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Since the last great universal crisis of 1867 many profound changes have taken place. The colossal extension of the means of transportation and communication -- seagoing steamers, railroads, electric telegraphs, the Suez Canal -- have made the real world market a fact...Infinitely greater and varied fields have been opened in all parts of the world for the investment of superfluous European capitals, so that it is far more distributed, and local overspeculation may be more easily overcome. By means of these things, the old breeding grounds of crises and opportunities for the growth of crises have been eliminated or strongly reduced.
-- Friedrich Engels (1894)
As the millennium turns, central banks are in apotheosis. Never has their prestige, their authority, or their independence -- indeed, their mystique -- been greater. But the appearances are deceptive. The volcano rumbles under Olympus and fissures are visible on the slopes. The unprecedented volatility in the markets -- stock markets, bond markets, foreign exchange markets -- demonstrates that instead of settling down, the postmodern financial system is acting up. Central banking in the twentieth century, especially as practiced by the Federal Reserve System in the United States, is one of the great stories in economic history, and no one can understand the present policy dilemma worldwide (the need, as former Treasury Secretary Robert Rubin put it, for a new financial architecture) without understanding that story. In a world where tiny changes in interest rates can produce rapid and vast change in the prices of financial instruments and the viability of national economic policies, the decisions the central banks must make are exquisitely important. They had better know what they're doing. We had better know what they're doing.
The touchstone has to be October 1998. It very nearly all came apart in October 1998.
As they do in two of every three years, bankers and central bankers, financiers and finance ministers came to Washington by the thousands in the first week of October 1998 for the annual meetings of the International Monetary Fund and the World Bank. It turned out to be an experience they will never forget as long as they live, a weekend of pure terror, as though an asteroid were descending on Earth, much worse than the riotous and riotously publicized protests at the smaller Interim Committee meeting eighteen months later. David Komansky, CEO of Merrill Lynch, the prototype of the jolly fat man, said that he woke up on Saturday morning an optimist, and that night he wanted to crawl under the bed to hide.
This was far from a normal experience at the Bank/Fund meetings, which have usually been a kind of reward for their participants, divided by age. Seniors enjoy their importance in various caucuses formed for self-congratulation and finger-pointing at others outside the caucus. They eat and drink the very best, decorously, at parties in venues like the Corcoran Gallery and the Folger Library. Juniors, drafted during the day to provide an audience for the big shots at the plenary sessions in the enormous ballroom of the Sheraton Park Hotel near the National Zoo, party vigorously late into the night at the expense of various publications and suppliers to the finance community. All the 182 countries that belong to the Bank and the Fund are represented, usually by both finance minister and central bank chairman (all expenses paid by the Bank or the Fund), and all the world's two hundred largest banks are there (at their own expense), sometimes with delegations of thirty and forty people.
Not much work is required. Some of the pleasantries in the corridors will turn into deals, and everybody's Rolodex grows larger. But the closing communiqués are in large part ritual, and where in fact real decisions must be made, the terms if not the details are arranged before the first limousine takes the first delegate from Dulles Airport to his or her hotel. ''The deputies'' have already met, in Paris or Tokyo or Rome, and written the draft of the communiqué, which will be presented in Washington to selected representatives of the outliers of globalism, noblesse oblige, before the public meetings begin on Monday. If disagreements persist, they are resolved on Saturday, when the finance ministers of the seven big financial powers (the list includes Canada, but not China or Russia) meet as a group.
The official meetings are only part of the show. Perhaps the most important side event is a Monday morning conference sponsored by the Group of Thirty, a think tank established in the late 1970s with help from the Rockefeller Foundation. The anointed Thirty in 1998 included active executives of the Bank for International Settlements in Basle, the Banque de France, the European Central Bank, the Bank of England, and the Bank of Israel, plus former chief executives of the Federal Reserve, the Bank of Japan, Danmarks Nationalbank, the International Monetary Fund, and the Federal Reserve Bank of New York; half a dozen academics; and present or recently retired senior executives of Citibank, Dresdner Bank, Deutsche Bank, Goldman, Sachs, Industrial Bank of Japan, Merrill Lynch, J. P. Morgan, and Morgan Stanley. When the Bank/Fund meeting is in Washington, the Group of Thirty affair occurs at the Pan-American Union or in the top-floor meeting room of the Federal Reserve's Martin Building.
Beneath the practiced mallet of Paul Volcker, a former Fed chairman, the conference proceeds in an orderly fashion for three hours through presentations by a dozen speakers (it always, miraculously, ends on time). Private bankers, finance ministers, and central bankers -- since 1987, the list has always included Federal Reserve chairman Alan Greenspan, early in the proceedings -- present their views on the world's financial situation and respond to a few questions from the audience. In 1998, the usual list of the great and the good -- the finance minister of Italy, the chairman of the Bank of Japan, a senior executive from Deutsche Bank, and so on -- was supplemented by George Soros, who had just lost $2 billion in Russia.
But for once the context of the meeting had been set not by its own eminent speakers but at another meeting two days before, when Deutsche Bank, the largest by some margin of the German banks, presented the report of its Global Markets Group. Volcker also chaired this meeting, which was held in the downstairs ballroom of the Omni Hotel near the Sheraton. Each member of the audience was presented with an 83-page large-format coated-paper pamphlet on Global Emerging Markets, tastefully illustrated on the cover with a drawing of the Titanic sinking in an iceberg field and a bunch of lifeboats seeking to escape. Next to the illustration was the sentence: ''The real problems lie below the waterline.''
Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that ''While it is difficult to argue that governments are insolvent...under most scenarios, the ability of the government to service its debt in the short run is questionable.'' Turning attention to Russia, the German bank's experts argue that ''there is a very high risk that Russia will not be able or willing to repay its foreign debt'' -- ever. Latin America might have a chance because most countries had large enough reserves to ride out a long storm, but ''failing to stay on course might have very costly and lasting consequences.'' And the main speaker in the Latin American part of the program, Professor Guillermo Calvo of the University of Maryland, thought it would be wisest to abandon hope. Then David Folkerts-Landau, ''Global Head'' of Emerging Markets Research, formerly director of capital markets research for the International Monetary Fund, presented his paper on why the current behavior patterns of the international banks and their supervisors, especially in the creation and valuation of derivatives, made crises worse. Volcker called everybody's attention to Folkerts-Landau's paper, both at the Deutsche Bank meeting and at the Group of Thirty conference the following Monday.
Russia had defaulted in August, telling foreign investors in its government debt that they could go whistle for their money. Long Term Capital Management (LTCM) of Greenwich, Connecticut, the biggest of the ''hedge funds'' -- the engines of great wealth that only the rich could ride -- had collapsed ten days before the Deutsche Bank presentation. The second biggest such fund, Julian Robertson's Tiger, was bleeding money in the billions of dollars from a wrong bet on what would happen to the Japanese yen. The old market-savvy trading firms made their money in times of high volatility, because they had antennae all over the market and felt the shifts in sentiment. But the new computer-oriented trading firms relied on statistical distributions and normal curves, and advertised that they didn't take risks in the market because they understood the probabilities of all the price movements and placed their bets scientifically. Volatility meant that the probabilities did not hold, and destroyed them. Because they had said they weren't risky, they had been able to borrow 98, 99, 100 percent of the money they bet, some of it from banks, some from securities houses. They were incorporated in places like the Cayman Islands, and nobody in any financial center, including the Federal Reserve System, knew what they were doing. But if they really smashed and defaulted on their borrowings, a lot of big institutions might be ruined.
Secondary effects hit harshly in the world of borrowers. In September 1997, Brazil had been able to borrow money on the international market for the rates on U.S. Treasury paper plus about 4 percentage points; in September 1998, Brazil could borrow money internationally only by paying the U.S. Treasury rate plus 22 percentage points. Japan was mired in recession, longing to export its way out of trouble but constrained by the knowledge that such a policy would devastate the rest of Asia, unable to think of anything else to do. In the United States itself, bonds issued by companies without a large asset base were selling to yield three times as much as bonds issued by the best corporations, and the market for initial public offerings -- first issues of stocks (or bonds) by new businesses -- had dried up completely. Though the publicized indices had not been so hard hit, the average share in a traded American corporation was down more than a third from its early summer highs. The closer you lived to the financial world, the greater the panic. Everybody knew there was bad trouble in Asia; in Washington, bankers, central bankers, and finance ministers from around the world -- especially from Europe, whence the bankers and ministers had come to the meetings interested only in themselves and their shiny new money -- were learning that if they hadn't felt the pain yet, it was because they were off the beaten track.
One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York, a pleasant, calculating former Chicago banker, usually a rather gray man, who said that what he saw around him was the greatest financial crisis of his lifetime. Everyone here, he said, is a banker or a bank supervisor. If you're a banker, go out and lend -- you don't have to dot every i and cross every t. If you're a bank supervisor, don't criticize your banks for making loans even if they're loans you might not have approved just a little while ago. Get the money out; the world needs the money.
Later that same week, the Federal Reserve Bank of Chicago held a symposium jointly sponsored with the International Monetary Fund (IMF) on the causes and consequences of the Asian crisis. I was among the speakers. On Friday morning, arguing that it was time for her to get away from her usual companions from universities and governments and see what real capitalism looked like, I took the U.S. executive director of the IMF across the street to the Chicago Board of Trade, where futures contracts for agricultural and financial commodities are bought and sold in open outcry markets. We went up to the upper level of the visitors' gallery and looked out on the ''pit'' where futures contracts for U.S. Treasury bonds are traded ($100,000 face value per contract). It is a large, dark wood, octagonal structure, with seven steps from bottom to top; almost three hundred traders were crammed onto the rings of steps, shouting and waving their trading cards in the air to get the attention of the others. Against the wall behind the pit are row on row of desks where the clerks sit at the telephones, taking the buy and sell messages from the outside world, wig-wagging them down to the brokers in the pit, who are in constant interaction with the ''locals,'' the traders for their own account. The important traders, making the most motions, are on the top step, where they can see the whole pit and all the clerks. (''A good place to stand,'' the most successful bond trader of the 1980s told novices in a lecture, ''is where the locals that drive the nicest cars and make the most money stand.'') Sealed off behind the glass, visitors can hear the roar.
And then the roar stopped. The men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market had closed ''lock limit down'' for the first time since Saddam Hussein invaded Kuwait. The traders stayed in the pit, because any bid above the current price would reopen trading; but there was no such bid. We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. ''Yes,'' he said. ''There are no bids for anything. There is no money.''
On Sunday, October 11, I flew off to Geneva, where I was to be one of four ''experts'' to help the member states of UNCTAD -- the United Nations Conference on Trade and Development -- think about ''standstill agreements'' that might permit everybody to draw breath after a banking-cum-currency crisis left a country unable to finance its imports or pay its debts. Monday, I met with Dr. Yilmaz Akyuz, UNCTAD's Turkish-born chief of macroeconomic and development policies, who thought the jig was probably up for economic development financed by cross-border flows of capital. As always, banks had lent short-term money for long-term purposes, and now the loans had to be rolled over, and the banks very clearly weren't willing to do it. Delegate after delegate told me he expected that his country would be in default on its obligations before the middle of 1999. To represent UNCTAD at UN headquarters in New York, Akyuz had just hired Jan Kregel, a very smart and knowledgeable young American economist with the brush mustache of a British grenadier, who taught at the University of Bologna. On Tuesday, after the conference standstill discussions, I had dinner with Kregel, a protégé of the great post-Keynesian economist Hyman Minsky, and he laid out a scenario based on an anticipated deep world recession in 1999. There was no money internationally; nobody was prepared to bid for anything.
Then, on Thursday, October 15, at 3:04 in the afternoon, a press release from the Federal Reserve Board informed the world that Chairman Alan Greenspan, acting on authority given him by the Federal Open Market Committee after a conference call with the members of that committee, had told the system's trading desk in New York to put enough new money in the banks to lower the ''Fed Funds'' rate, the interest banks pay each other for overnight loans, by 25 ''basis points,'' one-quarter of 1 percentage point.
The timing was fascinating. The bond markets had closed for Thursday, eliminating the small but real danger that bond traders, seeing Greenspan's action as an abandonment of the fight against inflation, would push up long-term rates while he was pushing down short-term rates. And the next day would see the monthly expiration of a set of exchange-traded options contracts on stocks -- contracts each of which gave their holder the right (but not the obligation) to purchase or sell one hundred shares of the specified stock at a preset ''strike price'' that might be above or below the market price. If not exercised, these contracts for this period would expire worthless at the close of trading on Friday. People who had written contracts that gave their purchaser the right to buy stocks tomorrow at yesterday's prices would have to worry that Greenspan's action would send the market soaring, and they would therefore have every reason to buy the underlying stocks as soon as possible to limit their losses on the contract. This need for the players in the options market to cover their positions immediately (because ''in-the-money'' options would definitely be exercised the next day) would further strengthen the upward pressure on stock prices Greenspan's announcement was sure to cause. From three o'clock Thursday afternoon to four o'clock Friday afternoon, the stock market rose more than 7 percent. Roughly $1 trillion was added to the world's wealth, on one man's say-so.
In a world where the Russians and the educated fools of Long Term Capital Management and the crony capitalists of Asia had changed everybody's estimate of the risks undertaken by investors in the capital markets, where there was a gap of 12 to 20 percentage points between the interest rates on foreign bonds or low-rated domestic bonds and the interest rates on U.S. government paper (perfectly safe by definition, because the U.S. government can print legal tender to redeem it), one-quarter of 1 percentage point was not in itself a noticeable, let alone a commanding, move by the authorities. But you had to consider -- or you thought you had to consider -- who was doing it.
In private conversation a couple of weeks before his October 15 intervention, Greenspan had noted with weary regret that the whole world seemed to believe that the Fed was in control of what happened to the economy. Of course, he said, the Fed could strangle the economy by pushing real interest rates beyond the level honest enterprise could pay -- which is roughly what his predecessor Paul Volcker had done in the early 1980s -- but its powers for stimulus were very limited. Nevertheless, on October 15, he went out on centerstage with his top hat and pulled a rabbit out of the hat. It wasn't Bugs Bunny or Roger Rabbit; it was a pretty scrawny little rabbit to which nobody really had to pay attention; and there wasn't anything else in the hat. But the magician concentrated the attention of the world on his rabbit, and the crisis eased. Someone, the magician seemed to be saying, was now in charge. The markets had desperately wanted to believe that someone was in charge; and they believed.
The reasons Alan Greenspan gave for his coup du théâtre explain much of how the world works today, and how the chairman of the Fed must think about it.
Greenspan said that what convinced him he had to move was the gap that had opened between the price of the current ''on-the-run'' 30-year U.S. Treasury bond and the price of the bond issued the year before. In October 1998, new 30-year bonds were selling to yield one-third of a percentage point less than the 1997 bond. As investments, the two are essentially identical; there is no fundamental reason why two long-dated bonds with only a year's difference in their maturity should not offer purchasers very similar yields. In October, however, the bond that had been issued in August is still mostly in the hands of dealers and hedge funds, which are busily playing all their little arbitrage games of stripping the coupons off the bonds and selling the parts, then putting the coupons back on the bonds and selling the whole. That meant that the market was liquid, and a purchaser could count on being able to get out fast at a reasonable price if it turned out that she needed cash. The bond issued in August of the year before, by contrast, had mostly disappeared into the vaults of the insurance companies and pension funds and bond mutual funds. They had acquired this paper pursuant to longer-term strategies. They're rarely in the market to add to their holdings of ''seasoned'' government bonds.
Thus a purchaser of a bond with twenty-nine rather than thirty years to go ran a slightly greater risk that she would have to cut her price substantially when she wanted to sell. In October 1998, there was no money and there were no bids, and a professional purchaser of a one-year-old 30-year bond had to worry that he could be locked in, paying interest to fund his holdings that might exceed his earnings on the bond. Indeed, the only way out might be to sell a futures contract on the Chicago Board of Trade, and then to deliver the bond in satisfaction of the contract when it expired. When the bond-futures pit closed lock limit down, even that chance seemed to be foreclosed.
On October 15, 1998, the world was in fact swimming in excess liquidity. The Bank of Japan was frantically pumping yen into the stagnant pools of its economy, and in the United States all the measures of money supply were rising rapidly. But as the gap between new and seasoned long-term bonds demonstrated, the appearances were deceptive. Money supplies were rising because participants in the markets wanted cash rather than securities. The banks, which could be called on to repay their depositors at any time, were keeping the liquidity for themselves, fearful that those who funded them would take their money out. Indeed, the Japanese banks, agents of a country with literally hundreds of billions of dollar-denominated reserves, were being forced to pay a ''Japan premium,'' a higher interest rate, when they went to market to borrow dollars from other banks.
There are many discussions in many venues of what numbers central bankers should watch. The Wall Street Journal is fixated on the price of gold: if gold goes up, its editors believe, there are inflationary pressures abroad in the world, and if gold goes down, the danger is deflation. Milton Friedman and a rapidly diminishing band of acolytes want the central banks to create money at a steady pace of 3 percent a year, which will give the economy room to grow at stable prices -- indeed, Friedman sometimes seems to believe that it will force the economy to grow at stable prices. The Maastricht Treaty of 1991 that wrote a framework for the European Central Bank calls for it to maintain ''price stability.'' The ''wise men'' who guide the Bank of England in its new independent existence target an inflation rate, elaborately calculated. The Humphrey-Hawkins Act in the United States requires the maintenance of high employment. In the real world, Mr. Greenspan monitors the spread between the interest rates on this year's and last year's 30-year bond.
Political Washington, a junior minister in the British Foreign and Commonwealth Office once told me, is a place where information, not knowledge, is power. Alan Greenspan's Fed is devoted to information beyond the imaginings of enterprise America or, indeed, the executive branch of the federal government; he drives his staff crazy with demands for disaggregated data. When he was a consultant in private practice, he once said that what he did for a living was ''statistical espionage.'' But he has been extraordinarily adept at finding those pieces of information that can in fact create knowledge.
One more aspect of this remarkable story should be considered. At the depth of despair in the financial world, Greenspan gave a speech to a convention of retailers in which he suggested that the best thing they could do for the next week was throw their daily newspapers into a dresser drawer, unread. Disasters are the best stories; the chairman expected a whirlpool of news attention that would suck public confidence to the depths already reached in the financial world. But in fact, with the single exception of Thomas Friedman of The New York Times, who wrote a column on the op-ed page incorporating an all-caps scream of ''BUT HAVE WE GONE NUTS???'', the press ignored the crisis. The fact that the T-bond contract had closed lock limit down in the middle of the trading day, for the first time in eight years, was never reported in the Times or The Washington Post, and simply appeared as part of the usual roundup piece about financial commodities on Monday in the Wall Street Journal. For newspaper editors, a story about bids drying up in the bond market is what William Safire was the first to call a MEGO (for My Eyes Glaze Over); for television producers, there is absolutely no redeeming social value in trying to tell about a financial crisis that has not yet punished telegenic people.
So the news that the world was passing through the worst financial crisis since World War II never got into the papers at all. Few beliefs are so widely held as the idea that an informed public helps decision makers do the right thing, but it's not guaranteed. Greenspan's rabbit might not have been so all-absorbing if newspaper readers had known there was blood in the streets. A little learning, Alexander Pope argued, is a dangerous thing. Looking out at the world from their eagles' nests, central bankers must feel once again that a little ignorance is a necessary evil.
Central bankers have always believed, and in their hearts most of them still do believe, though their tongues say something else, that what the people don't know won't hurt them. Historically, no occupation has been more secretive. The monetary economist Karl Brunner once described central banking as ''traditionally surrounded by a peculiar and protective political mystique...The possession of wisdom, perception and relevant knowledge is naturally attributed to the management of Central Banks...The mystique thrives on a pervasive impression that Central Banking is an esoteric art. Access to this art and its proper execution is confined to the initiated elite.''
In 1989, Alan Greenspan testified before Congress against the idea that the Federal Open Market Committee (FOMC) should announce its decisions to raise or lower or maintain short-term interest rates: ''it would be ill-advised and perhaps virtually impossible to announce short-run targets for reserves or interest rates when markets were in flux'' -- and even in normal times ''a public announcement requirement also could impede timely and appropriate adjustments to policy.'' A couple of years before, the Fed had fought to the Supreme Court and won a lawsuit in which a Georgetown University law student had tried to force publication of the decisions of the FOMC. Awful things would happen if the world knew the instructions being given to the desk that traded Treasury paper for the Fed, said Governor Charles Partee and senior staffer Steven Axilrod. It would cost the government more money to sell its bonds because the primary dealers would have to protect themselves against informed speculators (Governor Partee estimated a loss of $300 million a year), and the Fed itself might lose money on its trades if speculators had this information. Verbally, all that changed in the 1990s; the watchword now is ''transparency,'' and it is only cynics who feel that the lady doth protest too much. ''The word honor in the mouth of Daniel Webster,'' said Senator John Randolph of Virginia (on the Senate floor, too) ''is like the word love in the mouth of a whore.'' I have some of that feeling when I hear a central banker recommend ''transparency.''
The world's central bankers meet eight times a year -- formerly only those from the eleven largest Western economies, now with some added starters from poorer parts -- as the directors of the Bank for International Settlements (BIS), a leftover from the days of German reparations disputes a decade after World War I. Their meeting place is a handsome round tower in Basle, the highest building in the city, not in its center but at the railroad station, which was once the most convenient locus for European conclave. They rarely tell outsiders what they talk about.
The annual report does not discuss at any length what the BIS did during the year, but presents the views of the managing director (and his very talented multinational staff) on what has been happening to the world's economies and the world's monies. Written brilliantly in English by the curmudgeonly American economist Milton Gilbert in the 1960s and 1970s, then also in English by the equally brilliant multilingual Belgian Alexandre Lamfalussy in the 1980s and early 1990s (before Lamfalussy went off to put the future European Central Bank on an intellectually stable footing while it was still called the European Monetary Institute), the BIS annual report has been for decades the world's best source of information about cross-border banking and national economic policies. Lamfalussy's successor, Andrew Crockett from the Bank of England, is still trying, with help from the easygoing Canadian William White, who runs the BIS research operation, to fill those shoes.
It's not unreasonable for BIS to concentrate on its opinions rather than its actions, because the BIS has essentially no authority to act. It has some resources, especially a hoard of gold (it still keeps its own books in ''gold francs''), and the stock trades on the Paris Bourse, essentially as a proxy for gold. In January 2001, the private stockholders sued to prevent BIS from forcibly buying in their stock at what they considered an inequitable price. When big-time packages are put together to rescue this country or that from the consequences of bad luck or folly (the list includes the United States in 1978 as well as Mexico in 1995 and the Asians in 1997), the BIS has an advertised part in it, though in fact its contributions are bookkeeping on both sides and the bank almost never puts up any actual cash. Its most important role has been to establish forums where issues can be thrashed out among central bankers and guidelines can be set.
The most significant of these guidelines was a recommendation back in the 1980s that national central banks should set minimum ''risk-adjusted capital'' standards for banks headquartered in their countries that also operated elsewhere in the world. Banks notoriously buy their assets with Other People's Money; only the bank's capital is its owners' money. Obviously, a bank that has all its assets in government bonds requires less capital than a bank making real estate development loans and speculating in the derivatives markets; hence ''risk adjustment.'' But the immediate purpose of the capital standards recommended by Basle, and imposed over the next few years by the authorities in all the major countries, was to rein in the Japanese banks, which had been rampaging around the world's markets making loans at rates others could not match, because they had essentially no equity on which they had to deliver returns.
Unfortunately, the categories of risk were poorly defined -- for example, interbank loans between the banks of countries that were members of the Organization of Economic Cooperation and Development (OECD), a group that included Mexico and South Korea, were given a weighting of only 20 percent, which meant that the same capital could support loans to such banks five times as large as loans to manufacturing enterprise. Efforts to change the definitions of risk have foundered, mostly because the Germans want a special category for their housing bonds. Pending as these words are written is a proposal by which the banks could make up their own risk schedules with reference to the published ratings of Moody's and Standard & Poor's -- a truly awful idea, because lending officers at banks and ratings officers at the ratings agencies tend to be optimistic or pessimistic at the same time. So the talk at BIS too is about ''transparency,'' letting the markets know what each central bank is doing, and urging every nation's commercial banks to publish considerable though significantly incomplete information about their investments and off-balance-sheet activities.
The transparency push, originated with the world's finance ministers and the International Monetary Fund, was led by the American Susan Krause, then senior deputy comptroller for international affairs in the U.S. Office of the Comptroller of the Currency. Krause, an energetic lady in her forties, with a casual manner but square shoulders, really did believe (most of the time) that getting more information out about banks and central banks would make the regulators' job easier. But the regulators must make a credible commitment: ''[I]f shareholders, creditors and the market in general believe that governments will allow non-disclosure, partial disclosure or even misleading disclosure should a bank run into difficulties,'' she wrote in a paper for the Basle Committee on Banking Supervision, ''they are unlikely to consider publicly disclosed information credible.'' She admits that it goes against ''the gut reactions of banking supervision.'' But, she adds, ''Asia illustrated the dangers of a lack of transparency.'' It works, she suggests, if you can ''think separately about valuation and disclosure.'' There are important converts, at least in public, among them Alan Greenspan.
The symbol of the new openness is the light that now shines on the work of the Federal Open Market Committee. In the 1980s, ''Fed watchers'' at the Wall Street houses, like Salomon's Henry Kaufman and First Boston's Albert Woljinower, issued streams of comments on the significance of the Fed's daily purchases and sales of government paper. Now the Fed publishes before each FOMC meeting the ''beige book'' on economic conditions in each of the twelve districts, which is prepared by the staffs of the district Federal Reserve Banks and will guide the deliberations of the FOMC. And an announcement is made, during the FOMC's two-day meetings, in time for the markets to use the information on a same-day basis, to tell the world whether the Fed will be changing short-term interest rates -- and if so, why; if not, why not.
There is no question that this is Greenspan's doing, though perhaps some credit should be given to Alan S. Blinder, a Princeton economist who served as vice chairman through the middle 1990s. Blinder believes completely in transparency for central banks, arguing that it makes them more effective: ''A central bank which is inscrutable gives the markets little or no way to ground [its] perceptions in any underlying reality -- thereby opening the door to expectational bubbles that can make the effects of its policies hard to predict. A more open central bank, by contrast, naturally conditions expectations by providing the markets with more information about its own view of the fundamental factors guiding monetary policy. This conditioning ought to make market reactions to monetary policy changes somewhat more predictable, thereby creating a virtuous circle...And that makes it possible to do a better job of managing the economy.''
It is not clear that the Fed's staff, which has great influence on Greenspan (he says much more interesting things on the road than he does when he speaks from his office), has signed off on the values of transparency. The Fed in recent years has asked Congress to strengthen bank secrecy laws, increasing, for example, the penalties on anyone who leaks anything from an examination report that might indicate that a bank's public statements are less than full or less than honest. To protect the privacy of his colleagues, Greenspan even misled the Congress, claiming incorrectly that no transcript was made of the tape recordings of FOMC meetings, and that the tape recordings were destroyed (the tape, we were told, was recorded over for the next meeting) once they had been used to prepare the traditional ritualized summary of the meeting. On the general issue of putting out information so that ''market discipline'' could reinforce the supervisory work of bank examiners, the Fed staff really agrees with Lowell Bryan of McKinsey & Co. that ''market discipline by depositors is another name for bank panics.''
A Fed staff study, ''Improving Public Policy Disclosure in Banking,'' published in early 2000, notes that ''the public policy concern is that disclosure about individual banks would trigger actions by private stakeholders that would preempt the efforts of a central bank and supervisory agencies to contain a systemic threat.'' The study suggested that Federal Reserve examiners could ''review the public disclosures of large banking organizations as part of their evaluations of its management.'' By the time this process was completed, the intervention of the Fed's disclosure authorities would probably reduce the quantity of information legally available to the public.
Bank secrecy is in the bones of central bankers. It goes back to a time when the knowledge banks gathered -- about changes in interest rates and foreign exchange rates, the creditworthiness of borrowers, corporate investment plans -- was available only to banks, which spent a good deal of money gathering it. Bank income derived not so much from maturity transformation -- taking very short term money like checking account deposits and converting it to loans of some duration -- as from information advantages. Credit in Latin means ''he believes.'' Banks had a rational basis for belief, because they knew a lot. Direct lenders or investors, who employed their money without the intermediation of the bank, knew much less. (Remember Partee's comment that the Fed would lose $300 million a year in its trading if the speculators on the other side of its transactions were better informed.) Banks could spread the costs of gathering credit information over a number of accounts, and use the information in a number of contexts.
As late as the years right after World War II, more than three-fifths of all lending in the United States was mediated through the commercial banks. Their profits came from their exploitation of the information they had and others didn't. Of course they wanted legal protection of their secrecy.
Which left them sitting ducks for the information revolution and the development of modern finance economics. Today, for minimal expense, anyone with a computer modem can know just about everything a bank knows, certainly about conditions in the money market and probably about the quality of potential borrowers. The BIS has even suggested that the ratings agencies know more than the banks. It's Ozymandias -- there's a ruined statue in the desert, with a pedestal boasting of a glorious past when banks called the tune and markets danced to it.
In the old days, the central bank worked on the economy by influencing the behavior of the banks; enterprise was dependent on banks, and responded to their response to the pressure from the central bank; and the market moved according to participants' perceptions of what would happen to the economy with the change of behavior and attitude at the banks. Now what banks do doesn't matter all that much in the United States, and soon in Europe, too (indeed, part of the problem in the world is that banks still do matter enormously in the less developed countries and it's hard for the industrial countries to understand that, especially where there are touted ''emerging markets''). Where information technology has taken hold, the central bank, still charged with keeping the currency stable and the economy growing, must work its magic through the markets.
To abuse Isaiah Berlin's metaphor one more time, banks are hedgehogs who know the few things they know very, very well; markets are foxes that roam the world picking up snippets of fashion. Banks are stuck with their corporate customers, who owe them money; markets can sell out the stock in a twinkling. The conflict between the information systems, one deep, one shallow, could not be more striking. Banks generate and keep information; markets forage for it, publicize it, and consume it. Banks historically have been confident in their information, and set a course with it; markets are ready to turn on a dime. As markets rather than central banks set most of the interest rates that matter and markets rather than examiners value the banks' investment portfolios, and the instability of their funding multiplies their risks, banks have become less assiduous in seeking information, less confident in the information they have, more willing to go with a flow they and their supervisors only partially understand. ''Do we,'' asked E. Gerald Corrigan, former president of the Federal Reserve Bank of New York and chairman of the executive committee of Goldman, Sachs, ''really understand the long-term consequences of the technologically driven disintermediation of payment flows away from credit-sensitive financial institutions?'' To which the short answer is no; we don't.
The derivatives process, permitting participants to bet on the direction of market prices rather than on the absolute numbers, enables participants in the business of borrowing and lending to arrange their affairs so that the actions of the central bank do not greatly affect them. In the early 1990s, it was fashionable for economists at central banks to speak of a ''financial accelerator'' or a ''credit channel effect'' that multiplied the effects of the central bank's raising or lowering of short-term interest rates. Just a touch on the brakes, raising rates a smidgen, would reduce the value of the paper borrowers used to gain cash through repurchase agreements, and by increasing the costs of carrying inventory would reduce profits to damp what Keynes once called the animal high spirits of businessmen. A touch on the gas pedal would bring the economy back to speed, Paul Krugman of MIT proclaimed in his role as a columnist, because ''recessionary tendencies can usually be effectively treated with cheap, over-the-counter medication: cut interest rates a couple of percentage points, provide plenty of liquidity, and call me in the morning.''
But it isn't so. Ingo Fender of the Bank for International Settlements notes that given the opportunities afforded by derivatives, ''firms should not be expected to accept their fate...like lemmings. Instead, they will implement corporate risk management strategies that are likely to alter the sensitivity of the real economy to changes in interest rates.'' Because the hedging is necessarily imperfect, he adds, ''monetary policy will be increasingly unreliable when used to affect investment spending and real activity.'' What remains is theater, most useful when the threat to be countered is itself dramatic. Greenspan could master the threat to the world economy in 1998 because the reason for the disruption was the previously unimaginable default by Russia on its domestic debt. In January 2001, the decline in economic activity derived from several years of careless investment (especially, though not exclusively, in dot-coms and tele-coms) that did not and would not pay out its carrying cost. Against this backdrop, not even the most startling announcement -- half a point, between meetings of the Fed's rate-setting committee, while President-elect George W. Bush was meeting with the big businessmen who had financed his campaign -- could do much more than give a temporary goose to the stock market.
Theory has not yet confronted fact. Theory still says that the effects of changes in the interest rate play through the attitudes of the banks. The central bank cares about the real economy and the prices for goods and services, costs of production and costs of living. Too much ''money'' in the system generates higher prices for goods and services and the cost of living. Too little money denies funds to producers and reduces national product. But the central bank can't decree how much ''money'' will be in the economy. It needs ''intermediate targets'' that more closely impact the real economy. Those targets are interest rates and bank reserves (and through bank reserves, ''the quantity of money'').
Prior to the last quarter of the twentieth century, banks ''set'' interest rates: there was a ''prime rate'' for the best customers in the United States, a ''bank rate'' in England, and their equivalents elsewhere. The central bank by altering its ''discount rate'' -- the rate it would charge banks for, in effect, borrowings secured by the banks' best collateral -- would influence the banks to change their prime rate, which would affect business decisions. Rising interest rates would reduce the market price of fixed-income securities, which discouraged banks from lending because they felt the decline in the value of existing investments. If banks have bought 90-day government paper at 5 percent and the Fed by selling its holdings of that paper raises that rate to 6 percent, the prices on the 90-day paper the banks own will drop until they sell to yield 6 percent. To create new assets (make loans), banks either have to borrow money (at the new higher rates) or sell old assets (at the new lower price); the central bank has given banks reason to think hard before making new loans. Vice versa with declining rates: existing assets in the banks' portfolio became more valuable, which encouraged new lending as a way to use the profits.
Others could argue, equally plausibly, that the quantity of bank reserves, which the Fed could create and extinguish at will, determined the availability of money to borrowers from the banks. Putting money into the system by purchasing paper in the market, the Fed increased the banks' lending capacity and thus their borrowers' spending power. Taking money out of the system by selling paper in the market, the Fed forced the banks and thus the economy to cut back. The Fed's actions were always and necessarily pretty small by comparison with the effects desired, and their effectiveness was explained by the operation of a ''multiplier'' inherent in a system where banks had to keep ''reserves'' against some fraction of their liabilities. The bank that received the Fed's ''high-powered money'' might lend 90 percent of it, and the bank that received the proceeds of that loan would lend 90 percent of that, producing deposits in another bank that would lend 90 percent of that, etc. -- Big fleas have little fleas/That come in swarms to bite 'em/And little fleas have littler fleas/And so ad infinitum.
It is by no means clear that this ever worked, past the extraordinary decade of the 1950s when American banks funded their lending activities by selling the government bonds the Fed had helped them acquire to finance the war. That was then, and this is now. Today, Fed decisions that change banks' capacity to fund loans mean very little, partly because the most significant lending occurs directly in the markets and partly because the banks don't want to fund loans, anyway: they want to package their loans into salable ''asset-backed securities'' or in more sophisticated form. In the modern world, a bank loan is a bundle of risks -- risk that the borrower won't repay, that interest rates will change, that the lender will need the cash he has put out before he thought he would need it. These risks can be separated out, traded, sold, hedged by the creation or purchase of derivative instruments. This process, writes Henry Kaufman, the premier Fed watcher of the 1980s, ''has had the significant side effect of dispelling the illusion that nonmarketable assets by nature have stable prices.''
But while the intrusion of market values everywhere in the banks reduces the confidence of those enterprises, they and the Fed and the markets all take heart from the often ingenious calculus of probabilities expressed in the new instruments. The new interplay of borrowers and lenders in the market, Kaufman writes, ''allows the private sector to withstand monetary restraint for a longer time. As a result, the central bank will need to engineer considerably higher interest rates -- with correspondingly lower asset values -- to achieve noninflationary growth.''
These lower asset values will not be restricted to the segments of the bond market where the Fed sells. Especially at a time when obscure companies can fund themselves by selling equity -- when funding for investment is provided not through the intermediation of institutions that have continuing relations with their borrowers but through the presentations of stock salespeople who are gone the moment the deal is concluded -- the Fed must pay attention to the stock market. 'Twas not always so. In the 1920s, Benjamin Strong -- who ran the Federal Reserve Bank of New York and thus, at a time when the Board of Governors in Washington was weak, the Federal Reserve System -- had occasion to write to the head of the Federal Reserve Bank of Philadelphia that ''if the Federal Reserve System is to be run solely with a view to regulating stock speculation instead of being devoted to the interests of the industry and commerce of the country, then its policy will degenerate simply to regulating the affairs of gamblers.''
In the mid-1930s, when a stock market boom heralded a false dawn of recovery from the depression, the president of the New York Stock Exchange (then an unpaid part-time post) made a speech saying that if the market went pop, the blame should lie with the Federal Reserve, which had loosened money too far; and Fed chairman Marriner Eccles responded with a statement endorsed by all the governors to the effect that the rising stock prices had not been financed with Fed credit and the Fed couldn't do much about it anyway. Roosevelt sent Eccles a letter warning him against ''any statement relating, even remotely, to actual stock market operations. This is where Coolidge, Mellon and Hoover got into such trouble. A word to the wise!''
Erik Hoffmeyer, longtime head of the Danish National Bank, observes that players in markets are motivated by ''what they expect the market to do,'' and that these expectations ''are heavily influenced by the behavior of the monetary authorities concerned.'' Still, new economy or no new economy, the values asserted by the stock market represent the price of an anticipated stream of future earnings (''even if,'' as Alan Greenspan rather grumpily told a conference in summer 1999, ''no market participant consciously makes that calculation''). Higher interest rates mean a greater discount in those values looking forward, and thus lower stock prices today. Once an economy reaches a certain level of development, with a body of existing debt that must be rolled over periodically, everybody hates high interest rates, debtors because they have to pay them, creditors because the market value of their assets falls. Central banks have been given independent authority over interest rates because high interest rates are the necessary prophylactic when inflation threatens, and politically there is no constituency for increasing interest rates even after inflation has taken hold. The willingness of political leadership to abdicate responsibility for interest rates has been one of the most remarkable aspects of the postmodern political economy. As a German cabinet minister said many years ago, explaining this phenomenon in Germany, ''every politician knows that some day he may need a central banker to hide behind.''
To say that central banks must now seek their objectives through the market rather than through the banks masks the essential change. Securitization, derivatives, worldwide markets, and the vastly increased liquidity of once non-marketable assets (represented in the household world by home equity loans and easy access to margin values of stock market investments) have made the idea of the ''quantity'' of money a historical curiosity, like belief in a flat Earth. Credit may be amorphous, but credit risk is specific, and leverage -- the fraction of the money at risk that the lender or investor or speculator must repay to his creditors -- continues to rise. Henry Kaufman worries that securitization and derivatives will act as rubber bands allowing the system to keep stretching as the central bank pulls at it; an equal worry is that the chaos theoreticians may be right, and that a system where receipts and payments are tightly bound together may shatter beyond easy repair if a minor event far away -- the Indonesian butterfly's wings feared by the chaos maven -- leads with awesome inevitability to systemic disaster.
As the Asian crisis of 1997 demonstrated, much of this risk remains with the banks. The finance ministries and the central banks can probably protect them and their creditors, though there is a lot of work to be done to assure that government and central bank protections cannot be abused self-destructively by the participants in the system. But in a market-dominated age, most of the burden inevitably lies on investors who no longer use banks as their intermediaries, and who need unprecedented access to information and even more unprecedented capacity to analyze and use it.
The burden lies on you.
Copyright © 2001 by Martin Mayer
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