-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and "bubble" forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

– Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own –

Dollar bears have been disappointed by the G20.

Talk of re-balancing remained just talk; the bears can discern nothing substantial. Some risk is being taken off and dollars bought back selectively. While the dollar’s general downtrend is intact, there are risks of a temporary reversal, with some seeing the euro temporarily back to $1.4500/50.

Traders can contrast G20 with the Plaza Accord in 1985 which was driven by U.S. Treasury Secretary James Baker’s persistence. But he only had to convince four peers. G20 is and will be a different story. Dealing with the G20 must be like herding cats.

Disappointment over G20 has come at an inauspicious moment. Extensive short dollar foreign exchange positions have been underpinned by the unparalleled provision of dollar liquidity by the world’s central banks.

The market has used that dollar liquidity to fund purchases of other currencies and assets. Currency speculators raised their bets against the dollar in the latest week to the most since March, 2008, data from the Commodity Futures Trading Commission on Friday showed.

But the market is realising that the major central banks are contemplating the initial steps in their exit strategies, which would naturally reverse the dollar-funded carry trade.

The liquidity bonanza that has ignited the asset market rallies is going to be pared back. Last week’s withdrawal of some emergency facilities that are deemed to be no longer needed was the first step.

Federal Reserve Governor Kevin Warsh added fuel to the fire asserting “policy likely will need to begin normalisation before it is obvious that it is necessary, possibly with greater force than is customary”.

Seemingly Warsh is not expecting the “softly softly” approach of former Fed Chairman Alan Greenspan in his post-dot com bust tightening cycle that started in mid-2004 and lasted for two years.

Market players who are using the dollar as a carry currency will note Warsh’s comments and may trim back their short dollar positioning.

The yen’s strengthening to 88.23 yen against the dollar today should be seen in the same context, as a trimming back in carry trades by Japanese retail investors, who by and large remain wedded to the U.S. currency.

The market will ultimately want to target the year’s low of 87.15 yen and ultimately the all-time low of 79.80 yen, seeking to tempt Japan’s Ministry of Finance into a reaction.

In an atmosphere where the new Japanese government seems somewhat indifferent to yen appreciation, the market has delivered general yen strength. The headlines focused on dollar/yen but traders reveal that much of the emphasis was on the liquidation of cross yen trades such as euro/yen.

Risk trades have buoyed equity markets as well as fuelling short dollar positions on the foreign exchanges. Risk trades are predicated on the assumption that government economic stimuli will promote self-sustaining recoveries. If that assumption is faulty, then the positions will need some unwinding.

However, traders are now realising that programmes like “cash for clunkers” are merely cannibalising future purchases. Consumers will respond to incentives, but without those incentives they prefer thrift. Lengthening job queues are keeping purse strings tight.

There is therefore a growing belief that the dollar may find passing strength as positioning is adjusted, which traders would see as an opportunity. Proprietorial traders will welcome the unwind and look to take advantage of any such move. Their longer-term view of further dollar weakness is undimmed.

The U.S. national interest remains focused on re-balancing. The exclusion of Mexican trucks from U.S. roads and the imposition of tariffs on cheap Chinese tyres may be dismissed as sops to President Obama’s union backers.

Yet they betray a wider agenda to revive American industrial activity. A lower dollar, even if that hasn’t worked in the past, will be an integral part of that re-balancing act.

While the dollar may therefore draw some transient strength from position adjustment, dollar bears will see the euro around $1.4500 as opportunities to buy the single currency. Moves above $1.5000 are still envisaged.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The recession will soon be dead, laid to rest alongside the idea of the “Great Moderation”, a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

Economists, observing that since the 1980s recessions have been mild and short and expansions long and robust, developed the theory that better economic management, namely cutting rates in the aftermath of bubbles, globalisation and, get this, improvements in financial markets, had led to a sort of best-of-all-possible-worlds “Great Moderation”, in which economic volatility fell and with it the risk premia required for holding financial assets.

This little theory has, needless to say, come somewhat unstuck during the current downturn which has been great but far from moderate.

This raises the uncomfortable possibility that the last 25 years of good times were just a bit of luck, or even worse, an artificially engineered consumption binge with central banks and governments playing a role similar to what Chicago tavern keepers used to do — opening up early so last night’s patrons can have a quick nip to take the edge off on the way into work.

It’s a debate which is far from academic and its outcome will influence much more than the actions of central bankers and regulators.

While financial market volatility has been a feature during the past decades, the idea, or at least the feeling, of the Great Moderation has seeped into the culture, influencing the behaviour of actors across the economy.

A corporate manager is going to be more likely to leverage up and go for the big hit if he feels as if most recessions are mild and short, in the same way that a consumer will buy a boat on credit or an investment property for the same reasons. If the weather never gets that cold why waste money on insulation?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

This is really about volatility, which, because it can tend to ruin you, is expensive. Most investment or economic management strategies have at their heart attempts to limit or cushion volatility. And so, if we really can expect more volatility in the economy we can expect it to find expression in a lower ceiling for economic growth, leverage and asset prices.

IT AIN’T NECESSARILY SO
Of course, the current debacle may be just one data point rather than a trend, a view financial markets seem to have adopted. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

This thinking lies behind the strategy of making financial conditions so easy that people are tempted to borrow and invest. It just might work, and we just might have a sharp and long recovery which generates enough revenue to pay off the public debts we are now racking up.

But two other possibilities, both speculative, spring to mind.

One is that deleveraging proves to be not just an event but a state of mind. As in Japan, people may simply decide that they’ve had enough risk, thank you very much, leading to a weak recovery, a relapse and then a quandary about how best to pay off the bills we’ve recently run up.

The other is that the current mix of policy, deep cuts in interest rates, deficit spending and quantitative easing, the effects of which are little understood, ends up breeding volatility of its own, probably in inflation.

The cost of that volatility will be an unpleasant surprise to the investors now bidding up the prices of shares and managers now preparing to invest for expansion, and one that might lead them to at last act more conservatively.

Add to arguments for a new “Great Immoderation”  that emerging markets will almost certainly be more of a driver of global economic growth under most of the reasonable scenarios in the coming decade. Emerging markets historically are more volatile and if as they grow to be a bigger piece of the pie are likely to make overall growth more volatile.

None of this takes away from the essentially good news that the recession looks to be ending soon, but higher economic volatility will hang heavy over the recovery and the cycle to come.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

– John Kemp is a Reuters columnist. The views expressed are his own –

The bond market’s adverse reaction after the Fed announced no new asset purchase facilities or bond buyback programs highlights the fundamental difference between interest rates and quantitative easing (QE).

Rate cuts provide ongoing support for an indefinite period until the Federal Open Market Committee chooses to reverse them. In contrast, QE programs provide a one-off, time-limited boost that has to be continually reapplied to have the same effect.

With interest rates a decision to leave rates alone represents “no change” in policy; with QE, a decision to leave the scale and duration of the buyback program unchanged is a “tightening”.

QE is time-limited because it drives up bond prices and cuts yields only as long as buybacks continue, or are expected to do so. Once planned buybacks have been completed, or are not expected to be extended, the market will revert to its natural clearing equilibrium. Repeated doses of QE are needed just to keep yields unchanged.

This creates something of a dilemma for policymakers in both the United States and the United Kingdom. The Bank of England’s program to buy 75 billion pounds worth of government and corporate bonds will be completed in mid-June. The Fed’s program to buy $300 billion of medium and long-term U.S. Treasury securities finishes in September.

Once the current round of purchases are complete, both central banks will have to decide whether to embark on another one (intensifying criticism about inflationary financing of public debt) or end it (triggering a sharp yield increase).

In fact, yields will start rising well ahead of the formal end of the programs, unless the Bank and the Fed give a clear signal they will undertake further purchases.

The dilemma is especially pressing for the Bank of England given the imminent expiry of the current round. Officials will come under pressure to clarify their intentions at next week’s Monetary Policy Committee meeting. But the Fed too will face growing pressure over the summer to signal whether the existing programme will be extended beyond September.

It was the Fed’s failure to announce new and larger QE programs yesterday, and the implication that current support might expire in a few months, that caused the bond sell off overnight. Yields on 10-year U.S. Treasuries jumped to 3.16 percent, the highest since Nov. 2008 on Thursday, undoing all of the gains since the Fed announced its QE programme last month.

Terminating QE programs and not replacing them would amount to a sharp tightening of policy and trigger a large, destabilising rise in yields. So the central banks might opt to scale them back instead — continuing to buy debt, but in progressively smaller quantities — as a smoother way to withdraw exceptional support.

The problem is that if QE programs are not withdrawn fairly soon, they risk breaking down anyway under the weight of their own internal contradictions. Because the longer programs run, the more debt central banks will monetize, and the more fears of an eventual inflationary breakout will grow.

Eventually upward pressure on yields caused by increased fears about inflation will offset the downward pressure from QE purchases, neutering the programs’ effectiveness. At that point, ever larger quantities of QE will be needed to achieve the same degree of yield reduction or stabilization.

QE may have bought the central banks a little time but returns will diminish later in the year. The sooner they can articulate a managed retreat the more likely they are to retain some influence over the back end of the yield curve.

– Kenichi Kawasaki is managing director and senior analyst at Nomura Securities’ Financial and Economic Research Center. The views expressed are his own –

The G20 leaders failed to come up with any concrete policy steps to pull the global economy out of recession at the London summit. The leaders vowed to restore growth and jobs, but lacked specifics about fiscal measures by each country and there were no binding promises.

There were expectations that the summit would tackle the issue of rising protectionism, but the summit is not an appropriate place to discuss international trade and investment. We saw a measure of results in expanding assistance to emerging economies, but it made the summit look as if it were a mere international conference on aid to emerging economies.

Since the collapse of Lehman Brothers last September, G20 countries have been trying to stabilize the financial markets with central banks taking exceptional action and cutting interest rates aggressively. The governments’ focus now appears to have shifted to restoring growth and protecting jobs from reacting to contingencies arising from the financial crisis.

The G20 leaders vowed fiscal stimulus totalling $5 trillion and to raise output by 4 percent by the end of next year. However, it failed to break down how much spending each country would bear. There is no indication that there are any binding targets. Since the financial crisis erupted, it has become increasingly difficult to coordinate policy given differences in the economic, fiscal and financial situations of the member countries.

Japan fleshed out its own $150 billion economic stimulus package on April 10, but the impact on boosting gross domestic product remains to be seen. The Japanese government had previously dished out economic packages with spending totalling 12 trillion yen ($120 billion). Government spending in the last fiscal year ended in March, however, only increased by 2.6 trillion yen (equivalent to about 0.5 percent of GDP). The “real water” spending will likely be limited even with the new stimulus package.

On the concern that world trade is falling for the first time in 25 years, the G20 leaders promised to extend the pledge made last year to “refrain from raising new barriers to investment or to trade” by one year to the end of 2010. Certainly, protectionist measures in any country will not protect jobs, but rather hinder economic growth. Moreover, economic model analysis on the economic effects of liberalizing trade and investment shows that “free-rider” gains from other countries’ free-trade policy would be limited. The analysis also indicates that it is important to liberalize the domestic market to maximize the benefits of global trade and investment.

On the issue of building a new order for the global economy, there are concerns about leadership struggles between industrialized economies and emerging economies. Although emerging economies may be gaining influence in the field of trade, it is unlikely that their competence in financial matters will match that of industrialised economies anytime soon.

We saw some advancement in extending assistance to emerging economies at the G20 summit. Japan pledged an additional $22 billion to assist with trade and to expand official development assistance (ODA) to other Asian countries to about $20 billion. But the biggest contribution Japan can make for the sake of the global economy may simply be pulling itself out of recession.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The dollar is, and will remain, the U.S.’s currency and its own and everyone else’s problem.

The idea of creating a global currency, as espoused by China earlier this week, is interesting, has a certain amount of merit and is simply not going to happen any time soon.

U.S. desire for free access to the cookie jar that being the world’s reserve currency represents will be too strong, especially given its need to finance huge amounts of debt reasonably cheaply. As well practicalities are fearsome, even if consensus was more or less there.

Chinese central bank head Zhou Xiaochuan on Monday called for the creation of a new “super-sovereign” global reserve currency, advocating building on an International Monetary Fund instrument called Special Drawing Rights.

Zhou echoed a call by Russia last week, when it indicated it would raise the issue at the upcoming Group of 20 meeting in London on April 2, saying the idea had support from emerging market economies including Brazil, India, South Korea and South Africa.

There is no doubt that the current system breeds instability, but it enjoys the great advantage of entrenchment and sticking with it allows the U.S., and others, to avoid making hard choices and paying true market prices for their economic decisions.

No surprise then that President Obama knocked the idea down in blunt terms. “I don’t believe that there’s a need for a global currency,” Obama said, terming the dollar “extraordinarily strong right now.”

Exactly. Too strong by some margin, especially when one considers the coming effects of both quantitative easing and a massive long-term need to fund the costs of the debt binge that exploded and the ever increasing bailout to clean up the aftermath.

In fact you could say the dollar’s “extraordinary” strength can only be fully explained when you take into account the fact that foreign central banks keep piling up huge reserves of the thing and that it is the international medium of exchange for commodities and energy, well really for global trade and financial intermediation.

Treasury Secretary Timothy Geithner said on Wednesday the U.S. dollar is still the world’s reserve currency and will remain so for a long time, but expressed openness to greater use of IMF SDRs.

The dollar’s central role has two main implications, both rather ugly but also very seductive for those involved.

For the U.S. it’s a bit of a free ride as far as debt financing goes. People buy and hold treasuries more and the U.S. gets cheaper financing that would otherwise be the case. Of course that’s a bit like an alcoholic bartender getting a discount at work; a real benefit, but not a true one.

It also means that even if the U.S. has the will to take away the proverbial punchbowl or drive the dollar down, it doesn’t always have control, as what it does at the short end of the interest rate curve can be confounded by foreign purchases that keep the long end and financing costs down and the dollar up.

SOVEREIGN OVER US ALL?

The U.S. reserve status also opens up the opportunity for mercantilist countries, like, say China, to keep its own currency cheap, building up huge dollar stocks and force-feeding the American milch cow with cheap credit with which to buy imported goods.

That may not work any more anyway, as all of the cow’s stomachs are full and the milk’s gone thin.
There is a temptation also to build up reserves as protection against bad times and bitter IMF medicine.

Many Asian leaders seem to have vowed after 1997 that they would do what was needed, which often included building up dollar reserves, to avoid having to meet an IMF director’s plane at the airport and accept the accompanying prescription.

That rather indicates that the old system, with the U.S. as global reserve currency, is dying, but I doubt it will do so without a fight and with cooperation among nations willing to cede part of their sovereignty, even for a greater good.

It is amazing and encouraging that China speaks of ceding control of a portion of its foreign reserve assets to IMF management, but I have a hard time seeing it happening widely soon.

So, we will have to get through the next year or two without a super-sovereign currency and with global imbalances being worked out, or around, under the current system.

My best guess is that things actually go in the right direction, more or less. The dollar should weaken as a result of U.S. policy even without a deliberate push downhill from the Chinese. Asian exporting nations will see slowing reserve growth generally, which should translate into diminished flows into the dollar and Treasuries.

That’s going to be painful all around. The Chinese and others will see their investments dwindle, even as they have to resist the impulse to sell into the fall. For the U.S. the process of implementing monetary policy and paying for fiscal policy will be made that much more difficult.

So, goodbye and perhaps good riddance to dollar hegemony, but don’t expect a stable system of global cooperation to rise easily and quickly in its place.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– James Saft is a Reuters columnist. The opinions expressed are his own –

The shadow banking system in Europe isn’t so much dead as being kept on life support by banks and central banks in what amounts to a desperate but risky attempt to avoid the reckoning.

You might be forgiven for thinking that the biggest single month ever for securitization in Europe and Britain was sometime before we all realized that we were in a credit bubble, sometime like the sunny days of 2006.

In fact, the biggest month ever, by some margin, was December 2008, when more than 212 billion euros of securitizations were issued in Europe.

One small problem however is that there was almost no demand for them, with only about 8 billion euros in public deals intended to be bought by actual investors wanting to take on actual risk.

The rest were “retained” deals, almost always structured so they were eligible for financing by central banks under repo arrangements.

The numbers involved are staggering, with more than 750 billion euros of these retained deals having been created in 2008, according to Unicredit Group data. Retained securitizations in Spain total about 144 billion euros, according to UBS, or the equivalent of 14 percent of annual GDP. Before the deluge, banks in Europe and Britain pursued risky strategies of either originating and distributing — making loans and then selling them on via securitization to some bigger chump — or relying on wholesale funding so they could grow their balance sheets beyond their ability to gather actual deposits from bona fide savers.

When that dispensation fell apart, central banks stepped in as “emergency” sources of funding, with the argument being that the banking system needed liquidity to get it through an unforeseeable storm. Central banks will repo, or finance, securities that meet certain criteria, applying a discount to the face value to protect them but exchanging good old cash for hard-to-sell securities.

That storm is now about 20 months long and what were once emergency measures are now, more or less, the business model for banking.

Banks now lend money to homebuyers, businesses and consumers, turn those loans into securities, park the security with a friendly central bank and get cash back, thus allowing them to effectively take on more risk and continue lending despite balance sheet pressure.

This suits central banks, especially the ECB, as it keeps credit flowing and arguably supports asset valuations that would otherwise crush bank balance sheets and result in far more banking failures. Details of exactly how much and what kind of securitizations are parked with the ECB and other central banks are not available.

But like what came before, it is an inherently unstable arrangement, however convenient or useful.

“The structure-to-repo model is not sustainable. Repo-financing will be limited in 2009, or at least will not experience the same growth of 2008,” said James Zanesi, an analyst at Unicredit Group in Munich.

WHO BEARS THE RISK, WHO HOLDS THE BAG?

This strategy, which amounts to lending into a deteriorating collateral environment, is by definition riskier for the banks than originating and selling it on. After all, mortgage loans in Spain or Britain, where prices may fall another 15-20 percent and where unemployment is rising rapidly are probably not the world’s best risk right about now.

Bank investors will bear this risk, and you only need to look at the equity prices of European banks to see what the market thinks of it. It is also possible that people above equity holders in the capital structure could end up being hurt, though market orthodoxy now is that to hit bond holders would be suicidal.

Central banks and taxpayers may be on the hook as well, if banks with securities they’ve financed fail and the collateral proves worth less than they thought it would be.

The banks, for their part, are engaged in a Darwinian all-or-nothing bet. If they stop lending they are probably toast anyway, so may as well lend and hope that they are amongst the survivors and can then grow rich on fat margins.

Need I mention that there is a fair amount of moral hazard here. Banks have every incentive to make as many loans as ever they can, take on as much risk within the framework as can be managed and park as much as possible with their central bank.

The risk may bring with it the money they need to earn out of their problems and if things come apart, well then, the authorities have all the more reason to keep them alive if they are looking at an ugly loss if they fail.

Who says the days of big leveraged bets are over.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– John Kemp is a Reuters columnist. The views expressed are his own –

It is time to add another victim to the ever-growing list of institutions (Bear Stearns, Lehman Brothers) and theories (value at risk, fair value accounting and originate to distribute) which have been tested by the financial crisis and found wanting. The central bank practice of inflation targeting — the jewel in the crown of modern monetary economics — has palpably failed.

Over the last two decades, inflation targeting has emerged as the most popular strategy for monetary policy among the world’s major central banks, and become something of a state-of-the-art choice among theorists and central bankers.

Even the Fed, long skeptical, considered announcing a formal target for inflation last year. Senior officials considered whether it would be a useful way to counter the threat of deflation by providing an “anchor” for expectations about future prices. In the end the central bank ducked the decision and decided to press ahead with long-term inflation forecasts instead, as a form of “soft” targets.

But the experience of major central banks over the last five years — both those pursuing formal targets and those like the Fed which have been employing “shadow” ones — suggests inflation targeting has failed and will need to be overhauled once the immediate crisis has passed.

CENTRAL BANK PERFORMANCE

Controlling inflation has been the central objective for monetary policy for the last 30 years. But using interest rates to target the inflation rate directly emerged only in the early 1990s. In many countries, it was something of a default choice after strategies targeting intermediate variables (such as the money supply and the exchange rate) had been tried and failed.

In its own (narrow) terms, inflation targeting has been successful. In the United Kingdom, consumer prices have increased broadly in line with the Bank of England’s target since the central bank was given operational independence to set interest rates in May 1997.

Evidence from the United States is more mixed. The Fed has long insisted it does not have a formal inflation target (preferring to retain flexibility for what it calls a “risk-management” approach). But senior officials have defined the “price stability” component of its dual mandate as an inflation rate of about 1.5-2.0 percent per annum.

Both the all-items consumer price index and the core index excluding food and energy have consistently risen faster than the Fed’s implied target since 1997. Access PDF here.

In fact, the performance of inflation and the Fed’s interest rate decisions suggest the Fed has actually been targeting a core inflation rate of about 2.25 percent per year, or an all-items rate of 2.50 percent.

While this is slightly faster than officials have been prepared to admit publicly, it is still respectable by historical standards.

The real problem is that a narrow obsession with hitting inflation targets blinded central bankers around the world to the build up of other problems, including bubbles in the bond and real-estate markets, as well as the build up of excessive levels of household and corporate debt.

Moderate growth in each month’s consumer price numbers provided false comfort even as distortions built up in other parts of the financial system (overvalued asset markets) and economy (a gaping trade imbalances and surging commodity prices).

If the ultimate purpose of inflation targeting was to provide a stable economic framework for long-term decision-making by households and businesses, it has failed. Bubbles and over-indebtedness have caused far greater output losses when they collapsed than any amount of moderate consumer price inflation.

FLAWED THEORY

The excessively narrow focus of inflation targeting reflects conceptual shortcomings.

In 1952, Professor Jan Tinbergen proved that to achieve two independent policy objectives simultaneously, policymakers must employ two independent policy instruments.

Tinbergen’s rule implies monetary and fiscal policy work best when coordinated to achieve the optimal joint outcome for inflation and growth, or between internal balance (inflation-growth-employment) and external balance (the trade deficit and exchange rate).

But in a curious inversion, modern economics has sought to separate them, assigning monetary policy the role of pursuing price stability, while leaving fiscal policy to worry about growth and employment.

It reflects the impact on the discipline of Milton Friedman’s famous comment about inflation being “always and everywhere a monetary phenomenon,” amplified by the impact of the rational expectations revolution, which seemed to indicate monetary policy could not have an enduring impact on the level of business activity and employment, only on prices.

From this stemmed the idea monetary policy should focus on choosing a desirable (low) rate of inflation, leaving other aspects of demand-management and employment policy to fiscal policy.

The discipline has gone further, and sought to implement an institutional separation between the fiscal and monetary authorities. Most theorists have supported establishment of “independent” central banks able to set monetary policy at arms length from the fiscal authorities.

This reflects a mistaken view that monetary policy is essentially a technical academic exercise that can and should be insulated from other aspects of the policymaking process.

Reflecting this technocratic approach, modern monetary economics has been dominated by a debate over rules versus discretion — with a rule-based system generally held up as superior.

The history of the discipline since the late 1970s can be summed up as the perfect monetary “rule,” specifying how much the central bank should adjust the instruments under its control (reserves and interest rates) to achieve some intermediate variable (money growth and the exchange rate) or direct target (consumer prices) and ensure the ultimate goal of price stability is met.

PRACTICAL SHORTCOMINGS

But focusing monetary policy on consumer prices encouraged central banks to ignore signs of growing instability in other parts of the financial system (such as asset prices and lending). The target was too narrow and needs to be broadened in future.

It was a mistake to separate monetary policy and fiscal policy and assume monetary policy could somehow operate in isolation from tax and spending decisions and other interventions in the economy. Macro management would be more effective if monetary policy and fiscal policy were coordinated.

Elsewhere, I have suggested the authorities might need to go further and supplement existing monetary and fiscal policies with a third, distinct policy to govern the quantity of credit and build up of debt to ensure that internal balance, external balance and financial balance can all be achieved simultaneously.

Finally, it was a mistake to pretend monetary policy is a technocratic exercise. Decisions about interest rates have distributional effects (between savers and borrowers, more and less growth, more and less employment) and are inherently political.

This is not an argument for interference. But it is an argument for greater honesty about the social trade offs involved.

It is also an argument for allowing discretion back in. Rather than mechanically applying rules targeting a single variable such as consumer prices, central banks need freedom to respond to changing circumstances. That means freedom to cut interest rates dramatically in response to a financial panic. But it also means freedom to raise them during a boom to prevent wider distortions in the financial system even when there are no obvious signs of consumer price inflation.

Inflation targeting needs to be reworked in favor of a more holistic approach that gives central bankers more discretion to pursue a complex set of goals (including financial stability. But they must also be held more accountable, and accept this not just a technical exercise but one which involves difficult choices for society as a whole.

– Paul Taylor is a Reuters columnist. The opinions expressed are his own –

It works more like a sprinkler than a power hose, but the European Investment Bank has a role to play in preventing a financial inferno from sweeping across central and eastern Europe.

The trouble is that politicians have overloaded the European Union’s long-term lending arm with exaggerated expectations, calling on it like a fire brigade in every emergency, from saving credit-starved small firms to greening the car industry, combating the energy crisis and fighting climate change.

The need to serve many masters and focus on many priorities limits its impact, but the EIB now has more resources to back economic stimulus programs in the 27-nation bloc.

Philippe Maystadt, president of the Luxembourg-based bank, has received so many pleas for billions since the credit crisis struck that he starts by listing what the EIB cannot do.

It is not a central bank. It cannot provide liquidity. It cannot take equity stakes in banks and it cannot fund budgets. Its role is to finance investment projects that are aligned with the 27-nation EU’s policy objectives.

“What we can do is provide finance as intensely and rapidly as possible for investment. That’s what we’re doing (and) we aim to do more, better and faster,” Maystadt, a former Belgian finance minister, said in an interview.

The EIB plans to lend more than 7.5 billion euros to small and medium-size enterprises and local authorities in central and eastern Europe this year through local intermediary banks. That is three times last year’s volume, and on more flexible terms.

The bank has a triple-A credit rating because it is owned and backed by the EU’s solvent sovereign governments. So it borrows at cheap rates and lends the money on the same terms to clients who would otherwise have to pay far more to borrow.

Firms may now use the cash as working capital, for research and development and to buy patents and not just to buy goods.

The EIB is also working to address the special problems of eastern Europe. From Warsaw to Kiev, floating currencies have sunk against the euro, punishing hard-currency borrowers, while governments are struggling to raise funds as capital flows from parent banks in western Europe to eastern subsidiaries dwindle.

With the European Bank for Reconstruction and Development (EBRD) and the World Bank’s International Finance Corporation (IFC), Maystadt is looking to support banks in eastern Europe.

“For example one could imagine combining equity stakes from the EBRD with bigger credit lines provided by the EIB, using the specific instruments of each institution in a coordinated way to increase efficiency. If the EBRD comes in to reinforce a bank’s capital, it means we can lend more to that bank,” he said.

EU finance ministers agreed in December to raise the EIB’s capital by 67 billion euros to 232 billion euros so it can boost lending by 30 percent this year and in 2010 to help economic recovery. That is a stretch for the bank’s 1,400 staff.

The extra 15 billion euros a year will be targeted at SMEs, fighting climate change and speeding disbursements for projects in the new member states in central and eastern Europe.

Under EU rules, national governments or local authorities have to finance 35 percent of EIB-backed projects. The newcomers often lack the funds, especially during the credit crunch, so the EIB is also helping fund the local share.

However, the obligation to be even-handed among EU member states makes it hard to concentrate a large amount of lending on a few priorities or countries.

“It’s true we are an EU institution, so we have to work for all member states and our interventions have to be well balanced,” Maystadt said.

So far, the EIB has had no trouble borrowing on capital markets, but things could get tighter and more expensive as the bank raises its extra funds just as governments are tapping the market massively to finance national recovery plans.

That raises the question of whether the EIB could borrow from the European Central Bank, which is not allowed to lend money directly to member states.

“This question hasn’t yet been posed,” Maystadt said. “For the moment we don’t call on the ECB. It’s a question that would have to be examined with the ECB. That hasn’t yet been done.”

Pressed to say whether the idea was topical, he laughed and fell silent.