Four years ago, Zoltan Pozsar helped change how policy makers visualise the financial world when he worked with colleagues at the New York Federal Reserve to create a gigantic wall map of shadow banking. Astonishingly, it was the first time anyone had laid out these financial flows in detailed, graphic form. And by doing that, the NY Fed researchers showed why the sector mattered – and why policy makers needed to rethink how the financial ecosystem did (or did not) work.
Now Pozsar has left the NY Fed and teamed up with Paul McCulley, the former investment luminary of Pimco (and the man who coined that phrase 'shadow banking') to tackle another issue. But this time, it is not securitisation they want to map – but 'helicopter money', or quantitative easing.
For Pozsar and McCulley argue that just as we needed to rethink finance five years ago, we now need to embrace a new mental map of central banks. For while there has been a widespread assumption that central bank independence is always a good thing, they argue, this paradigm does not hold true. "As long as there will be secular debt cycles, central bank independence will be a station, not a final destination,” they insist.
And while that assertion will horrify some commentators, the map provides a timely device to stimulate debate; and doubly so given the splits inside the Federal Reserve about the merits of quantitative easing – and the policy dilemma besetting the European Central Bank, as the European economy ails.
The key issue at stake, Pozsar and McCulley argue, is that long-term debt cycles tend to produce diametrically opposed states of the world, in two different fields, which can be plotted as axes on a graph. Sometimes private sector creditors are in a 'leveraging' mode; sometimes they are 'deleveraging' instead. So too with public policy: sometimes fiscal policy is restrictive (via austerity); sometimes it is stimulative (ie governments are borrowing).
If you plot those two factors as two different axes on a chart, you get four quadrants, representing different points in economic history. When public and private activity is stimulative, there is a credit boom (which central banks need to rein in by damping inflation). When you have deleveraging in one sector, the pattern is mixed. But when both the private and public sector are deleveraging, there is often deflation and a liquidity trap: borrowers do not want to borrow, no matter how cheap money becomes, making monetary policy less effective.
So, Pozsar and McCulley argue that in this fourth quadrant we need to embrace a mental flip. Instead of considering central bank independence to be a good thing, because it prevents inflation, central banks need to lose that independence, and work under finance ministries instead. Monetary policy and fiscal expansion must both be stimulative, since loose money alone will not work. Thus the central bank needs to monetise the public debt by buying lots of government bonds, say, or take other steps to co-ordinate fiscal and monetary measures.
Now a cynic might suggest that some Western central banks have already done this, by accident, if not design; the Fed has been gobbling up treasury bonds. Indeed, in 2003, before becoming Fed chairman, Ben Bernanke himself observed that it is "important to recognise that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation... the virtue of an independent central bank is its ability to say "no” to the government. [In private deleveraging cycles], however... greater co-operation for a time between [central banks] and fiscal authorities is in no way inconsistent with the independence of the central banks.”
But I doubt that Bernanke would choose such language today; in the current climate, particularly in the US, "monetisation” is a dirty word. Most Western governments are committed to fiscal austerity. And there is so much political fragmentation in the eurozone and the US that it is hard to imagine anybody actually developing a proactive and rational plan to co-ordinate monetary and fiscal policy.
As Pozsar and McCulley also show, history provides ample evidence that policy paradigms can sometimes shift. In the years after the second world war, central banks effectively lost their independence, when the West embarked on financial repression. In the interwar years, central banks lost control even more dramatically, as crises hit Germany.
We are not in the same place today: the US, say, faces modest inflation, not deflation. But it would be a bold investor who would assume history could never be replayed, if the economic crises grind on.
If there is one thing we learnt in the 2008 financial crisis, it is that events which once appeared unimaginable do sometimes occur. In retrospect, the only reason we were surprised by events was that we had a bad (or limited) mental map of how the world worked. Shadow banking was one case in point. It is unlikely to be the last.
Copyright the Financial Times 2013.