November 18, 2007

Central Bank Transparency and Speculation

Comparing the levels of transparency in the US and UK central banks, Michael Shedlock, of "Mish's global economic analysis", writes:

Now that's candor and true transparency. In the UK, rate cuts are "penciled in" while the Fed disingenuously calls the risks balanced. In the UK there is talk of falling commercial real estate prices. In the U.S. the Fed knows commercial real estate is staring over the abyss but no one talks about it. While King says financial turmoil is "far from over", the Fed's Poole says "the market is healing".

I beg to differ. Even if Mervyn King is now talking straight, it does not deserve the name of candor and transparency. King has started to talk about the problems now that the problems are already self evident. He would make an ass of himself, if he was still trying to talk up the situation.

Compared with the people at the Fed, he is, of course, a paragon of virtue. The general US belief in the power of jawboning is quite ridiculous, and a fitting symbol of the insubstantial nature of the conceptual US economy. In the typical American mental state, only marketing is important, whether it is related to economic or political products.

If there was real wisdom and responsibility in the central banks, they would start talking when the problems are building up, not when a catastrophe can no longer be avoided. Mish writes:

Does anyone ever recall Bernanke, Paulson, Bush, or for that matter any Fed governor actually giving a genuine warning about possible economic malaise? Compare and contrast all of the above with the following.

Alan Greenspan had a moment of candor, when he tried to take up the issue of "irrational exuberance" in the early rising side of the dot-com bubble in December 1996. Unfortunately he was too weak to resist the shouting down by people with vested interests in blowing up the bubble.

So now Mervyn King is talking, when the damage has already been done and a catastrophe is imminent. Words of caution would have been so much more useful, if they had been uttered in the height of the hubris. But it takes a lot of courage to speak against a prevailing trend.

Central banks should be proactive in working against trends that have no cause in the underlying fundamentals. They should be actively discouraging useless speculation. It's a hard and ungratifying job, but price stability is in the interest of everybody in the long term.

Mish quotes an article from Bloomberg:

Bernanke said yesterday that Fed officials will add a third year to their forecasts and double the frequency to once a quarter. The reports will give investors and companies more details on why interest rates were adjusted and offer a map for where they are likely to go.

In promoting price stability, central banks should use their statements as a means of spreading information about fundamental aspects that have an indisputable effect on the values of assets. In this sense, the move to even longer term forecasts in central bank statements is a negative.

Central banks should discourage investment that is too heavily based on forecasting. They should have their focus on intrinsic values, and speculative trends that go against it. They should be making it clear that whenever they see excessive speculation, they will move against it. And they should back up their words with action, withdrawing the means of continuing speculation.

To make it clear, I am not promoting a tighter monetary policy at this state of affairs. The time of tightening has long gone. The credit market has already been forced to tighten itself dramatically. It is exactly this situation, where excessive looseness has resulted in a forced tightening at the worst possible time, that could have been avoided by a tighter monetary policy a few years earlier.

But the Fed should be honest about the situation. Even if it means a more rapid crash. A rapid crash might actually be better, because normal economic activity would return sooner, and the losses would be incurred by the speculators that deserve them. In fact, it would be best, if the crash in paper values would be so quick, that the real economy would not have time to react.

If the decline in paper values is prolonged, there will be a sustained deadlock of actual economic activity, and that would not be in the interest of the general public. This deadlock is currently happening the US housing market, where the gap between the buyers and the sellers has brought the market to a virtual standstill. The quicker the sellers come to terms with the situation, and capitulate on their bubbly asking prices, the quicker the market comes back to life.

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