The Paradox of Risk

Leaving the Monetary Policy Comfort Zone

Ángel Ubide

• Publisher: Peterson Institute for International Economics
• Year: 2017
• ISBN:
  9780881327205
• Topic: Économie
• Subtopic: Politique monétaire

For decades, economic policymakers have worshipped at the altar of combating inflation, reducing public deficits, and discouraging risky behavior by investors. That mindset made them hesitate when the global financial crisis erupted in 2007–08. In the face of the worst economic disaster in 75 years, they often worried excessively about the risks and possible losses from their actions, rather than moving forcefully to support financial institutions, governments and people. Ángel Ubide's provocative thesis in Paradox of Risk is that central banks' fear of inflation and risk taking has hampered their efforts to revive global prosperity. In their confusion, he argues, policymakers made the recovery weaker. He calls on world leaders to abandon old shibboleths and learn the lessons from the financial crisis and its sluggish aftermath. Ubide mobilizes a wealth of research on the experience from the last decade, urging policymakers to leave their "comfort zone," embrace risk taking, and take bolder action to brighten the world's economic prospects.

1

Introduction

All courses of action are risky, so prudence is not in avoiding danger but in calculating risk and acting decisively.

—Niccolò Macchiavelli

The world crossed a financial Rubicon on March 1, 2016, though few people noticed it. Japan, the most indebted country in the world, with government debt 2.5 times its GDP, was able to borrow money for 10 years at –0.02 percent. Investors were willing to pay for the privilege of lending money to the country with the highest debt-to-GDP ratio ever recorded in modern times outside of war periods.¹

Japan was not alone. At the peak in mid-2016, more than $10 trillion bonds—more than a third of the world’s total—were yielding negative interest rates (figure 1.1). The records piled up. After the United Kingdom voted to exit the European Union, bond yields in the United States and United Kingdom, while still positive, reached all-time lows—lower than during the Great Depression or major wars. For a brief period, the whole yield curve in Switzerland, all the way to the 50-year maturity point, was trading at negative yields. Several major central banks—including the European Central Bank (ECB), Bank of Japan (BoJ), Swiss National Bank (SNB), and Sveriges Riksbank—were charging commercial banks negative interest rates on their cash deposits. It was the world upside down.

It was not supposed to be this way. Before the 2007 financial crisis struck, the overwhelming consensus among economists was that we understood well the dynamics of the economy, that we had been able to domesticate economic fluctuations with economic policies, that we had tamed the business cycle. We were not humble, and we called the economic period since the mid-1980s “the Great Moderation.” We were certain to be able to avoid the policy mistakes that had cost Japan its lost decade of weak growth and very low inflation that followed the burst of its asset bubble in the late 1980s.

Figure 1.1 Market value of bonds with negative yields, 2010–17

Source:Bloomberg.

We were wrong.

A decade after the financial crisis shook the foundations of the global economy, the world is beginning to climb out of its economic trough. Central banks deployed a massive effort, with the combined balance sheets of the Federal Reserve, ECB, BoJ, Bank of England (BoE), SNB, and People’s Bank of China ballooning to more than $18 trillion dollars—equal to more than 20 percent of the world’s GDP.

The effort paid off. The feared deflationary spiral did not materialize, the expansion in the United States is already the third longest of the post–World War II period, and some economies are back to near full employment. But, overall, the world struggles to leave what Christine Lagarde, the managing director of the International Monetary Fund (IMF), has christened the “new mediocre.” Stock markets and confidence indicators increased after Donald Trump’s victory in 2016, celebrating the higher likelihood of fiscal stimulus, and global interest rates increased. Once the smoke cleared, however, little had changed. By mid-2017 interest rates remained very low and still negative in some regions, core inflation was still below target in most developed countries, and global growth expectations had picked up only modestly.

The Paradox of Risk

This book tells the story of how the world got stuck in this environment of low or even negative interest rates through the dialectic of the actions of monetary policy and the reactions of financial markets. It describes how policymakers got trapped in a paradox of risk.

When the crisis erupted and central banks and governments were called to fix it, they hesitated. Their main goal was to minimize the risk they were taking and the possible losses from their actions, rather than maximizing the benefit of their policy decisions. By confusing prudence with avoiding risk, they made the recovery riskier.

How did this paradox of risk happen? The very scary experience of the financial crisis created a sharp increase in risk aversion. Many people had lost their savings and their jobs, many banks and firms had gone under. Fundamental pieces of the financial system that had been taken for granted, such as the availability of liquidity in interbank markets or the ability of firms to issue commercial paper, had temporarily evaporated. It was as if, all of a sudden, water no longer flowed from the taps. Like soldiers returning from the battlefield, households, firms, and financial markets suffered an economic and financial version of posttraumatic stress disorder. Instinctively, people became more risk averse. They looked to the public sector-central banks and governments-for protection, for assurances that everything would turn out all right and that they could go back to their normal lives.

But central bankers and governments were also scared and, to some extent, unprepared. Central bankers had been educated to be conservative, to always aim for lower inflation and less risk. They had earned their credibility fighting the inflation of the 1970s and being vigilant about the risks of financial market exuberance of the 2000s. In Europe they had adopted the additional role of guardians of economic policy rectitude, relentlessly lecturing governments on the need for more fiscal adjustment, structural reforms, and competitiveness gains. Central bankers arrived at the crisis with the conviction that their job was to take the punch bowl away when the party was starting, as the legendary central banker William McChesney Martin quipped. They did not realize that their job now was to spike up the punch to ensure that the party would not end. These mental shackles were often difficult to escape.

The conservative nature of central bankers created a paradox of risk. Faced with a new world of deflationary fears and heightened risk aversion among households, firms, and investors, central bankers had to take risks and provide insurance on the economic outlook, to convince markets that they would do whatever it took to restore growth and inflation. The more insurance central banks provided, the better their policies worked. Yet, concerned about taking too much risk, they often dithered and took only half-measures. Too often, they worried more about when and how to remove the stimulus than about providing the right amount of stimulus, often yielding to political pressures advocating against decisive action.

These political constraints were particularly strong in Europe. For example, the early decision by the ECB to prioritize liquidity provision to banks instead of engaging in large-scale government bond purchases was heavily influenced by strong opposition to asset purchases by German political figures, who cared more about the potential negative impact of asset purchases on fiscal discipline than about supporting the economy with the right amount of stimulus. By the time the ECB finally started buying government bonds, much economic damage had been done.

This widespread hesitation in providing stimulus is largely responsible for the weakness of the global economic recovery. Fed researchers estimate that it accounted for 30 percent of the contraction in GDP in 2009 and an even larger fraction of the slow recovery that followed (Gust et al. 2017). The recovery saved the world from a second Great Depression, but it was not the recovery that could have been possible had central banks been free of their mental shackles.

The paradox of risk did not apply only to monetary policy. No central bank operates in a vacuum. The consensus narrative of the causes of the crisis was built around the concept that “debt is bad.” That notion had two pillars: (1) excessive financial debt led to the financial crisis and (2) excessive fiscal debt led to the euro area crisis and the Greek default. Thus, the consensus argued, debt had to be reduced at all costs. This narrative encouraged private sector deleveraging and fiscal austerity and constituted a strong headwind for monetary policy. After a coordinated, albeit modest and transitory, fiscal expansion in 2009, governments across the globe prematurely declared victory and moved on to fiscal tightening.

The mistaken European strategy of using the threat of sovereign debt defaults as a disciplinary device for the governments of the euro area countries in crisis added to the “debt is bad” narrative, creating an environment in which politicians preferred to cut deficits first and ask questions later, advocating fiscal austerity at all cost to avoid “becoming Greece.” Learning from fearful experiences is much faster and creates more persistent effects than other forms of learning (Lo 2017). The fear of default, however irrational, overwhelmed everything.

As it had happened to the central bankers with their anti-inflation worries, this overarching focus on fiscal discipline was based on sound analysis applied to the wrong reality. The mental shackles were at play here as well. Governments and politicians had been educated on a precrisis consensus built on two pillars: (1) fiscal policy should focus on long-term sustainability and leave the management of the business cycle to monetary policy and (2) fiscal contractions were often expansionary, as they lowered interest rates and boosted private sector confidence. This conventional wisdom was correct for a world of small output gaps and positive inflation and interest rates. It was not appropriate for the postcrisis world of very large output gaps, zero interest rates, and very low inflation. In this world, interest rates had little room to decline, and there was no confidence to be gained from austerity. Tightening fiscal policy excessively and prematurely weakened the economy and diminished the effectiveness of monetary policy. Seeking to reduce debt-to-GDP ratios, governments often weakened GDP and increased debt-to-GDP ratios. Like their central banking colleagues, governments and politicians confused prudence with avoiding risks, inadvertently making the environment riskier.

The obstinate focus of the Republican Party on public spending cuts in the United States and the staunch German opposition to a mutualization of euro area fiscal policy that could alleviate deficit reductions in crisis countries are vivid examples of this confusion. It was a textbook case of “motivated reasoning” (Epley and Gilovich 2016), with political goals commanding attention and a selective reading of the evidence guiding reasoning at the expense of accuracy. Retail politics prevailed over economic needs, and fiscal policy became a strong headwind for monetary policy.

This conflict between monetary and fiscal policy is not new. The United States faced the opposite situation in 1981. Two years after Paul A. Volcker, chair of the Federal Reserve in the early years of the Reagan administration, began tightening monetary policy, inflation was proving difficult to tame, because President Reagan was embarking on tax cuts and military spending increases that expanded the fiscal deficit. When Reagan met Volcker for the first time after he became president, he asked him about the rationale for having a Federal Reserve in the first place. Volcker is said to have replied: “We are the only game in town right now fighting inflation. . . . Once the budget gets under control, we’ll have a better shot at taking the pressure off of prices” (Mallaby 2016, 263). The political pressure against Volcker’s monetary tightening mounted as the recession got deeper. A return to the gold standard was debated.

The lesson was then, and it is now, that it is dangerous for governments to hide behind the central bank and make monetary policy the only game in town. Not surprisingly, governments and politicians ended up disliking the central bank activism they were responsible for.

Of Boring Central Bankers, “NICE” Economies, and the Power of Narratives

Before the crisis there was clear consensus that a “successful central bank should be boring.”² Yet, since 2007 it has been anything but boring, a reality that is likely to persist for decades.

Central banking was expected to be boring because the economy was enjoying the Great Moderation, the period between the mid-1980s and 2007 that witnessed a dramatic decline in the variability of output and inflation. Back then, with stable inflation, output near potential, and smooth business cycle fluctuations, managing the economy was easy. Simple rules were very good approximations of the process that determined the setting of interest rates, making monetary policy rather predictable. All that central banks had to do was to adjust short-term interest rates in a very gradual manner and wait for the effect to trickle down to the real economy in a predictable way. Back then, cutting rates by 50 basis points was considered “aggressive.” Mervyn King, the governor of the BoE, coined an acronym for this world: the NICE (noninflationary, consistently expansionary) economy.³

That NICE economy is ancient history. The brutality and persistence of the crisis; the unexpected linkages across markets, countries, and financial institutions; and the many policy mistakes along the way have created deep scars that will affect the behavior of economic agents for decades. Old paradigms have been replaced with a web of overlapping and competing narratives that affect the behavior of the private sector, governments, and regulators in a persistent, and sometimes perverse, manner. As Nobel Laureate Robert Shiller said, “We have to consider the possibility that sometimes the dominant reason why a recession is severe is related to the prevalence and vividness of certain stories, not the purely economic feedback or multipliers that economists love to model.”⁴

This perversity occurs because narratives drive attention, and elevated attention can easily lead to the misleading impression of causality. In his book Pre-suasion: A Revolutionary Way to Influence and Persuade, Robert Cialdini, one of the most prominent researchers in the field of psychological influence and persuasion, writes that “what is focal is causal.” In experiments in which people were asked to observe conversations between two people that had been carefully scripted so that no one was leading the discussion, observers overwhelmingly concluded that the person whose face was more visible was the leader (Cialdini 2016). People assign causal properties to the narratives that drive the news.

The causal links created by this web of narratives have reduced the effectiveness of monetary policy, in two main ways. First, they have increased risk aversion in a persistent way and across the board. Having missed the crisis and underestimated the severity of its impact, economists, policy-makers, and market participants now feel the obligation to consider all possible downside risks. A “not on my watch” narrative has developed. Risk managers must ensure that firms can withstand another shock of the size and persistence of the post-Lehman downturn, however unlikely such a shock may be. Politicians and policymakers must ensure that they are covered against the consensus political narrative of the causes of the crisis: “debt is bad.” They thus argue for fiscal discipline and regulatory tightening of the financial sector at all costs, so that another crisis does not happen on their watch. Economists must consider all possible interlinkages and, in case of doubt, always warn about downside risks.

The failure to predict the crisis had a persistent impact on the way economic expectations are formed, developing an “it looks wise to be gloomy” narrative. Risk management is an exercise in imagination; wha...