Commentary |
17 March 2020

The RBA's job is to back banks, not bail out gamblers

It’s quite a while since I was at the Reserve Bank, but one of my tasks there was to draft replies to letters received. So let me try my hand at responding to Christopher Joye’s "Virus gets upper hand in battle against central banks" (AFR, March 13). Originally published in the Australian Financial Review.

Stephen Grenville
Stephen Grenville

It’s quite a while since I was at the Reserve Bank, but one of my tasks there was to draft replies to letters received. So let me try my hand at responding to Christopher Joye’s "Virus gets upper hand in battle against central banks" (AFR, March 13).

Dear Christopher,

Thank you for your letters: the RBA is always open for gratuitous advice.

First, to the pandemic itself. You say that "markets have never had to price a real public pandemic". Actually, there have been a number of comparable epidemics. The Spanish flu at the end of World War I killed 30 to 50 million people. The Asian flu in the 1950s (1 to 4 million deaths) didn’t seem to affect financial markets much, but the Hong Kong flu in the '60s sent the S&P down by more than 20 per cent. What about SARS, MERS and Avian flu? If this one is having more impact, perhaps it is because financial markets have made themselves more fragile, with multiple layers of risk-taking and excessive gearing.

You want to fault governments for their containment strategies. Who is doing better – Singapore, Taiwan, South Korea and (belatedly) China, with their active containment, or Italy and Iran with their tardy inadequacies?

You say that the key problem is illiquidity. "Liquidity" is a slippery idea, with at least three different concepts. 

For central bankers, liquidity means the supply of currency and riskless central bank assets that can be used to settle inter-bank payment obligations – what the textbooks call "base money". Recently, this idea has widened a little to include riskless short-term assets like treasuries. It’s the job of central banks to ensure that there is enough of this kind of liquidity to keep the payments system working seamlessly.

Then there is the idea of liquidity as readily available credit for those who want to borrow. Banks should be ready to provide business loans and mortgages to creditworthy borrowers.

In the 2008 crisis, the US Federal Reserve's quantitative easing operations broadened this idea, making substantial purchases in the mortgage-backed securities market, vital for housing, as it had frozen. The problem was not so much illiquidity but the issue identified by George Akerlof in his famous paper, The Market for Lemons. When there are some dodgy assets in the market, buyers fear they might buy a "lemon", while sellers don’t sell because they can’t get a proper price for their non-lemons. No deals are done.

This segues neatly into the third type of liquidity: assets are "liquid" when they can readily be sold without a huge discount. In 2008, all MBS (mortgage-backed securities) assets were illiquid in that sense, even the sound ones.

You are asking the RBA to jump in where private sector investors fear to tread?

You don’t make it clear, but I think you are mainly talking about the third idea, as you cite "extreme information asymmetries". You talk about "a global liquidity crisis across both equity and bond markets". But equities and most bonds are still readily marketable. Government bonds are in such strong demand that yields are historically low.

Certainly, there are financial assets that can’t be sold for their pre-COVID-19 price and even some which, like MBS in 2008, can’t find a buyer at any price. Among them are some assets which aren’t going to recover. You warned us of fragility in credit markets. BBB credit might be downgraded so that it is no longer investment-grade, forcing sales. Riskier still are the high-yield "junk bonds".

Now you want the RBA to rescue all these markets, right across the board: "It is imperative that global synchronised monetary policy immediately offers to vouchsafe liquidity and funding to all parts of the financial system." Phew! "Vouchsafe liquidity and funding". It has a biblical cadence, but doesn’t it just mean "bail out"?

I assume you took your own advice about the vulnerability of overleveraged credit markets, so have no issues with your own portfolio. It’s really rather noble of you to argue the case for investors who didn’t bother to take your advice. But is it fair on those who were more cautious?

Lots of investors held conservative portfolios (all those pensioners, eking out their frugal existence on the low returns from bank deposits). Shouldn’t the risk-takers, having enjoyed their higher returns, now have to accept the consequences?

What are the RBA’s obligations in these circumstances? Since Walter Bagehot wrote more than a century ago, everyone accepts that it is the central bank’s job to do whatever it takes to support the core of the financial system – the banks. But banks seem in good shape, and the Australian Prudential Regulation Authority will keep a gimlet eye on them. The RBA has to make sure there is enough of the first kind of "liquidity" – the central bank money that keeps the payments system operating smoothly. This is being done.

The high-leverage credit market may be experiencing a "lemons" problem. You are asking the RBA to jump in where private sector investors fear to tread? Some of these assets will, in fact, turn out to be "lemons". If so, you want the taxpayer to bear the cost?

Global financial markets share your views: they should all be bailed out. Christine Lagarde ran into flak when she tried to make the entirely reasonable point that it wasn’t the role of central banks to close the yield gaps resulting from the market’s rational reassessment of risk. Financial market participants want a repeat of 2008, when they were bailed out. Ordinary people were so annoyed that they elected Donald Trump.

I’ve always thought of you as a believer in free markets, perhaps even in "efficient markets". Can markets operate efficiently, pricing risk, if there is a fallback central bank "put" option for any assets that markets can’t price accurately in a moment of uncertainty?

Meanwhile, the government must decide who should be helped, among the many in the non-financial real sector who are being adversely affected by circumstances that they could truly say were unforeseeable: the casual workers who have suddenly lost their jobs, the tourist industry, the small and medium enterprises whose cash flow has shrivelled, and the healthcare workers who bear the real-world risks.

Kind regards, RBA

Of course, drafts like this never get past the bureaucratic process. "Let Joye’s letter go through to the keeper," my former colleagues would insist. Instead they will send a rote reply, leaving unchallenged Christopher Joye’s view that the RBA is hopelessly incompetent and he is, as usual, uniquely prescient.