At 46, Mark Carney manages to look both younger and older than his years. This is fitting, as his approach to the economy combines a commitment to old-fashioned central bankerly verities—sound money, prudent risks—with a modish flexibility as to how these are to be secured.
That has been an unavoidable necessity in what we should perhaps now refer to as his day job, as governor of the Bank of Canada. Gone are the days when central bankers could simply focus on keeping the so-called monetary aggregates—M1, M2, all the gang—to a fixed annual growth rate, as monetarists had advised. While this approach had succeeded in reining in the Great Inflation of the 1970s and ’80s, it eventually fell victim to Goodhart’s law, named for a former adviser to the Bank of England: namely, that the moment you target any particular measure of the money supply it loses its usefulness—because people in financial markets find ways to innovate around the constraint. Central bankers have since had to steer by a variety of other measures, even as the overall objective—stable prices—has remained unchanged.
The lesson of that experience, that policy does not consist in simply issuing a set of rules, but rather exists as a continuing process of interaction between the regulators and the regulated, appears to inform Carney’s views on the causes of the financial crisis, and how to prevent another—a subject that will be his focus in his new, part-time job as chairman of the Financial Stability Board, the international body tasked with coordinating and overseeing the reform of global banking regulations. In speeches and interviews the governor has given, a number of related themes and concerns emerge. Among them:
Markets are not inherently stable. Classical theory sees markets as self-equilibrating: any movement in one direction, toward excess supply or excess demand, sets in train forces that correct it. Carney sometimes cites his own experience as an investment banker—he spent 13 years at Goldman Sachs—in persuading him financial markets can overshoot for some time before returning to balance.
Certainly that’s his view of the excesses that built up in asset markets during the long boom that preceded the crisis. While conventional analysis blames much of the run-up in asset prices that preceded the crash on the Federal Reserve’s loose monetary policy after the 2001 recession, Carney sees it as much a product of all those years of stable growth and low inflation before: the very things central bankers are supposed to produce. The same absence of volatility, he argues, over time breeds a certain complacency among financial actors, even as the prevailing low interest rates drive them to seek out new risks in search of higher returns.
So in addition to the usual oversight role of regulators like Canada’s Office of the Superintendent of Financial Institutions (OSFI), Carney sees a complementary, “macroprudential” role for central bankers, in anticipating and, so far as possible, restraining the buildup of such “irrational exuberance.”
Avoid pro-cyclicality. If the seeds of the bust were sown in the boom, both were made worse by forces tending to exaggerate swings, rather than temper them. Among these, unfortunately, was the international regulatory regime in force at the time, embodied in a set of directives known as Basel II (named for the Basel Committee on Banking Supervision, the Swiss-based body of leading central bankers). Banks were required to set aside a certain amount of capital against their loans. But as the boom continued, and asset prices rose, so did the value of the capital, encouraging banks to lend still more, and driving prices still higher. When the bubble burst, the process was thrown in reverse, worsening the contraction.
Does the new, “counter-cyclical” set of rules, known as Basel III, risk strangling the recovery in its cradle, as some complain? Carney doesn’t see it that way. While banks are being told to increase capital ratios, they have until 2019 to do so. Where credit growth is currently weak, he argues, the constraint is one of demand, as households rebuild their savings, not supply.
Regulations are not enough. The growth in so-called shadow banking in recent decades—hedge funds and other investment vehicles that raised money via ﬁnancial markets rather than traditional deposit-taking, and as such were outside the reach of regulations set up to protect depositors—can be understood in part as an outgrowth of Goodhart’s law, that is, as a response to the regulations.
That’s not an argument against financial regulation; indeed, part of the agenda of Basel III is to bring the shadow-banking sector under the regulatory umbrella. But it does serve as a reminder, Carney warns, of the need to take into account how financial players are likely to respond to any new regulations. That’s also why regulations need to be coordinated internationally, as in Basel III, to limit regulatory “arbitrage.”
Still, regulators will always be playing catch-up: regulation, he says, is a “necessary, but not sufficient” condition. The ultimate sanction for any financial institution is bankruptcy. While the crisis of 2008 forced governments to step in to save several banks, and the current crisis in Europe may again require some sort of backstop, Carney is adamant the long-run aim must be to dispel any notion that some banks are “too big to fail”—to impress upon bankers (and those who finance them) that they, and not the taxpayers, will bear the consequences of any excessive risk-taking.
So the bedrock of a reformed financial system would be . . . responsibility for your own actions? That’s new, but hardly novel.