How Central banks moved from fiscal dominance to financial dominance..

Daniela Gabor of University of the West of England has a nice paper on political economy of repo markets.

The summary of the paper is here. She explains how we move from one crisis to another in macro/monetary policy. Emergence of Repo was seen as an end to fiscal dominance. But it triggered a new problem of financial dominance:

Since the 1980s, central banks have been increasingly freed from fiscal dominance, the obligation to monetize government debt. The new regime of monetary dominance celebrated the (price) stability benefits of insulating scientific monetary policy from poorly theorized, highly politicized fiscal policy. Yet the growing dominance of the ‘monetary science, fiscal alchemy’ view in both academia and policy circles played a critical role in the rapid rise of shadow banking. The untold story of shadow banking is the story of (failed) attempts to separate monetary from fiscal policy, and of the bordeland that connects them, mapped onto the repo market.

While the state withdrew from economic life, privatizing state-owned enterprises or state banks, and putting macroeconomic governance in the hands of independent central banks, its role in financial life grew bigger. Sovereign debt evolved into the cornerstone of modern financial systems, used as benchmark for pricing private assets, for hedging and as base asset for credit creation via shadow banking. The state’s role as debt issuer, passive and systemic at once, has been reliant, beyond the arithmetic of budget deficits, on the intricate workings of the repo trinity.

The repo trinity captures a consensus in central bank circles emerging after the 1998 Russian crisis, the first systemic crisis of collateral-intensive finance, that financial stability requires liquid government bond markets and liberalized repo markets (fig. 1).

It all started from US and then moved to Europe. France took the lead in Repo threatening both Germans and English over loss of financial power:

The repo-government bond market nexus took shape in the 1980s. In the US, securities dealers preferred repos to secured lending against collateral because market convention treated repos as outright sales and repurchases of collateral that allowed dealers to re-use collateral for a wide range of activities (short-selling, hedging, selling to a third party). When bankruptcy courts decided that repos would be subjected to automatic stay rules, Paul Volcker, then the Federal Reserve chairperson, successfully lobbied Congress to exempt repos with US Treasuries (UST) and agency securities collateral. Then, Salomon Brothers short-squeezed the UST market in 1991 by becoming the only repo supplier of a two-year note. This allowed Salomon to fund securities through repo transactions at exceptionally low rates. The ensuing public enquiry into the Salomon scandal showed little appetite for regulating repos. Rather, the Fed and the Treasuryintroduced new practices to fix gaps in repo plumbing, celebrating repos as innovative, liquidity enhancing instruments that would support the state in the post fiscal-dominance era.

The UST blueprint diffused rapidly to Europe. Pressured to adjust to a world of independent central banks, market-based financing and global competition for liquidity, European states embarked on a project of creating modern government bond markets, with modernity understood to mean the structural features of the US government bond market: regular auctions, market-making based on primary dealers and a liberalised repo market.

Central banks were at first divided on the benefits of opening up repo markets. While Banque de France followed the US Fed in assuming a catalyst role for the repo-sovereign bond market nexus, Bundesbank and Bank of England worried that deregulated repo markets would unleash structural changes in finance that could undermine the conduct of monetary policy and financial stability. In the architecture of the US government bond market, the Bundesbank saw the conditions nurturing short-term, fragile finance. Seeking to keep banks captive on the uncollateralized segment of interbank markets, Bundesbank imposed reserve requirements on repo liabilities. In parallel, as government’s fiscal agent, Bundesbank followed a conservative strategy, with irregular auctions, issuance concentrated at long maturities and repo rules that increased the costs of funding bunds via repos. German banks responded by moving (bund) repo activities to London and warned that France’s open repo strategy would make it into the benchmark sovereign issuer for the Euroarea. For similar reasons, the Bank of England exercised strict control over the repo gilt market for 10 years after the 1986 Big Bang liberalisation of financial markets. Under intense pressure from the financial industry and Ministries of Finance, the two central banks liberalized repo markets by 1997.

We all saw what happened in 2008. It was a repo market crisis. So we move from one issue to another:

The quiet revolution in crisis central banking that involves direct support for core markets may appear like, but does not entail a return to, fiscal dominance. Rather, it creates financial dominance, defined as asymmetric support for falling asset prices. While financial dominance should be addressed by direct regulatory interventions, the quest for biting repo rules has so far proved illusive. The precise impact of Basel III liquidity and leverage rules is yet to be determined, whereas the failed attempts to include repos in the European Financial Transactions Tax and the FSB’s watered-down repo proposals suggest that (countercyclical) collateral rules are only possible once states design alternative models of organizing their sovereign debt markets. Paradoxically, new initiatives in Europe suggest that a return to the repo trinity is rather more likely: the Capital Market Union plans to create Simple, Transparent and Standardized (STS) securitisation again illustrate the catalyst role that central banks choose to play in market-driven solutions to safe asset shortages.

Central banks wanted to end fiscal dominance but are not sure about financial dominance. Central bankers know the powers they enjoy as being leaders of finocracy. End of or Limited Fiscal dominance meant central banks could call themselves independent. Without being elected, they enjoy vast powers almost equal to or even more than the elected heads of the countries.

Moreover, a job in a central bank means a very cushy job in financial sector as several people have shown in recent times. Even if a central banker does not join the financial sector directly, it can make loads by hidden consulting and lectures.  So any such actions on curbing financial dominance takes away the powers of central bankers themselves. Talk about paradoxes here.

One should be weary of all these macro fixes which are usually hyped up extensively. Most of them end up creating new problems of their own. One key issue is most macro is around this power game of few central institutions who try to undermine the other. It has hardly got anything to do with letting markets work. More about controlling them actually.

Political economy of macroeconomics is crucial to understanding this roulette of powers..

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