Thomas P.M. Barnett :: Weblog

BRIEFING: "Central banks: The monetary-policy maze; The simple rules by which central banks lived have crumbled. A messier, more political future awaits," The Economist, 25 April 2009.

Just going to rerun the opening para's here:

In the world that existed before the financial crisis, central bankers were triumphant. They had defeated inflation and tamed the business cycle. And they had developed a powerful intellectual consensus on how to do their job, summarized recently by David Blanchflower, a member of the Bank of England's monetary policy committee, as "one tool, one target." The tool was the short-term interest rate, the target was price stability.

This minimalist formula fitted the laissez-faire temper of the times. A growing array of financial markets could price risk and allocate credit efficiently. Central bankers had merely to calibrate their interest-rate tools and all other markets would automatically adjust. Central banks still cared about financial stability and full employment, but could argue these were best served by stabilizing prices--without, if you please, interference from politicians.

The financial crisis has upended all that. The business cycle was supposedly subdued, yet the world is in the deepest recession since the 1930s. Deflation has become a more dangerous enemy than inflation; with interest rates in many countries at or close to zero, central banks had had to reach for other tools.

More fundamentally, the collapse of stable relationships in financial markets has forced central banks to make judgments they once left to the private sector. From lenders of last resort, they became lenders of first resort when banks stopped trusting each other. They are, increasingly, arbiters of which types of borrowers get credit. With the reputation of market discipline in tatters, central bankers will get vast new supervisory powers. All this is dragging central banks back towards political turf from which they had been distancing themselves for years.

Central bankers still believe that once the crisis has passed they will return to their pre-2007 roles as apolitical technocrats pulling a single lever and eyeing a single variable. It may be a vain hope. "When you question the basic premise which you have worked under for the last 15 to 20 years, which is that markets are rational and efficient, there is a case for a different approach to both monetary policy and regulation," says Thomas Mayer, chief European economist of Deutsche Bank.

The essential definition of what I long ago dubbed a System Perturbation is the permanent (as in, for the foreseeable future) resetting of rules.

The new term is "macroprudential," as in, regulators now need to view your company's behavior more in terms of its impact on the market than merely its impact on the company's bottom line. The system needs administering.

Why? Rule sets are clearly out of whack, leaving the market less trustworthy.

Does this last forever? About as long as central bankers thinking they ended the business cycle on a global basis.

Crisis never rules. It's the responses that matter.

Great explanation in five paras. It's why I religiously read The Economist.