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LONDON (Reuters Breakingviews) - Anyone wondering about the curious predicaments of Jeffrey Lacker and Paul Tucker might want to cast a glance at a 1906 comment in Banker’s Magazine, a British trade journal: “The money market is controlled by the joint-stock banks and the Bank of England is compelled to seek their active cooperation in order to protect its stock of gold.” The terms are dated, but the compulsion problem is current. Central banks are too weak to do their job well.
Lacker resigned last week as president of the Federal Reserve Bank of Richmond. He admitted that he had not acted appropriately in 2012, saying a conversation he had with a financially savvy outsider may have disclosed confidential information about Fed policy options.
Fed leaks at any time are not really surprising. Back in 2012, the U.S. central bank was trying to persuade the financial world that monetary-policy largesse would continue for a long time. To win hearts, minds and dollars, it supplemented official statements with fuller and franker private conversations. Valuable information can easily slip out when you’re anxious to sell your story, and Lacker wasn't alone in having such conversations.
Tucker’s problem dates from the 2008 financial crisis. A newly discovered recording revives the accusation that the then-executive director of the Bank of England encouraged market participants to bend the truth about the cost of funding. He has denied any wrongdoing.
But if Tucker did not encourage bankers to put an optimistic spin on the state of the money market, he was in dereliction of one part of his professional duty. The UK’s central bank was responsible for avoiding market panic. A fully honest account might well have sparked one.
The 1906 article identified the common theme of these two scandals. Now, just as 111 years ago, the monetary authorities depend on the cooperation of the institutions they are supposed to be regulating. Central banks have to cajole the financial system to keep it in line.
A century ago, financial stability took the form of a high ratio of actual gold to gold-backed money. It was a sort of confidence game. In a panic, the Bank of England would never keep its promise to pay out gold for banknotes, so the system relied on financial-market participants not panicking. But a meltdown was more likely if the market participants, in particular the joint-stock banks, created too many deposits which could be redeemed for cash and then for gold.
So the central bank was left in an awkward position of simultaneously begging its trading counterparties to behave and telling them to trust its ability to make them conform. It was as needy as it was needed, a co-dependence which gave financial institutions a good deal of power.
The Bank of England was a private institution then. Nationalisation in 1946 gave it more official clout, but not enough to be able to calm the markets on its own in 2008. Once again, it needed cooperation from the institutions it was supposed to be controlling. The Fed, which was only created in 1913, also requires the compliance of the financial system to ensure that its policies bear the desired fruit. That is the same system that the Fed is supposed to keep aligned with the economic good.
This is not the normal relationship of the regulator to the regulated. The government agencies which keep food, medical care and flying safe have full and ultimate control. They can push around any company, no matter how large. Of course, the regulators often fall short. They are frequently captured, as economists say – promoting the agenda of industries which offer them helpful but biased information, fine meals and perhaps the prospect of excellent jobs.
Central banks also suffer from this sort of capture. Indeed, finance offers great enough material rewards to tempt saints. The migration of central bankers to and from financial institutions is unseemly at best, destructive at worst.
But monetary regulation has a more severe structural problem. Central banks are not far enough above the system they supervise. Since they cannot tell banks how much or what kind of credit to offer, they cannot really control the money system. They can only work indirectly. Mostly, they use open-market transactions to push the financial system in the desired directions. Sometimes they resort to words.
The situation has not changed much since 1906. Central banks still work much as they did when they were basically normal banks, just with the special privilege of printing banknotes. That level of authority is totally inadequate for an economy which runs almost entirely on bank-created deposits.
The monetary authorities would be much better placed to avoid credit bubbles and busts, and to limit conflicts and deceit, if they could behave more like other regulators. That would require more direct control over the active money supply and more adversarial relationships with banks and brokers. The changes would be revolutionary – and perhaps politically impossible – but it is foolish to put 19th-century organisations at the centre of 21st-century finance and expect a perfect outcome.
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