Vítor Constâncio, Vice-President of the ECB: 34 years as a central banker!

Nice interview of Vítor Constâncio, the VP of ECB. He spent 34 years of his professional life as a central banker. He was twice the Governor of Central Bank of Portugal from 1985-86 and 2000-10.

How have you seen the relationship with markets and with banks change during your 34 years in central banking?

Back when I began, the European financial system was much more bank-based than it is now. That was true everywhere, but it was particularly true in Europe. Monetary policy was totally directed towards bank’s behaviour.

In 1973 in the United Kingdom, you had limits to deposits, which was a new attempt to put some limit on banks’ ability to expand their balance sheets. Many other European had credit ceilings. Italy, France, Portugal, Spain all had ceilings, some up to the end of the 1980s.

It was only after that that more market-based monetary policy instruments started to become more significant. The growing importance of markets and the liberalisation of the controls exerted by central banks on the activity of banks started to change monetary policy in Europe completely, especially since the 1990s.

We’ve ended up with the present inflation targeting regimes, using interest rates as the main tool to control the spectrum of market interest rates.

The importance of banks in financing the economy has continued to decline and this requires a change in approach in the future. All these new fields beyond banking require some degree of regulation that is still not there, and this in my view will become more and more clear as market-based finance continues to grow to a huge size. The approach will need to become much more intrusive, and will be a return to the past in that respect.

What will that entail?

Controlling the excesses of finance cannot be achieved only with monetary policy interest rates. We need to expand the concept of leverage to other segments of the financial system, particularly synthetic leverage. I mean leverage which is not easily seen in the balance sheet, because it’s built up with derivatives. It’s not seen but it’s very relevant for banks and for the economy, as we saw during the crisis.

The obstacles to regulating markets, and not just banks, are not so much technical; the obstacles are more political or ideological. It requires more regulation and supervision by not only central banks, but also in some cases governments. It is politicians that often need to enforce macroprudential measures, and in some countries some governments do not want to use them.

Another aspect that is different now is that we have in our economies too much finance. There is a strand of literature showing that after certain limits there are diminishing returns in the expansion of finance. And to tame these imbalances we will also need macroprudential measures.

Over the course of your career what are you most proud of?

I’m proud of many things I’ve done in my 34 years in central banking. I am proud that I eliminated credit ceilings in my country when I was Governor and introduced a market-based system of monetary policy with the creation of auctions for treasury bills. I also ended the fixation that Portugal had on its exchange rate, which involved daily auctions with market players. We modernised the bank and the financial system during the 1980s, so that is one thing.

Here at the ECB, I’ve overseen the creation of a macroprudential policy and financial stability department, which is state of the art. And I am proud of course of having participated actively in all of the policy decisions that happened since I came here in 2010, especially those that put a stop to the existential crisis over the future of the euro.

Is there any decision that the ECB took that in hindsight you regret?

The rate hike in 2008 was an overreaction. There seemed to be some justification at the time for the increase in rates in 2011, though in hindsight it was clearly premature. That’s it, I already said it in the speech.

He is looking forward to start a blog. Welcome to the club 🙂

Will you stay in Germany or are you going to go back to Portugal?

I’m going back to Portugal. In June, I will be at the ECB conference in Sintra. Normally we invite former members of the Executive Board, so I hope they will continue to invite me. Particularly as I don’t intend to go and work for any private financial institution. I will do some postgraduate teaching in Madrid.

I always hoped I would have the opportunity to be a free intellectual. In my career I never had that luxury.

I always thought and dreamed about it, and I hope to have a sufficient number of years to satisfy that ambition. I am going to have a blog. It’s usual in the United States; in other places, not so usual. I will comment on general questions about the future, about Europe, about macroeconomics.

What will your first post be about?

I am still hesitating. It could be about the future of monetary policy and the points I left out in my recent speech, from neutral interest rates to yield curve control.

Are there any rules that bind you in terms of what you can write about?

Beyond the ECB rules what will bind me is European decorum.

Nice bit…

He also speaks on changes in economics:

You have talked about the need to reform economics too. What do you have in mind?

Big changes are happening, we are going in the right direction, but in my view we are not there yet.

The joke in the American camp at the beginning of the 1980s was that macro is just bad micro, meaning that the models had become dominated by the idea that agents make optimal economic decisions over infinite horizons into the future and that markets therefore tend to be self-equilibrating towards a single steady state.

Central banks’ standard models – DGSE [Dynamic General Stochastic Equilibrium] models – have been transformed in many ways, but the 1980s view has still not fully disappeared.

This has to change. Economic agents clearly have finite horizons, which impact on their consumption decisions. People do not optimise and plan their lives up to their death. Nor does the financial sector play as important a part in models as it should. The possibility of multiple equilibria has also to be introduced; there are fallacies of composition, there are coordination failures.

All these elements have to become part and parcel of macroeconomics; macroeconomics is not just the aggregation of individual decisions by optimising agents, we should not just assume everything moves towards a general equilibrium of competitive markets.

The absolute minimum that has to happen is to rid macroeconomics of the imperialism of a certain type of microeconomic foundations; a new core model for macroeconomics has to emerge.

If agents act in different ways, we also have to address the question of income distribution. And fortunately there are already models, so-called HANK models, Heterogeneous Agents New Keynesian models, that consider this. There is a very nice paper in the latest NBER issue which is called “When Inequality Matters to Macro and Macro Matters for Inequality”. So indeed, that places within macro the question of inequality – inequality which has been increasing too much in the past few decades.

Changes are being discussed and are taking place I just hope that progress could be quicker.

How does that impact central banking? We thought we could just target inflation, now you are saying the next generation has to consider all of these different preferences of agents, multiple equilibria, inequality…

Well first of all, central banks will always focus mostly on control of inflation, or more broadly macroeconomic stabilisation. The regime of flexible inflation targeting will not change in the visible horizon, and that is because it allows central banks to take a medium-term perspective towards hitting the inflation target. The advantage of adopting this gradualist approach to reaching the target, is – as [leading monetary economist and former Riksbank official] Lars Svensson has demonstrated very convincingly – that you can allow for some consideration of stabilisation of the economy in trying to move gradually towards the inflation target.

What will change are the models used to analyse the consequences of policy – and the set of instruments that will have to be used. Central banks in the future will have to respond in a different way if they want to achieve the overall objective of reasonable inflation and macroeconomic stabilisation.

The growing complexity of market-based finance and the change in the financial system will make it difficult for central banks to go back completely to the old, comfortable, traditional approach of having very lean balance sheets and just targeting the overnight money market rate.

The set of instruments will have to be broadened. Several have been used during the crisis, some of them just for very stressful periods of course, but they are now part of the toolkit.

Do you think what you’re saying is shared by other people on the Governing Council?

I wouldn’t speculate on that. This view is developing in academia everywhere and has been discussed extensively in [the Kansas City Federal Reserve’s flagship conference in] Jackson Hole in 2016, for instance. So it’s part of the ongoing discussion at the interface between academia and central banking.


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