Central Banking in an Age of Improvisation

Monday, November 28, 2011
Arminio Fraga

Founding Partner, Gávea Investimentos Ltda.; Chairman of the Board, BM&F Bovespa; Former Governor, Central Bank of Brazil

Adam Posen

Member, Monetary Policy Committee of the Bank of England; Senior Fellow, Peterson Institute for International Economics

Kevin M. Warsh

Distinguished Visiting Fellow, Hoover Institution, Stanford Graduate School of Business; Former Governor, Federal Reserve System

Peter R. Fisher

Senior Managing Director and Head of Fixed Income, BlackRock Inc.

Experts discuss policy steps taken by central banks in the United States, Brazil, and Europe, and analyze the challenges ahead.

This meeting is part of the McKinsey Executive Roundtable series in International Economics, presented by the Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

PETER FISHER: All right. Good morning. Thank you all for joining us. This is—I'm—my name is Peter Fisher. I work at BlackRock. I run the fixed income group there.

And we have a great panel discussion this morning. Let me welcome you to the council. This meeting is part of a McKinsey Executive Roundtable series in international economics. So thank you all for coming.

I'd like to now ask you all to please turn off your electronic devices. So here, I've—mine is off. You see it's got a black screen, so let's all see black screens everywhere we can. And I'd like to remind you all that this meeting is on the record, so I believe we're being videoed for future use, not live in any way, available to council members in the future.

So we are here to discuss the age—central banking in an age of improvisation. I think our hosts have been generous in titling this an "age of improvisation" for central bankers, but that will be what we—what we talk about.

Here up on the panel—I won't dwell on this—we have three individuals which I'm sure are familiar to most of you: Arminio Fraga, who's a former governor of the Central Bank of Brazil and the founding partner of Gavea Investments; Adam Posen, who's currently a member of the Monetary Policy Committee at the Bank of England and a senior fellow at the Peterson Institute in Washington; and Kevin Warsh, a distinguished visiting fellow at the Hoover Institution and a former governor of the Federal Reserve System. So we have a fair bit of central banking talent arrayed up here on the stage.

Let me frame this for each of—each of our three panelists, and then we'll each say a few words. We'll have a conversation for 20 minutes or so, and then we'll open it up to questions for the group.

Technically speaking, I think we find central bankers awkwardly midway between regimes, between rate-targeting regimes and quantity-management regimes. That's the easy part, that you can see them struggling with this. If you listened to Chairman Bernanke several weeks ago, he explained that the advent of the Fed's new Operation Twist was the equivalent of a 50-basis point cut in the federal funds rate. And all the while he said this, the federal funds rate continued to trade at 9 basis points.

During my career at managing the Fed's balance sheet, if the chairman of the Fed had announced a 50-basis-point cut in the Fed funds rate, the Fed funds rate would have fallen 50 basis points, but that's not the case anymore. Chairman Bernanke found himself trying to explain the current regime in which they manage quantities on their balance sheets and the composition of their balance sheets with reference to the regime we were coming from, which is where the Fed had targeted rates. Now, the same you can see unfolding around the world. The Bank of Japan has been there for some time, the Bank of England is running a partial experiment in this, and the ECB is having a hard time making up its mind. (Laughter.)

Much more profoundly, the question is of what's the purpose of central banks. The 20th century was the greatest burst of inflation in modern economic history. Many central banks came into existence in order to target—to manage that burst of inflation and manage it down. Prior to the 20th century, central banks weren't thought of principally as managing inflation. (Inaudible.) The origins of the Bank of England centuries ago or even the Fed in 1914 wasn't so much about inflation, but managing an elastic currency on behalf of a central government and a banking system.

So with all that by way of background, I'm going to ask a series of opening questions here to our panel. First I'll ask them each to say what they fear most over the next three to five years, inflation or deflation. So—and give a one-word answer to that—(laughter)—and then I'll be asking them each a—an—a broader question in the theme of thinking about how central banks are behaving and the challenges ahead. There are lots of challenges we're responding to which I'm sure we'll touch on.

So Arminio, inflation or deflation—that's the first part of the question—do you worry more over the next three to five years? And secondly, when we look back 50 years from now, what do you think historians will make of this period we're in? Do you think that the orthodoxy of the Deutsche Bundesbank will be vindicated? Do you think the Fed's "QE2" and Operation Twist will look too timid or foolhardy? Over to you.

ARMINIO FRAGA: So you want my --

FISHER: Yeah—(inaudible)—yeah.

FRAGA:—cute little statement too?

OK, I once—when I was at the central bank in Brazil, I once asked Paul Volcker what he thought of inflation targeting, and he said, well, I don't like inflation; I don't like deflation; I guess I like "flation". (Laughter.) So—but I'll say—I'll say inflation (just for ?)—I think I'll take that side.

On the age of improvisation, like you, I think central banks have always improvised. It's no accident you mentioned the gold standard. The famous rules were really never followed. You have the famous book by Hawtrey, "The Art of Central Banking". So there's always some degree of improvisation there, capital controls all over the place throughout history and so on, experiments with monetary credit aggregates.

I, for one, think, coming from Brazil, that, again, if you had to—if you put a gun to my head, do you like improvisation or not, I tend to not like it. I guess coming from Brazil we've seen it all. In case you ever need some help, you know, feel free—(laughter)—feel free to call me. We have tried everything in the book you can imagine, and most of it didn't work. (Laughter).

And the truth is we tried it because we were usually under tremendous stress. So my initial point, just to get it over with, is central banks tend to improvise when they get—they have to face limit situations, you know. So for instance, if the country that kind of hosts your central bank is in trouble and is losing its access to credit, what do you do?

We know from basic economics that, you know, in the end you can default or you can inflate, and many do inflate. And we see a lot of interesting things in the world now happening in areas that have that possibility in the extreme of monetizing, and then parts of the world that don't; and how they are trading in the market's also very interesting.

I also have the issue of deflation that you pointed out. I think central banks have correctly improvised in trying to deal with that. That's a big problem. You have also huge concern about what the exchange rate is doing. That has also led to a fair amount of improvisation. And you have new regimes. We say in Brazil jokingly—I better be careful here—(chuckles)—but we say—we now talk about the—I call it the Sino-Ottoman model, with a lot of controls. I'll elaborate on that, if anybody cares, to defend myself if—(inaudible).

But anyway, for my taste I kind of like a more simple macroeconomic regime where you don't get to these limit limitations. That's my kind of first conclusion. We can talk about the future, too. It's much more interesting than that. But that's what I have to say. My simple regime is, you know, fiscal responsibility, keeping inflation low, worry about financial stability—which is also kind of eternal stuff, by the way.

So that's what I have.

FISHER: OK, for opening.

Kevin, all the measures of money velocity in the United States are collapsing at a rate that can only but bring to mind 2008, the panel's—we discussed before we came in. So if you were at the Fed, would you be more afraid of doing too much or too little? And what would you be doing in terms of driving the conversation as you look out to 2012 and 2013?

WARSH: Peter, this isn't the question that requires the one-word answer, is it?

FISHER: No, you can—you can give that first. First you say inflation or deflation; then you get to --

WARSH: OK. So I guess in response to the one-word answer of inflation or deflation, I'd say neither. (Laughter.)

FISHER: That doesn't meet the test.

WARSH: And if I had two words, I'd say not deflation. Let me then try your broader view of what some of this data on money means.

First, I would say the periodic trotting out of monetarist tables to justify dramatic policy responses usually happens when the monetary tables are falling fast. They tend not to be spoken about in the academy when those data flows are moving up. But I guess my judgment is we don't know how to measure money very well. And I would say even if Milton Friedman were here with us today, he would continue to be puzzling how do we measure money in a world that is as complex as the one we have, where the instruments of money—financial instruments and otherwise—make that calculation very difficult.

So I guess, Peter, what I'd say is if we could measure money well, if we could properly understand the levels and rate of change, then that data would be quite useful, could actually inform good central bankers' views, but not in isolation. I think if anything, what we should have all come through this crisis with a broader understanding of is that we need dashboards that are not just model-driven, not just market-driven and not just driven by measures of M1 and M2. And I'd say policymakers err if they are restricting their dashboards, if they are looking only at one set of data.

What the finest economists recognize, I think, is that the study of economics knows preciously little about what's happening in the global economy. We have to be, as central bankers current and past, exceptionally humble about understanding how the financial markets and the real economy are interacting with each other. And I think there are huge policy errors made when we presume too much, when we have total conviction. I don't think many would have predicted five years ago where we'd be today. I think our predictive abilities over where we're going to be the next three to five years isn't great.

I guess it would come, then, down to the question that Peter led off with, which is, shouldn't we just improvise? And my answer is no. By necessity, when you're in a financial crisis, when you're in a dark weekend in September of 2008, some degree of improvisation is essential, is necessary, is not in any textbook, but you find yourself in that box, in that corner.

But we haven't been in that kind of financial crisis now for a couple of years, at least in the United States. And to continue to improvise policy strikes me as quite counterproductive. The crisis response is one thing and requires some degree of improvisation. A recession response or a response to weaker economic conditions, I think, to me, suggests that you go back to a view of rules, a view of understanding between markets and central bankers so they're not surprised, so they are not finding themselves waiting breathlessly on what central bankers announce on Sunday nights to get markets to move up on Monday morning, with press releases in hand.

FISHER: Okeydoke.

Adam, so first, do you worry more about inflation or deflation? Secondly, a couple—10 days ago in The Times, you had a piece about central banks should stop dithering.

ADAM POSEN: Not my title. (Laughter.)

FISHER: Not your title. I'm sorry, your—not your title. You urged action, I think would be a nicer way to say it, in fairness. I guess the prescription you spelled out there of more aggressive action, particularly by the Fed and the ECB you were addressing, was easy to discern. I guess I'd like to ask you, by what criteria do you think—were you judging central banks in their inaction and your urge for action? If we—again, we're looking back 50 years from now at this age, what do you think we'd be assessing the central banks on? How would we be scoring them, independent of their narrower statutory mandates?

POSEN: The fear, Peter, for me, and I think for many people rightly, is that we're going to be looking back 50 years from now on this period the way we were looking back on 1933, '34 or '37 with the Fed or the '20s with the U.K. going back on gold—in other words, a major deflationary mistake.

So starting with the one-word answer, what I'm worried about is stagnation. What I've argued in a series of speeches is that we're going back to what I call the "old normal". You're right, we're having a regime change. But sort of in the spirit of what you're saying, we're going back to the late 19th century when monetary matters and credit are going to matter, but it's not about inflation or deflation, it's about very large real shocks that buffet the economy up and down around a relatively austere low-growth path. And so that means we're going to tip occasionally into deflation, tip occasionally into inflation. Let's say the U.S. currency were to adjust. You would temporarily have inflation, but it needn't be ongoing inflation if the Fed does its job.

And so when we ask about looking back 50 years—I want to go back to where you started, Peter, and what I think Arminio said, which is historically, central banking isn't about price stability alone. I mean—(inaudible)—price stability is what you do when you've made sure the situation isn't falling apart. The reason the Fed was founded was to counter panics in the financial market. The reason the Bank of England was founded, as you said, was to deal with elastic currency, which, again, was about keeping the payment system running, keeping the credit system running. And so in that sense, I'm very similar to Kevin.

What I worry about—sometimes when I advocate for more policy, more stimulus, people say to me, well, do you think that's going to fix everything. My answer is no, more monetary stimulus isn't going to fix anything. Irresponsible monetary tightening will make your problems insoluble. That's the point. It's necessary, but not sufficient. If we repeat the mistakes of the past and we prematurely tighten or we insufficiently loosen, whatever you do on fiscal policy, whatever you do on financial regulation will be overwhelmed by that mistake. That's what I'm concentrating on.

And so to take it back into this issue of improv, that may sound more radical than it really is because when you talk about improv, of course, here in New York, everybody thinks cool school, bebop, Miles Davis, free jazz, hey, man—(laughter)—central bank improvisation is more like Dixieland bands. You know, we're a little bit swing; we're a little bit old-fashioned. And this is right because we're there to provide the background music. We're there to provide the underlying beat and rhythm that everybody can dance to. We're not there to go on a riff and say, hey, everybody, look at me. The best central banking is when nobody needs to look at you. And that's why I'm saying—what are the criteria for looking at central bankers now, as you put it—the idea is you have to act because—Kevin is right to be—talk about our need for humility.

Benn Steil has heard me say this on several occasions. I mean, this really is about central bankers being more humble, but my emphasis on humility would be in a different area. I get very offended by the ECB deciding that, in their arrogance, they should be trying, as unelected officials, to figure out what the fiscal policies of other countries should be and the growth paths of other countries. Central bankers should be sticking to their knitting, saying it honestly, doing it straight up, and not overstepping their (agreement ?). That's where you should be humble.

And so if you stick to your knitting and look at the economics and don't let all these image issues—that's what I was trying to argue in my article—and political issues get in your way, all the indicators right now tell you you've got to avoid the deflationary mistake. Wage growth is nil in the advanced economies; energy prices, commodity prices are flatter, going down; money supply and velocity, as you say—Kevin's right, it's a different world. But if you take any version of Milton Friedman and the Bundesbank's canonical—"MV = PQ," right?—Q is going down, growth is going down; V is going doing precipitously. So the money supply isn't there. It's not going to have the inflationary effect. There is no union pressure. There's globalization pressure. I mean, there's just no story without arrogantly telling central banks they've got to be doing something beyond what they should be doing to get you to an inflation scenario from here.

FISHER: Thank you. Thank you, each. Well, we'll have a little more up here and then we'll open it up.

Kevin, I thought I'd give you another bite at the apple. I think Adam set it up. It's the Fed that has decided to massively expand its balance sheet. So giving you the opportunity to address the question of whether—and I don't mean to put you on the spot about the Fed, but the money numbers must mean something if the Fed has moved us from merely targeting the overnight rate to this massive expansion of the monetary base in the form of its balance sheet and in the form of arguing that QE2 and the early programs were the equivalent of putting the overnight rate at minus-250 basis points.

And so it—there must be some—while it's awkward and while we know there's not a lot of stability in the money aggregates, that seems to be the path the Fed has chosen. And so the question is, should they abandon it now and go back to some other orthodoxy, or should they embrace it and work with the quantities? And I wonder, you know, what you would be doing if you were advising those inside.

WARSH: OK. Sure feels like you're putting me on the spot, but I'll—(laughter) --

FISHER: (Laughs.)

WARSH: But I'll take it. So I would say the Fed's reaction function, both six months ago and beyond when I was there and more recently, I don't mean to suggest that that is being driven disproportionately by the money data that you trotted out. That data might be broadly consistent with the other data, however, that they're finding.

The best I could rationalize the Fed's judgments about growing its balance sheet would be you've hit the zero lower bounds, that monetary policy can't do much more by its traditional policy rate channels, and perhaps this is the moment, they would argue, where you need to try to find lower rates by hook or by crook. And expanding the balance sheet is an attempt to take duration out of the market under the theory that investors—all of you—will then find riskier assets more attractive and you will provide a floor under asset prices which will then have an effect in the broad economy. That's the best I could describe what they're doing. My own judgments on the benefits and costs are probably a bit different than the conventional view.

So I think when you move policy rates lower, as the ECB appears now to be doing, we central bankers know how that works. We're not certain exactly what the impacts are, but we know the benefits, and we think we can (couch ?) and understand what are the costs. Once you've hit the zero lower bounds and once you've concluded, as my judgment was and is in the U.S., that fiscal policy, trade policy and regulatory policy are not doing their bit, are not helping to support a growing economy, then the risk/reward for a central bank to try to compensate for the failings of these other policies is not good.

That does not mean that balance sheets don't—balance sheets for central banks shouldn't be expanded in some cases. I wish I were more dogmatic about the point. But when there is liquidity in our markets, when there are bid-ask spreads that are crossing, then the risk/reward for central banks to be still more aggressive, in spite of the failings of these other policies, strike me as less obvious.

FISHER: Thank you. That's terrific.

Arminio, you helpfully draw our attention to Brazil's experience muddling through past crises, but I think the question—that you also alluded to the roles. There's the fiscal role, the monetary role. You like a little bit of orthodoxy. But we know we have an agency problem; you have to get them all to line up and to behave in a consistent way. But taking that, that we have some different roles—we have the fiscal policy, as Kevin helpfully pointed out, fiscal regulatory—in Brazil's past episodes, fiscal orthodoxy looked like a good prescription. If you were prescribing for Europe or the United States right now, is fiscal orthodoxy—tightening fiscal policy—what you'd be prescribing?

FRAGA: I would, and I have from day one, interaction I had with people here, many of whom I've been close to in sort of (wartimes ?) in our country.

What I find missing here is very much, I think, in the direction of what Kevin was saying. And if you look at the emerging and submerging markets over the years, you'll find that the crisis situations that were well-managed, where you got out of your hole pretty well—had always a blend of short-term—call it firefighting, and it differs from country to country; in the emerging markets usually that meant you were cut off from credit, so there was some support from the IMF and what not—had that, but also had an awful lot of stuff getting done addressing long-term issues.

And to me what is frustrating in looking at many of the—many of the mature-economy cases now is the lack of work being done to address long-term issues. You see a bit of that now in parts of Europe, and Germany did it on its own over the last 10 years. That's what I think is missing. So I just find it complicated, to use a light word, that you do health care reform and you don't address long-term health care costs. So that kind of thing really makes people nervous.

And then, I'm not much—I'm not big on money aggregates, because I think they're a bit of a moving target. I do like to look at credit aggregates, and if you look at recent data from the OECD that adds up household—household borrowings, nonfinancial corporates and governments for the OECD countries—and there's a paper by Steve Cecchetti this year at Jackson Hole, had that table—it doubled in the last 30 years, that total. And that, I think, scares me a bit.

So, unfortunately, I think we went through a big bubble period, probably growing faster—"growing" in quotes; I don't think we're really growing—but moving faster than we could, and now we're kind of going—we're paying—it's payback time. We got drunk; now we're in a hangover. And I think when you're at that point, you have to make something of it and address the issues.

For now, I find that money is on a lot steroids—I come from a family of doctors—but that doesn't cure everything. Sometimes even if you keep pumping steroids, your patient blows up and it doesn't quite do it. It may buy you some time.

Anyway, I have more to say on inflation and money aggregates, but we can save that for later.

FISHER: OK. Adam, you suggested that it is a buying time, that the idea of central banker accommodation at this point would be to buy time.

POSEN: Right.

FISHER: But how—what would you say to the nervous financial-market participant that it's hard to figure out whether central bankers have lost their heads and they're, you know, throwing caution to the wind and are going to generate the great inflation of the 21st century, or whether they're rescuing the financial markets by making sure the contraction of the banking system doesn't happen too quickly? How do you talk clearly to the markets about that apparent schizophrenia?

POSEN: Well, Peter, I mean, it's a good question but I think it's—in many ways you're being disingenuous with your 3 1/2 trillion (dollars). I talk a lot to market participants, including some of your colleagues. I've talked with, if you add it up, several trillion dollars worth of money under management in the last two months, and the fact is the real money is not acting—not believing this garbage about central bankers being out of control.

If you look at the bond markets, if you look at any possible way of trying to extract inflation expectations, from index bonds, from forwards, from the difference between five-year forwards and 10-year forwards, from the exchange market option trading, from any of these, all of you have priced in as far as the eye can see are very low interest rates.

There is—it is plenty easy, if you're a bondholder, to say, oh, god, the Dove Posen has taken over the Bank of England, and they're going to print money. And well, every gilt currently in issuance is trading above par, at the moment—first time in British history.

So there's a lot of chattering. There are the Paulsons of this world, who want you to buy his gold fund and tell you these stories. But the people who are betting real money are not betting on inflation.

Now that doesn't mean that they couldn't be wrong and we couldn't be wrong, but it goes back to where we started, which is, even if we've created money, even if we've expanded the central banks' balance sheet, that only becomes inflationary if the economy is already growing or if velocity, however you want to define it, picks back up. And so that only becomes inflationary if the central banks are unwilling to withdraw that stimulus when the time comes. And there is nothing in the last 30 years—since Paul Volcker came in, since Maggie Thatcher changed round the Bank of England, since the Bundesbank took over in Europe, there is nothing to suggest that the main or central banks are unwilling to tighten, and I certainly am.

FISHER: OK. I'm going to open it up now. I'm sure members of the panel will want to slip in other thoughts they've had, but I'll be opening it up. So—to all of you. Please, when I call on you, stand, wait for a microphone and state your name and affiliation, and try to limit yourself to one question, so we can see how many people we can get around to.

Mr. Tempelsman. OK, let's get you a mic.

QUESTIONER: Maurice Tempelsman, Leon Tempelsman & Son. My question is really focused on the (interphase ?) between the political and the economics, at this point, and subscribe fully to the fact that the central bankers have stepped in at a time when there was failure on the other side to carry their (own ?). But the dynamics of a central bank really are to be independent; the dynamics of the decision-makers in the other areas, to be responsive to the political requirements.

Addressing your concern that this is a bad thing in the longer term, if one looks back to the beginning of the middle of last century, and you saw the rather dramatic political consequences for economic failures, how do you see addressing this issue, in the sense—haven't you built in, by making it easier, by saving this situation—I'm deliberately being provocative here—by saving that situation, haven't you made it easier for those who are driven by the political pressures to sit back and let you carry the burden?

FISHER: All right. Well, Kevin, take a shot at that, and ask everyone—everyone, have a brief shot at that too.

WARSH: So—I fear you're right. So I think the risk is that, at least in the United States, coming out of the financial crisis peaking in '08 and '09, those outside of the central bank saw central bankers that were on weekend after weekend able to pull rabbits out of the hat, able to create new products, to address new market concerns. And while the recovery from then to now has been weak, it has been a recovery.

It would be a—it would be a bad habit to be formed if the policymakers outside of central banks thought there were more rabbits to be pulled out of hats, that could absolve them of their responsibilities to do what they can to help the economy grow stronger and—Arminio's point—to use this window of opportunity to defease long-term liabilities. I don't think that's the intention of Chairman Bernanke and his colleagues, but politicians of all parties are prone to look at the most recent scenario and to extrapolate based upon that.

I would say that the opportunity continues to exist for good central bankers, in the U.S. and elsewhere, to use their institutional credibility to call out those politicians that are outside of central banks and to speak very clearly about the home truths, to speak about what responsibilities they best accomplish. It's not the job of the central bank, and central banks will get in a lot of trouble if they try to compensate for these failings. We are terrible repair shops for broken fiscal policy.

And what concerns me most isn't just the dynamic between politicians and central bankers, but between markets and central bankers. The (head ?) markets also learned the lesson that central banks will bail them out of their positions through breathless weekend announcements. I think that would be a dangerous, dangerous sign. And every time that I see financial markets focused on the world's new financial center in Washington, D.C., I get very, very concerned.

FISHER: Adam or—want to add something?

POSEN: I regret to say I fear that both Kevin and you, Mr. Templesman, are wrong. The historical record of central banks, instead of being repair shops, as Kevin gives it, is being nagging park-it meter ticket-givers: I don't like your fiscal policy; you have to shape up—(in higher-pitched voice)—which is terrible because one of two things happens: They either get ignored, in which case their credibility is none, or they do something stupid on monetary policy that is contrary to their economic conditions and contrary to their mission, and their credibility evaporates.

And you can see this right now in the euro area, where central banks are so caught up in this ghostly image that if we as central bankers are seen as being too cooperative with governments, that will destroy matters. And instead, what it's doing is it's backing every government into a corner and continuing to feed the panic that we've got right now in Europe. We saw this in Japan. That was my expertise in the past. In the late '90s the Bank of Japan and the Ministry of Finance played chicken games with each other, and Japan sunk further and further into the abyss.

There are things—again, I completely agree with Kevin that monetary policy is not going to fix the underlying structural problems. And that's why in my New York Times article, in a series of speeches, I've talked about things central bankers can do, like restructuring mortgage debt in this country in cooperation with the elected officials. And we're going to get an announcement from Chancellor Osborne in the U.K. tomorrow in which he is going to be talking about some of the credit-easing materials that he renamed my proposals, where the Bank of England and the government can work together.

So I don't think the issue is us going soft. I think the issue is us being constructive. And us being nags is not going to do anything except make us look either impotent or foolish.

FISHER: Should we open up—you want to say a few words?

FRAGA: I'll jump in on that just for a second. I don't disagree, Adam, that fighting deflation is a central bank's kind of obvious priority now, and I think they'll eventually succeed. In many ways, they probably don't right now because people see them as being somewhat cautious. But I just worry about one thing. You—this is a, I think, mature-economy bias, and you—your model has demand and that's it, no supply --

POSEN: That's not true.

FRAGA:—for the most part. And—because you're basically saying, there's not enough demand, there's not enough demand. And what we've learned in our laboratories—and we've gone through all of this, and all these limits we've calculated. These are complicated functions like you used to get in calculus, and you first look at it, you don't really know what the limit is.

We've calculated most of those. And the lesson we've learned is—to put it nicely, is stuff happens. (Laughter.) And so my worry now is that we may be moving in that direction. I think it is a no-brainer policy for the ECB to cut it down to zero and to do some QE. In our models, now we don't have M anymore. So, you know, we're playing with other approaches, but we know if you double M and just leave it there forever --

POSEN: Right.

FRAGA:—that P will go up.

POSEN: Yeah, if you just leave it there, correct.

FRAGA: And leave it there. But right now nobody believes you're going to leave it there.

POSEN: Right.

FRAGA: And the question is whether you want to leave it there or not. But I do think in the end we're also doing this as a one-off, and it isn't a one-off. So there is going to come a point—this is different from the Depression. It is so much debt, and government debt in particular, that I think you're going to have to at some point face it.

POSEN: Oh, yeah. Oh, yeah, but I'm just saying it's not up to the central bank to provoke a crisis to face it. That's all I'm saying.

FISHER: Let's have the next question here. There in the back. Yes, right there. Could you identify yourself?

QUESTIONER: Mahaj Kutchacha (ph), (SAIC ?). There's much press discussion on ECB and lender of last resort. So sort of a factual issue: Is ECB by statute able to be a lender of last resort? Is it, in a pragmatic sense, able to actually do that? And politically, should it do that?

POSEN: Let me answer the factual question as we understand it. If the ECB were to do one of two things, it would be legal. First, if they were to engage in a form of quantitative easing and buy all eurobond shares—all eurobond—oh, excuse me—all euro member country bonds simultaneously in roughly the proportions of the economy, that's legal. If they have this—what they call their Securities Market Programme, and they put it under the fig leaf of saying we're doing liquidity management, they can buy targeted bonds like Greek or Irish.

The question is, is that going to work, either of those, or do you need to say, I'm actually buying, on large scale as necessary, Italian and Spanish bonds? And if—that's where it becomes illegal, according to the German constitutional court. And so the question is would one of these other things be an effective substitute, and if you do that, are you cheating the democratic process in Germany and elsewhere?

FISHER: I think that's an accurate statement of the facts as I understand it, too.

Let's have another question here in the back.

QUESTIONER: During the 2008 crisis we saw unprecedented liquidity injections into banks, and some economists have likened the banks' access to the lender-of-last-resort programs as free liquidity insurance or a standing credit line without paying the annual premiums that the banks themselves charge their customers. Question is whether you see the need for any major structural reforms in the way that central banks do their lender-of-last-resort programs. You know, the response has been higher capital requirements to head off some of the subsidy that is provided. But the question is whether there should be direct charges for standing access to lender of last resort or perhaps consequences for tapping the lender of last resort such as, you know, memorandums of understanding that require banks to shrink or get out of businesses or cut comp, some measures until these problems in the banking system are solved.

FISHER: Want to take it?

FRAGA: I'll start. I think that you have to—if you go back over a hundred years, banks used to leverage their capital very little, 3-to-5 times. And then recently they were—who knows; this is not very transparent—but probably leveraging 50 times or more. So something had to change. I think that's the issue. Where does it come from?

And the other thing that bothers me is that not only is there a lot of leverage, but that the bulk of it is short-term. So financial systems have become these machines that produce these gigantic liabilities, and to make it worse, they're made to be short-term. And I think there are a lot of—a lot of things that go into this, including asymmetric monetary policies. You know, there are more microincentives. And there—I think there's plenty of work to be done still, although some of it is probably moving in that direction.

I could argue too, by the way, that it wasn't lack of regulation, it was—I would love to take the side—it would be a good debate, and I think I would come out with a black eye, but—(chuckles)—I would argue that is—you could argue that is wrong; the system is poorly designed is more of an issue than the system is not regulated enough.

FISHER: I'll second that emotion.

Any of you want to add anything here?

WARSH: So I'll—let me—let me perhaps unanimously endorse that motion. So I think the question really is are there other reforms coming out of 2008 that somehow weren't included in what's described as fundamental, comprehensive regulatory reform passed in Dodd-Frank. The answer is yes, there are. I would say that the piece that is almost altogether missing from a fundamental reform in our banking sector is the lack of market discipline.

So what did we learn in 2008? What we learned is what we should have long known: Sometimes markets are right; sometimes markets are wrong; sometimes regulators are right; sometimes they're wrong; and sometimes capital standards aren't enough. And in the reforms coming out of the crisis, what did we conclude? What did Congress, at least in the U.S., conclude?

If we only had regulators with more power, more money and more authority, if we could only add another 50 people to the regulatory ranks, that we will make sure bad things don't happen. Well, bad things are going to happen in financial institutions. That's what the history of financial crises tell us.

But I would say what regulators need is certainly some clear authority, but at least as important, they need markets to help us. And the reason why market discipline, in my view, was lacking then and now is that markets have very little to go on in understanding the underlying financial wherewithal of large financial institutions. Read the 10Ks or 10Qs of large institutions in the U.S. Read them of big German banks and Japanese banks. These are very difficult documents to understand really how resistant these firms would be to crisis.

And I would say markets spend so much time focused on headlines, running in and out of different bank credits because they haven't been empowered with the information they need—in calm times and more panicked times—to figure out which banks they like and don't like. And we've given up on market discipline, I would say as a former regulator. We need, as regulators, markets to help us police these markets. And if we don't empower them with information, then we're giving up on, I'd say, the most critical pillar, prudential supervision.

FISHER: Very well said.

WARSH: Thank you.

FISHER: Let me remind people to try to keep your questions brief and identify yourself. Yes. Oh, well. All right, the mic's right behind you, so we'll come to you next. Sorry.

QUESTIONER: Niso Abuaf, Pace University. Why is it a foregone conclusion that the lower bound of the policy rate is zero? Why can't the Federal Reserve charge commercial banks for the excess reserves?

FISHER: Kevin, do you want to --

WARSH: So it's—whether or not you could have effective negative rates has been reviewed periodically in the halls of most central banks, at least those that I'm closest to. And we end up with a series of operational questions, a series of questions not about whether it's a good idea or bad idea, but does it work. How do we make it so that there is a penalty in keeping your money with us without doing great harm to a broader financial architecture of money-market mutual funds and the like?

And the judgments—they could not—they might not be right—the judgments are the zero lower bound, at least in the U.S., is somewhere around zero. The judgment made in other countries might be it's even higher than that, because of the financial architecture that separates central banks from the real economy. It doesn't have to be the final answer, but at least during my time, that was our answer.

POSEN: Can I just add quickly, Kevin's absolutely right. I know, Bank of England, we went through that and decided our effective zero bound was 0.5. I know BOJ went through a—Bank of Japan—went through a similar exercise. It's very operational.

One thing I would add—just to get on record, since I am the one who can mess up if I'm not clear on record—is I do fundamentally disagree with some of the statements about the potential costs of QE. I think there are a number of central bankers out there who view large-scale asset purchases as just normal policy by another means. Go look at Governor Mervyn King's statements on this. He's been very clear about this, and I agree with him.

And that's what central banks traditionally did before we were targeting interest rates or when interest rates (were/weren't ?) controlled. We bought and sold government securities. So to me it's not that big a shift. There is definitely more uncertainty, the impact of QE, but it's not—it's apples and pears, not apples and oranges.

WARSH: And just a word on that, Peter, if I can. And just to be clear, I'd say that judgments that each central bank makes on the risk-reward of further balance sheet expansion is a function of a broader set of economic policies. The same central banker sitting where Adam does or where Arminio or I once sat could very well come to different judgments on that conclusion.

POSEN: That's—(inaudible).

FISHER: Yeah, thanks.

Here. There's a mic right behind you.

QUESTIONER: Yves Istel, Rothschild. I just wanted—there are obviously quite different views about what to do in the short and medium term that I hear. What do all of you think of the concept that's been increasingly bruited about targeting nominal GDP as a way of having a guideline for the next year or two or longer?

FISHER: OK. Let's each take a quick bite at that. Arminio, what do you think of --

FRAGA: I like targeting inflation better. It is simpler, and you can take into account what's happening to your economy and get a little more freedom. There's no reason to bundle them up. You're paying attention to economic activity, for sure, but I wouldn't bundle them up.

WARSH: So I share Arminio's view. Nominal GDP can be used—not necessarily by all those who propose it—but can be used as a way of saying, in effect, a little more inflation's not going to hurt anybody.

I'd say my own judgment is that central bankers may be good at broader things, as Adam described, but we do have the secret sauce to do our best to keep inflation anchored over the medium term. Once we wander into other areas that can have a huge effect on nominal GDP, then we are signing up for a set of responsibilities over which we do not have total control.


POSEN: Again, I—this is where, for all my talk about deficits, and very clearly where Kevin and Arminio are—Arminio remembers, he was one of the first to implement inflation targeting in an emerging market. He remembers when I was sent out by Bernanke in Michigan to write that book on inflation targeting. The point—I just want to expand one thing on what Kevin's saying.

I don't like the idea that there's a technical fix to our problems. I don't like the idea that if we redefine something or tweak some definition, somehow the central bankers will fix things. And I like the clarity of inflation targeting, that if you want to inflate more, you have to get the elected officials to authorize your inflating more. That's true at the Bank of England; that would be true in a formal inflation-targeting regime any place you do it.

So for me, along with just another way of saying what they're saying, let's work on the actual problems. And there are serious problems that monetary policy can't affect, and let's not pretend by tweaking our monetary regime we can get around those.

FRAGA: Price level targeting is a more interesting question.

FISHER: All right, I was going to—each get one minute on price level targeting.

FRAGA: Price level targeting is great when you're going through deflation, because it allows you to inflate a little more. And so it's appealing right now. It won't be so appealing when you go past zero and you're having some inflation and you're going to be forced to deflate. So I think we need to think about that one a little bit more. I'm not convinced.

FISHER: Anyone have different views?

WARSH: So the textbook—if we were starting brand new and we were in a calm environment and central banks were being created, I think there is fertile ground to having this discussion. But markets will view this sort of changing of (raiments ?), this sort of tinkering, at a time that there is a fundamental question about the role of central banks and the strength of our economies—will view this as trying to prove—central bankers trying to have more liberty, more freedom, trying to remove shackles that are perceived to be upon us. As a result, my own view is this is not the right time to be changing our formulas.

POSEN: I completely agree. And I just published a co-authored paper which looks at the fact that part of the reason when the Bank of England overshot our inflation target in the last couple of years—because we're accountable, because we have to keep explaining it, because that helped anchor inflation expectations, there's no technical advantage that outweighs that.

FISHER: Henny? And Mike here, and in the center here.

QUESTIONER: Thank you. Henny Sender of the Financial Times. I have a question for you, Kevin. Would you agree with the proposition that one consequence of QE here, intended or otherwise, is to put downward pressure on the dollar? And if you accept that, how concerned are you about our wave of financial protectionism, trade protectionism, and an increasing perception among non-dollar-based investors, at least, that Treasurys are no longer risk free? Thank you.

WARSH: So about six months ago, I got to answer that question by saying: The Treasury secretary handles the dollar and we're just humble central bankers, so next question. I guess I don't have the ability to do that any more, Peter. (Laughter.)

FISHER: Nope. (Laughs.)

WARSH: I would say that the academy's view, the broad view of folks at the IMF and economics departments at elite universities, is that if only the dollar were weaker, then somehow we'd be getting this improvement in GDP arithmetic, we'd have an improvement in exports and we'd be getting much closer to trend. That's not a view I share.

My own views are that having a stable currency, now more than ever, provides huge advantages to the U.S. The U.S. with the world's reserve currency is a privilege, but it is a privilege that we can't just look to history to remind us of; it's a privilege we have to earn and continually re-earn.

And so it does strike me that those that think that dollar weakness, made possible by QE as one channel for QE, is the way to achieve these vaunted objectives are going to be sorely disappointed.

FISHER: Thank you. You have a question here?

QUESTIONER: Yes, thank you. Sergio Galvis from Sullivan and Cromwell, really feeding into the same question. We have U.K, former reserve currency; Brazil, not yet ever been a reserve currency; the United States, current reserve currency. And this is really—you know, if you accept that there's an enormous national interest benefit to having a reserve currency, what is the mix between monetary policy, fiscal policy, that goes—that is—that goes to the question of maintenance or achievement of reserve currency status?

FISHER: Let's each take a crack at that for maybe one minute, and make the—(inaudible)—in a summing up.

POSEN: Past, present, maybe future, right? At least in a basket, for Arminio.

Look, the—there are benefits to being a reserve currency, but what you really care about are the benefits of being able to issue debt in your own currency and invoice trade as much as possible in your own currency. Being a reserve currency is an extra fillip on that. But the U.K. has benefitted for the last 50 years, when it's been in major relative economic decline, of still being a AAA bond, of still being a huge share in reserve portfolios compared to its size of GDP, of still being a globally traded currency.

The reason we lost the reserve currency status was part fiscal folly—I mean, for all that I've been saying, nothing I say counteracts the fact that if you have a long-term fiscal problem that eats away at the fundamentals of your economy, limits your monetary stability at best. So the fiscal policies of the '60s—fiscal policies of the '60s, '70s, '80s in the U.K. did that. But also, there's inherently an issue that if you're not controlling 25 (percent), 30 (percent), 40 percent of world GDP, you can't be a reserve currency. I mean, there is ultimately some—has to be some matching between the importance of your economy globally and your currency status.

And so that's why you can say the U.S. dollar at some point has to shift its role. The question is how orderly and how quickly, and that depends on the kinds of fiscal issues that I think we all in this Peterson Hall share. They're that the U.S. is not doing anything about its long-term fiscal position, and that is going to accelerate the decline of the U.S., including as a reserve currency, if we're not careful.

FISHER: Kevin, do you want (to put something in ?)?

WARSH: So—just a quick word. So in times like this, tough times, having the world wanting to hold dollar-denominated assets is a huge benefit to the U.S. That shouldn't be taken for granted. And if somehow policy tries to manage our risk-free rates, then we won't be seeing the signals that Adam was talking about, signals that we need to put our own house in order.

So it's a privilege, it's something that is useful. In a time that the world economy is looking for things that they can depend on, the dollar as a source of stability is of great benefit to the U.S. And we have to take this moment in time to do good things with it. And doing good things really means (the seizing ?) liabilities. And I would say, unlike many in the—in the academy, my view is we are not necessarily stuck with a new normal in the next 10 years. We are—we have huge opportunities, but we've got to take advantage of them now. And the idea that the way to take advantage of them is to goose GDP through higher net exports in the next 12 or 18 months is more of the same, rather than the fundamental reforms we need.

FISHER: Arminio.

FRAGA: I agree with both my colleagues here. I would add a couple of things quickly. One, in addition to running, you know, sort of long-term sustainable fiscal policy, which means keeping a fairly low debt-to-GDP ratio, keeping it low allows you actually to play with fiscal policy should bad things happen. But we also now have learned—and we sort of learned from history—we also need to keep, you know, healthy financial matters.

In many of the cases we're looking at in Europe, there wasn't—fiscal policy looked pretty good. And we have that—they've had that in Latin America as well, but there were other problems, say, with the financial system. And that ended up in the hands of the government. So you need to do that.

And lastly, on being a reserve currency, I find it healthy that countries compete against one another. Going in the opposite direction as to where they're going now, because I can just see for Europe, Europe would love to have a weaker euro—should, anyway—I don't know what some of the people there are thinking, but they—and so soon you will find everybody looking for a weaker currency, and that may be an opportunity, say, for China to, you know, jump in and say, you know, I'm keeping my act together and here's another possibility for you, for your portfolios and for your invoicing and whatnot.

So I think we're going into fascinating number of decades. Most of us won't—I certainly won't be around to see what'll happen. But I think the fact that countries are going to be competing against each other—that I find to be healthy and desirable, as supposed to some plan where you create some SDR basket where a bunch of people in Brussels or Washington decide what the weights are. I kind of like the market to run that show.

FISHER: On that note, let me thank my good friends for letting me press them a little more than they expected—(applause)—and thank you all.

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