Structure Makes the Central Banker

Op-ed in Welt am Sonntag

August 26, 2007

With the hubbub of the current financial panic, everyone's attention has turned to central banks. Speculators looking for a bailout or bankers seeking a provision of emergency liquidity are focused on monetary policy decisions. The buzz is that the eurozone's lead central banker is gaining fans through his activism, while the Federal Reserve's chairman is showing restraint-contrary to stereotypes and to the two institutions' own self-proclaimed orientations.

There is less difference there than meets the eye. Arguably the seeming distinction between European Central Bank (ECB) President Trichet's and Fed Chairman Bernanke's responses to recent events comes from a real situational, not personal, difference: The financial-and particularly the banking-system is still more vulnerable in continental Europe than in the United States, and the transmission of problems in the banking system to the real economy is greater in the eurozone than in the United States. Thus, the differences in central bank responses across the Atlantic are not caused by a difference in style or ideology.

That said, there is no question that Trichet has gotten more opportunities of late for making a dramatic impression with his actions (and getting to act earlier in the daily news cycle than Bernanke). Bernanke is conveying calm well, but he has not yet mastered the Robert Rubinesque quality of doing nothing seem like an act of courage, which it may well turn into if political pressures on him for ease and intervention mount. It also reflects the fact that Trichet wants to lead the ECB and give it a more decisive face than it had under Duisenberg, while Bernanke wants to make the Federal Open Market Committee (FOMC) more collegial and less personalized in him than it was under Greenspan. Both are valid moderating responses to the respective institutional distortions created by their predecessors, but end up making Trichet seem more of a star and Bernanke less of one.

In fact, almost all central bankers in the major economies today are cut from the same cloth and would behave much the same way when presented with the same challenges. A recent study I completed with Kenneth Kuttner of Oberlin College shows while markets do react to surprise information about the appointments of new central bank leaders, the size of shifts in market expectations are mostly small, and almost all central bankers in advanced countries seem to be shooting for similar inflation goals. If markets with their information gathering and money at stake cannot tell governors apart, there probably is little to distinguish between them. This result is also consistent with an earlier body of econometric research which establishes that, with rare exceptions, modern central banks follow pretty much the same policy rules when reacting to economic news and shocks.

What is different for the major economies' central banks are the circumstances they face, even with global financial markets and a simultaneous shock. Trichet's ECB has some pretty clear financial priorities. Structurally, bank lending makes up a much greater share of corporate and housing finance in the eurozone than the United States, despite recent liberalizations, so the impact of any given financial shock on bank lending and the overall economy tends to be greater.

In addition, the European banking system is fragmented in size, across national lines, and between public and private institutions. As a result, supervision has been less consistent across the eurozone, and more risky investments by banks-as opposed to other financial institutions-have remained on their balance sheets (as illustrated by IKB's recent need to be bailed out) than in the United States (where the mortgage lenders, not the money center banks, are in trouble). Even in normal times, the average volume of the ECB's discounting of bills for banks is a 1000 times as large as that of the Fed's, given these differences in their financial systems and the far greater use of securitization by US banks. Thus, the ECB had reason to be more aggressive and rapid in responding to banking system problems than the Fed.

The importance of financial structure and supervision to central bank decision making is further demonstrated by the relative inaction of the Bank of England in response to recent events, and in contrast to the ECB and the Fed. Yes, the Bank's Governor, Mervyn King, has repeatedly expressed concern about asset price bubbles and about moral hazard when central banks bail out those who made poor investments by cutting rates. Ultimately, though, what has made the Bank of England's stance viable is the fact that the London-based financial institutions had made their loans and investments under the best practice financial supervision system and therefore have not been hit significantly by liquidity problems and surprises in the current crisis.

In fact, the relative success of the UK financial system in this time of stress will likely accelerate the movement from around the world to London as the center of global finance-an interesting prospect for those who assert that central banks have to be aggressively accommodating to be popular with market participants. For the Fed and the US Treasury, this is a further reminder that encouraging the development of adjustable rate mortgage and collateralized debt products does not require giving up on all forms of regulation and supervision. And for the ECB, this is a strong counterexample to the already burgeoning claims that Anglo-Saxon style securitization is a recipe for instability-done properly, securitization is a stabilizing force in financial markets.

Bernanke and Trichet probably already recognize these facts. The challenge will be getting politicians on both sides of the Atlantic to take the proper lessons from the different ways in which the current financial panic affects their respective economies. The tendency, just as during the Asian financial crisis a decade ago, will be to push for the quick solution of interest rate cuts when the issue lies in the underlying financial structures and beyond central banks' direct control.