Robert J. Shiller
Central bankers around the world failed to see the current financial crisis coming before its beginnings in 2007. Martin ?ihák of the International Monetary Fund reported in July 2007 that, of 47 central banks found to publish financial stability reports (FSRs), “virtually all” gave a “positive overall assessment of their domestic financial system” in their most recent reports.
And yet, although these central banks failed us before the crisis, they should still play the lead role in preventing the next crisis. That is the conclusion, perhaps counterintuitive, that the Squam Lake Group [http://squamlakegroup.org/], a think tank of 15 academic financial economists to which I belong, reached in our recently published report, Fixing the Financial System.
Macro-prudential regulators (government officials who focus not on the soundness of individual financial institutions, but rather on the stability of the whole financial system) are sorely needed, and central bankers are the logical people to fill this role. Other regulators did no better in predicting this crisis, and are even less suited to prevent the next.
David Cameron’s new government in the United Kingdom apparently came to the same conclusion when it announced plans to transfer regulatory authority from the Financial Services Authority (FSA) to the Bank of England.
But agreement about the regulatory role of central banks is not widely spread. In the United States, for example, there is recognition of the importance of macro-prudential regulation, but not of giving this authority to the Federal Reserve. The newly passed US financial-reform legislation entrusts macro-prudential policy to a new Financial Stability Oversight Council. That is good, but the US Treasury secretary will be the council’s chairman, and the Fed, despite gaining some new powers, will for the most part be only one of many members.
The head of the council is thus a political appointee who serves at the pleasure of the president. Recent history shows that political appointees often fail to take courageous or unpopular steps to stabilize the economy. A modern US president certainly remembers how difficult it was to convince voters to put him where he is, and is perpetually campaigning to maintain approval ratings and to preserve his party’s prospects in the next election. The Treasury secretary is part of the president’s team, and works next door to the White House.
George W. Bush won the 2000 election, despite losing the popular vote. In 2003, Bush chose as his Treasury secretary John W. Snow, a railroad president who, as Barron’s columnist Alan Abelson put it, “may not be the sharpest knife in the cabinet.” Snow obliged the president and gave unquestioning support to his policies until leaving office in 2006, just before the crisis erupted. Under the new law, Snow would have been in charge of the stability of the entire US economy.
One theme that Bush found resonated with voters in his 2004 re-election campaign was that of the “ownership society.” A successful economy, Bush argued, requires that people learn to take responsibility for their actions, and policies aimed at boosting home ownership would inculcate this virtue on a broader scale. That sounded right to voters, especially if it meant government policies that encouraged the emerging real-estate bubble and made their investments in homes soar in value.
Snow echoed his boss. “The American economy is coiled like a spring and ready to go,” he chirped in 2003. Two years later, near the very height of the bubbles in the equity and housing markets, he declared that, “We can be pleased that the economy is on a good and sustainable path.” But, to Bush’s credit, he also brought in Ben Bernanke in 2006 as Fed Chairman. Not part of Bush’s team, Bernanke was protected from political pressures by America’s long tradition of respect for the Fed’s independence. The choice of Bernanke, an accomplished scholar, apparently reflected Bush’s acceptance of the public’s expectation of a first-rate appointee.
The same problems occur in many other countries. People who are chosen in part to win the next election often find their economic judgment constrained. A news story in 2003 reported, for example, that Australian Secretary to the Treasury Ken Henry had warned of a “housing bubble” there, but then quickly tried to withdraw his comment, saying that it was “not for quotation outside of this room.” He did earlier this year finally propose new tax policy to slow the still-continuing Australian housing bubble, but now he can’t get his government to implement it.