Randall S Kroszner, professor of economics at the University of Chicago Booth School of Business, compared the responses of the Federal Reserve, the Bank of England and the European Central Bank to the financial crisis when he addressed a large audience in London last night. His talk drew a big crowd for good reason. Kroszner was a governor of the Federal Reserve from March 2006 to January 2009, saw the financial crisis hit and helped chairman Ben Bernanke develop the extraordinary measures to offset its consequences.
A spry figure with a sharp sense of humour, Kroszner recalls being confronted by a phalanx of wire-service reporters at his first public engagement at the Fed and resolutely informing them that, just two weeks into the job, he would have nothing to say about monetary policy.
Dutifully the reporters sent the headline around the world: New Fed governor says nothing.
The lessons Kroszner took away from his time at the Fed arent all so amusing. The first concerned the limits of its capacity.
Central banks are much less powerful than we thought, he says. They can put liquidity into a banking system, but when the banking system is broken that doesnt do much good.
Hence, he recalls, the Fed found it first necessary to invest in specific markets commercial paper, mortgages to expand the list of counterparties with which it dealt, the collateral it would expand funding against and the maturities over which it would provide it all to stave off the threat of deflation that gripped the Federal Reserve at this time. He points out that the Feds balance sheet expanded from $800 billion to $3 trillion in three years, taking the worlds leading central bank into uncharted territory from which the return path is hard to discern.
He retains a central bankers caution. It looks for now as if the Fed has succeeded in preventing deflation. Kroszner reminds those in his audience celebrating strong recent figures for employment and economic activity in the US that we have seen false dawns before, in 2010 and early 2011.
Each time, encouraging signs in the job market were reversed, eventually leading to QE II in 2010 and Operation Twist last year.
While contrasts are often drawn between the US response to the crisis and that in Europe the US has not yet done much in the way of fiscal austerity Kroszner sees mainly comparisons with the Bank of England and the ECB.
Mario Draghi, since taking over from Jean-Claude Trichet as ECB president, has also expanded the ECBs balance sheet, widened the collateral it will fund against and extended maturities. Now, while many market economists predict take-up from the second LTRO next week at between 250 billion and 500 billion, Kroszner suggests it could be bigger.
I think the next tranche could be in the trillions, he says, with many European banks coming to fund a very large fraction of their balance sheets with these funds at 1%.
He points out: The ECB has shown itself to be the only fiscal agent for the eurozone capable of sharing profits and losses among member states.
He warns that he sees potential for enormous litigation around the ECBs insistence on not sharing private-sector bondholders losses on Greek sovereign bonds.
On regulation, he is particularly aggrieved that more has not been done to protect the world financial system against exposure to failure of systemically important financial institutions.
We have not addressed the fundamentals, which is that markets are vulnerable to failure of even small institutions like Bear Stearns bringing down others.
A capital surcharge for Sifis doesnt address this. We need to focus much more on strengthening market infrastructure in areas such as OTC derivatives and especially repo. Dodd-Frank doesnt even touch repo and yet its more important than any market Dodd-Frank did touch.