leverage.
Another profound mistake has been the too narrow focus of monetary policy. In recent years, central banks have seen the pursuit of price stability as their main objective. Following the lead of Germany's Bundesbank, over 40 central banks adopted inflation targets. This focus on price stability encouraged policymakers to ignore the excessive growth of credit and the appearance of other economic imbalances, such as the decline in US and British household savings, which occurred during the boom years.
This policy was particularly misguided at a time when technology and globalisation were producing a fall in the price of traded goods. In order to maintain the stability of overall price levels, interest rates were kept low, thereby inflating the prices of non-traded goods and services and contributing to the credit boom. Bernanke and others argued that it was important to avoid "deflation," but they ignored the vital distinction between the "good deflation" that comes from rising productivity and the "bad deflation" that accompanies a credit bust. By avoiding the good deflation, monetary policy has led the world economy to the brink of the severest debt deflation since the 1930s.
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Central banks have also failed in their stewardship of the international financial system. Since the collapse of Bretton Woods in the early 1970s, we have lived under a dollar standard. During this period, there has been no limit to the amount of dollars which have flooded the world. By 2006, the US current account deficit had climbed to $800bn and the foreign exchange reserves of the world's central banks had risen to $6 trillion, a threefold increase since the turn of the century. Greenspan downplayed the US current account deficit, claiming that it was a natural consequence of globalisation. Bernanke went further, arguing that the US deficit reflected excess savings among Asian exporters and other trade surplus countries.
In truth, the imbalances in the global financial system are truly pernicious. The central bankers of surplus economies in Asia and the middle east sought to prevent their currencies from rising by acquiring dollars from their domestic exporters. According to Richard Duncan, author of The Dollar Crisis, published in 2003, foreign central banks printed their own currencies in order to buy dollars. This inflated credit at home, contributing to the stock market bubble in the Gulf states and to an investment boom and asset price bubble in China.
Large current account deficits allowed consumers in the US, Britain and elsewhere to continue spending more than they earned, racking up ever larger amounts of debt. As Asian central banks recycled their dollars back to the US, they created an enormous demand for dollar-denominated bonds. This resulted in lower interest rates on longer-dated bonds and propelled the real estate market even after the Fed had started raising short-term rates.
As there weren't enough US treasury bonds to meet demand, foreign central banks bought mortgage-backed securities. Wall Street met this demand by creating investment-grade bonds from subprime mortgages. "Asian central banks," writes Duncan, "bear a meaningful part of the responsibility for the global imbalances which are now coming disastrously unwound. They played the part of enabler to America's destructive consumption."
Another error of central bankers involves their lax regulation of the banking system. In his youth, Greenspan was a disciple of the libertarian Ayn Rand (see my Prospect article, "Alan's Bubble," November 1999). He welcomed financial innovation, arguing that derivatives and hedge funds should be unregulated. Markets were best left to their own devices. This was a bizarre position given that the Fed chairman is the nation's chief financial regulator.
Under Greenspan, Fed officials turned a blind eye as commercial banks shifted loans off their balance sheets, a move intended to avoid existing regulations against excess leverage. What's known as "regulatory arbitrage" became rife on both sides of the Atlantic. US regulators ignored the "unsafe and unsound" banking practices that abounded. The Fed even failed to use its powers to regulate the cowboys in the subprime mortgage market, who knowingly originated home loans with fraudulent appraisals and provided them to people without any documented means of repaying them.
The Fed is not the only culprit. The British authorities allowed their banks to be too highly leveraged—their ratio of liabilities to tangible shareholders' equity climbed to 70 times, according to analysis by Credit Suisse. British banks, like Northern Rock, became dangerously dependent on the wholesale loan market for funding. The Hungarian central bank allowed its citizens to fund their mortgages with Swiss franc and euro loans, although the perils of borrowing in foreign currencies had been exposed by the 1997 Asian crisis. The Icelandic authorities permitted their banks to accumulate foreign liabilities equivalent to six times this tiny country's GDP. The European Central Bank set policy rates to accommodate the slow-growing German economy, but this only served to inflate real estate bubbles on the peripheries of Europe, most notably in Spain and Ireland.
Why did the central bankers get things so wrong? Unlike their private sector counterparts, they weren't motivated by financial gain. The only explanation is that they were blinded by ideology. Our central bankers are drawn from a generation of economists who have been taught that financial markets tend towards equilibrium, that credit matters and asset price bubbles can be safely ignored, that international capital flows produce an optimal distribution of capital and that financial innovations are always to be welcomed.
These optimistic beliefs produced what psychologists call cognitive dissonance. Burdened with a flawed economic paradigm, central bankers and their academic collaborators refused to comprehend the dangers posed by the rapid credit growth and reckless behaviour. Seduced by their sophisticated mathematical models, they refused to heed either history's lessons or the teachings of unorthodox economists, such as Hyman Minsky and Friedrich Hayek, whose work addressed the dangers of credit bubbles. Minsky's "financial instability hypothesis" was difficult to model. So it was ignored.
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Our central bankers have, in Keynes's famous phrase, been "slaves of some defunct economist," in this case, Milton Friedman. This leading exponent of monetarism famously denied that any relationship existed between the speculative boom of the 1920s and the great depression which followed. Instead, he blamed the world economic crisis on the Fed's failure to prevent the money supply from contracting. At Friedman's 90th birthday party, Bernanke publicly apologised on behalf of the Fed for causing the 1930s slump, promising that it wouldn't happen again. Before his death in November 2006, Friedman hailed the success of Greenspan's policies. On the day after his death, the Wall Street Journal carried a posthumous opinion piece in which Friedman asserted that "monetary policy deserves much credit for the mildness of the recession" after the technology boom ended.
Just as the great depression brought about a revolution in economic thought, this current crisis is shaking the certainties of our leading economists and central bankers. At congressional hearings in October, Greenspan confessed that his laissez-faire approach to financial regulation was flawed. The same month, Bernanke stated that in future policymakers would have to address the "dangerous phenomenon" of asset price bubbles. A few months earlier, Blinder conceded in the Financial Times that "recent events are sowing some seeds of doubt." It's a depressing reflection on the dismal science that it has taken a global economic crisis to bring our central bankers to their senses.
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