Insight: Why policymakers should have known better

Clients frequently tell me they are puzzled that policymakers allowed such a significant crisis to develop. Their incomprehension is deepened by the recognition that, in recent years, many countries made their central banks independent, and these are typically run by people with formidable reputations as academics.

I wonder if a common thread running through many of the policy mistakes is a belief in the Efficient Markets Hypothesis (EMH).

Over the past decade, while the bubbles were emerging, it was frequently argued that central bankers have neither more information nor greater expertise in valuing an asset than private market participants. This was often one of the primary explanations for why central banks were not attempting to “lean against the wind” with respect to emerging bubbles.

As I argue in my recent National Institute article, had central banks raised interest rates by more than was justified by a fixed-horizon inflation target while house prices were rising above most conventional valuation measures, it is likely that the size of the eventual bubble would have been smaller. At least as importantly, because of the fear of being seen as ‘market-unfriendly’, fiscal and regulatory policy did not lean against the wind either. Our economies would plausibly have exhibited greater stability if tax policy were used in an anti-bubble fashion (eg a counter-cyclical land tax) and if regulatory policy were more activist (eg a ceiling on loan-value ratios) and contra-cyclical (eg time-varying bank capital requirements).

Once the recent bubbles burst in 2007, some central banks (eg many of those in Europe) were surprisingly slow to cut interest rates, and this policy mistake may well lead the current recession to be longer and deeper than it might have been. One reason for their reticence in cutting rates was the significant rise in commodity prices. In relying on the EMH yet again, policymakers used longer-dated futures prices for these commodities in preparing their inflation projections. Their failure to allow for the then widely-discussed possibility that a “bubble” had developed in the commodity markets thereby led them to significantly overestimate prospective inflationary pressures.

Recently, the Nobel laureate, George Akerlof has, with Robert Shiller, argued that Keynes’ explanations for excessive financial market volatility and depressions relied importantly on the possibility that individuals can act irrationally and for non-economic reasons. However, modern-day “Keynesian” models of the economy typically ignore this essential insight and can therefore be a deficient tool for setting policy. Personally, I find this neglect of Keynes surprising as at least some fund management companies (including the hedge funds I help manage) assign an important role to this insight in their investment process.

This failure to incorporate the role of what Keynes described as “animal spirits” might well have permitted the naïve belief that recapitalising the banks would lead them to lend again. Once “confidence” evaporates, banks will not lend however well-capitalised they may be. Unsurprisingly, governments are now having to explore other ways of making banks lend, and one has to wonder whether they might be driven to full-scale nationalisation.

Of course, because of “animal spirits”, one can find that monetary policy becomes surprisingly ineffective in slumps. Hence, although it is laudable the Bank of England has cut rates significantly in recent months, we would all have been much better off if it had reduced rates more pre-emptively. Now we will need so-called quantitative easing with, perhaps, the Treasury guaranteeing assets acquired by the BoE.

This financial crisis should not have surprised anybody: financial history is littered with examples of bubbles, manias and crashes.

The key lesson is that our monetary, fiscal and regulatory policies must be designed to protect the many innocent people in the rest of the economy from the consequences of excessive financial market volatility.

The writer is the CEO of Wadhwani Asset Management, and a former member of the Bank of England’s Monetary Policy Committee.