New Zealand’s monetary policy mess

The New Zealand Initiative has a new report out this morning, written by Bryce Wilkinson, under the heading “Made by Government: New Zealand’s Monetary Policy Mess”. (Full disclosure: I provided fairly extensive detailed comments on an earlier draft.)

It is a curious report. There is a lot of detail that I agree with (and the report draws quite extensively on various criticisms I have made in recent years) but it ends up having the feel of a bit of a muddle.

(It is perhaps not helped by the Foreword from an Otago academic who seems wedded to a fiscal theory of the price level that doesn’t exactly command widespread support anywhere, and which would appear on the face of it to have predicted that New Zealand would have had one of the lowest inflation rates anywhere. His approach appears to absolve the Reserve Bank of responsibility for the high inflation: “the key reason why we have high inflation rates is fiscal policy and not monetary policy” and “even if the RBNZ had not made mistakes, I doubt that it could have avoided high inflation”.)

The title of the report is clearly supposed to suggest that what has gone on is primarily the government’s responsibility (and specifically that of the Minister of Finance). And there are plenty of things one might reasonably blame the Minister for:

  • changing the Bank’s statutory mandate (if you think this was a mistake, or mattered to macro outcomes, which I don’t)
  • reappointing Orr despite the opposition of the two main opposition political parties, having himself changed the law to explicitly require prior consultation with other parties in Parliament,
  • going along with the Orr/Quigley preference to prevent experts from serving as external MPC members (which still seems incredible, no matter how times one writes it),
  • appointing a weak Board with barely any subject expertise, the same board being primarily responsible for Governor and MPC appointments and for holding the MPC to account,
  • being indifferent to serious conflicts of interest in people he was appointing to the board,
  • prioritising a person’s sex in making key appointments,
  • for bloating the Bank’s budget, and
  • never once have shown any sign of unease about the massive losses the MPC-driven LSAP has run up, about the Orr operating style, or any urgency around better understanding what has gone on (you will search letters of expectation in vain for any suggestions from the Minister that, for example, more/better research capability and output might be appropriate, or that speeches more of the quality seen from other advanced country central banks might be appropriate)

and so on.  Robertson has been both an active and passive party in the serious decline in the quality of our central bank over recent years, and given that Orr has been reappointed and seems disinclined to acknowledge the validity of any criticisms, only the Minister of Finance –  current or future –  can make a start on fixing the institution.  Institutional decline –  and it isn’t just the Reserve Bank –  has been a growing problem in New Zealand, and the current government’s indifference has only seen the situation worsen: one might think too of the Productivity Commission.

But, for better or worse, when most people think of a “monetary mess” at present they probably primarily have in mind inflation.  And the way the report is structured it would seem that both the author and the Foreword writer also put a lot of emphasis on the bad inflation outcomes.  No doubt rightly so.

But there simply isn’t any compelling evidence, or really even any sustained argumentation that would stand scrutiny, that any or all of the many things one can criticise Robertson for really go anywhere towards explaining how badly things have gone with inflation (or even with the massive losses on the LSAP).  I’m not, of course, one of those who believe the Bank should escape blame –  that somehow for example (as per one of the Governor’s ludicrous attempts at distraction) we can blame it all instead on Putin or “supply chain disruptions”, as if they somehow explain the most overheated economy and labour market in decades.

But how confident can we really be that a better Reserve Bank –  on the sorts of dimensions the NZI report rightly draws attention to –  really would have made much macroeconomic difference?   As just a small example (and from a country with a similar pandemic experience) the report rightly draws attention to the better academic qualifications of the Governor and senior figures at the Reserve Bank of Australia.  But nothing about Australian inflation outcomes –  or LSAP losses for that matter –  suggests that the RBA has done even slightly better than the RBNZ in recent years.  If anything, I (the Bank’s “most persistent and prolific” critic, as the report puts it) reckon the RBA has done a little worse, even if there is a better class of people and some more thoughtful speeches.    One could extend the comparisons.  As I’ve highlighted here, New Zealand’s core inflation outcomes have been bad, but about middle of the pack among OECD countries/regions.   Fed Governors do lots of good speeches, the institution does lots of interesting research, experts are allowed to be decisionmakers, but…..core inflation outcomes are little or no better and the Fed was even slower than the RB to get started with serious tightening.  And so on, around most of the OECD.

There is –  as the report notes –  no absolute defence for Orr and the MPC in other countries’ inflation records. We have a floating exchange rate to allow us to set our own path on inflation, and just because other countries’ policymakers messed up should not absolve ours of responsibility.    But to me the evidence very strongly suggests that what happened over the last two to three years was that (a) central banks badly misunderstood what was going on around the macroeconomics of Covid, (b) so did almost all other forecasters, here and abroad, and (c) there isn’t much sign that central banks with better qualified more focused people or more open and contested policy processes did even slightly discernibly better than the others.   I wish it wasn’t so.  With all the many faults in the RBNZ system and personnel, it would be deeply satisfying to be able to tie bad outcomes to those choices (active and passive).  But I just don’t think one really can.    All those governance and style matters etc matter in their own right –  we want well-run, expert, open, engaged, accountable, learning institutions, especially ones so powerful.  And weak institutions are likely over time to produce worse outcomes in some episodes.  But there is little sign yet that this is one of those episodes.

And it is clear when one gets to his conclusion that Wilkinson more or less knows this, as he struggles to connect the very real concerns about the Bank, and what Robertson has initiated or abetted, with the most unfortunate macroeconomic/inflation outcomes.

I was going to say that it isn’t really clear either who the report is written for.  But in fact I think that is wrong, and that the primary intended audience is Nicola Willis, her boss, and her colleagues/advisers.    Thus we find this

Bryce 5

Talk about deferential and accommodating.

And the entire report ends this way

bryce 6

In terms of fixing the institution that seems largely right. It could be fixed, but it will need ministers/governments that care and that are willing to devote sustained attention to using the levers they have to gradually right the ship. As Bryce notes, many of these changes can’t be effected quickly, but mostly because the laws are deliberately (and appropriately) written to make it not easy for new governments of either stripe to make sudden or marked changes. That is helpful when the institution is working well, but quite an obstacle otherwise, and may – if a new government were to care enough – need legislative change.

(I wrote a post here last year with some thoughts on what a new government could and could not do.)

As you watch the interactions between Orr and Nicola Willis at FEC – in which Orr is routinely scornful and dismissive – you wonder how in decency he could possibly continue to serve under a National-led government, But perhaps if he were that sort of person – staying in his lane, acknowledging mistakes, open and engaging etc – the concerns would not exist in the first place. As it is, it would be hard (all but impossible under current law I’d say) to get him out if he wants to stay, and so reform efforts will need to go around him, including progressively replacing the Board with able people and ensuring that the external MPC members are both able and expected to be individually and publicly accountable for their own views and analysis. But do all that and we – and other countries – will still be at risk of really bad macro forecasting errors, and central banks unable to live up to their rhetoric, albeit we might hope for no repeats for another generation or two.

What risks should the state protect people from?

Later yesterday morning, before major international markets opened for the week, the US authorities announced two steps in response to the failure of SVB Bank

  • first, depositors not covered by the FDIC (amounts in excess of US$250000) would in fact be completely covered, with the costs to be covered by levies (taxes) on other US banks,
  • second, a new Fed lending facility was set up, backed by the US Treasury, under which banks could borrow at market rate against securities that for these purposes would be valued at face value not market value.   For most longer-term securities issued in the last decade, market value is currently less than face value.

Legislative changes after 2008/09 were supposed to make bailouts much harder and less likely, but at the first real test – in respect of one failed bank that was 16th largest in the US (and another a bit smaller still) – there were significant elements of a bailout anyway. In respect of a bank that mostly had large deposits (this wasn’t an entity where just a few people had a bit more than $250K on deposit), all depositors were made whole. Most of the commentary suggests that had the assets been liquidated and depositors and other creditors been paid out what was left they’d probably have got back more than 90 cents in the dollar, and the FDIC resolution procedures could readily have allowed those larger depositors access to some portion of their money upfront (this incidentally is/was similar in this respect to the way the Reserve Bank’s Open Bank Resolution model was envisaged as working). The precedent value of this action suggests that in future any depositors at even a moderate-sized US bank are likely to be made whole (“what do you mean you aren’t going to bail out depositors in a failed bank in my district when you bailed out those Silicon Valley tech companies?”)

The main focus of yesterday’s announcement seems to have been to snuff out the risk of further bank runs. Signalling to depositors that they won’t lose their money (no matter how large and otherwise sophisticated they are) is one way of doing that. Another is providing ready access to liquidity for other banks, to signal that such banks would have no problem paying any requests for accelerated withdrawals that did arise. It bears some resemblance to a classic lender of last resort (a function of central banks that few have too much problem with in principle), except that whereas Bagehot counselled that central banks should lend readily on good collateral at a high price, yesterday’s announcement really only met the first element of that test. Much of the collateral has a market value less than the valuation being used to secure these loans (that isn’t good collateral, even if the bond itself is issued by the US government), and the loans are simply at normal market prices. It is, in effect, subsidised lending by the state.

Perhaps some might be inclined to pardon less than ideal policy responses when things have to be done in a rush. And I’m sure the weekend was pretty fraught for many relevant officials and politicians. But the US is a big country with huge bureaucracies and ample time and resources to have robustly war-gamed how failures and potential failures of significant-sized institutions would and should be handled, including thinking hard about the lessons from such exercises for future incentives. If state insurance of all deposits made sense, it made sense a couple of years ago, not just today. But that wasn’t the model adopted. It is hard to believe that lending on collateral using face rather than market value, at normal market rates, would ever make a lot of sense (at least outside some deep and severe systemic crisis where wholesale securities markets had become deeply dysfunctional).

Various people point out that the moral hazard is not complete. After all, SVB’s management will have lost their jobs (but not presumably past salaries and bonuses), shareholders will have lost their money (but not past dividends), and other creditors including any bondholders will not be made whole. But the benefits of yesterday’s bailout will also flow to the management, shareholders, and other creditors of other banks with somewhat similar (albeit typically less extreme) business models. And if the quid pro quo for the heightened moral hazard is supposed to be heightened regulation and supervisory intensity, how much confidence should people really have in that given the evident failure of supervisors and regulators in this case? Perhaps exemplary bank regulation might act as an adequate counter, but in the real world of US banking/regulatory politics?

I’m not one of those opposed to all deposit insurance. Well before the current government decided to introduce deposit insurance to New Zealand I was arguing for it as a second-best response because absent a limited deposit insurance system it seemed all but certain that in a stress event for any major bank (and perhaps some less major ones) in New Zealand, all creditors would end up being bailed out, and no one would have paid the Crown anything for the insurance that was being provided. Even in conjunction with Open Bank Resolution as an option in the toolkit there is still a high risk of a full bailout of creditors of the larger banks – partly because of the pressure that will almost certainly come from the Australian government – and at the margins actions like yesterday’s from the US authorities only increase that likelihood. Perhaps in truth, our deposit insurance scheme will end up only ever being practically relevant should banks like TSB or Heartland be close to failure (in terms of relative size comparisons they are our SVB).

There are people who believe that it is practically desirable, or at least unproblematic, to provide full deposit insurance. My stance is much closer to that of Peter Conti-Brown (professor of financial regulation and author of a stimulating book on various Fed governance issues) than to the former chair of the US Council of Economic Advisers.

And I’m not uninfluenced by having observed, and been involved with, our own NZ retail deposit guarantee scheme in 2008 where once guarantees were in place money flooded towards entities (notably South Canterbury Finance) that offered slightly higher yields. It isn’t a perfect comparison, since prudential supervision of finance companies wasn’t a thing at the time, but it is a useful cautionary experience nonetheless. And my perspective on bank runs is that generally they happen too late and too rarely, rather than seeing them as typically some random or fundamentally unwarranted event. The threat of a run is an important element in market discipline.

But I guess my wider caution is around the question that is the title of this post? What economic risks should the state be offering full protection against?

I can see a reasonable case for retail transactions balances being protected, even guaranteed. In that vein of course, people can choose to use Reserve Bank banknotes. More seriously, one reason why I have always been inclined to favour allowing the general public access to individual Reserve Bank settlement accounts (in modern parlance a CBDC) is precisely to provide such a credit risk-free option (even as, as I noted in my CBDC submission, I do not believe there would be a great deal of demand for such a product). But even then, an overnight Reserve Bank deposit account for transactions purposes might be free of credit risk and market risk, but it is hardly free of inflation risk (any more than a commercial bank deposit).

But if you or I have half a million dollars on deposit with a bank (let alone if an investment fund has $10m or $100m), there is no obvious public interest in the state guaranteeing that you will never lose the nominal value of your deposit. No doubt it would be tough to be substantially hair cut if your bank happened to fail and the assets came well short of covering 100 cents in the dollar but (a) you did have choices (under the proposed NZ system protection will be limited to $100K, so you have a reasonable option of spreading your deposit across five banks and securing full protection), and (b) there are so many other economic risks in life against which the state provides at most limited protection (all while providing a basic welfare system where entitlement in case of need is near universal, in the case of age universal).

I’ve already mentioned inflation. Out of the blue, quite in breach of their published targets, central banks in the last couple of years have delivered a quite unexpected 10 per cent boost to the price level. That is pure windfall gain if you have borrowed money in a conventional nominal loan, and pure windfall loss (not likely to be, or able to be, recouped) to those holding conventional nominal financial assets. Sensibly enough in macro terms, we don’t have price level targets, so no effort will be made to reverse these transfers, but for many the losses are real. For someone with $500000 in the bank, the real loss of purchasing power might be similar to many retail bank failure haircuts. It has surprised me a little – and is useful data after decades of low stable inflation – that more is not made of this arbitrary state set of wealth transfers.

House prices are falling at present in much of New Zealand. For many people – those of us without mortgages, and with a natural position long one (and only one) house – it doesn’t make much difference to anything. But there are plenty of people for whom it does – whether the owners of investment properties, or those who borrowed heavily at the peak of the most recent boom. If you had bought a house in Wellington 2 years ago rather than now you are perhaps 20 per cent worse off for that choice. And there is no state compensation scheme.

Share prices- and market values of Kiwisaver accounts – go up and down and no one proposes compensation (even champions of a capital gains tax are rarely keen on full offsetting of losses, which itself would still only offer partial compensation).

We have a system of accident compensation in New Zealand. I generally support it. It pays income-related compensation for loss of earnings, but only partially (80 per cent) and only up to a threshold (maximum liable income about $130000 per annum). Beyond that even for those risks, you are on your own (albeit with private options). And for many disabling conditions the state provides no specific insurance or compensation at all beyond the basic welfare system (and the health system itself of course). EQC cover is also capped.

Same goes for human capital or the fortunes of particular towns/regions. Or the real economic costs of a failed marriage. Many of these potential economic losses run far beyond the plausible scale of what an individual might have exposure to in a bank failure. And yet while we often sympathise individually, and support having in place a welfare system for basic support, we don’t as a society collectively attempt to compensate individuals for such losses. For most of such losses, no modern state – no matter how socialist in its reach – has ever really attempted to. We have debates at the margin – eg the government’s preferred social insurance scheme – but relative to many of the potential losses such instruments don’t really go very far.

So I struggle to see a strong principled case for treating larger bank depositors more generously. Yes, sometimes bank failures can appear to come from the blue, but they rarely do. Diversification is usually an option (and typically much more readily than you can, say, diversify your human capital or housing or relationship exposures), and so is private insurance. I suspect that few would really disagree as a matter of principle, and much just comes down to “its easier not to let any depositor lose their money” and associated fear of (the minority of ill-founded) bank runs, or “it is too hard to envisage our politicians even being willing to let big banks fail at all”, and living with the third-best consequences of that resigned stance. It isn’t a good place to be – especially when the beneficiaries of these resigned third-best policies will often be among the wealthier parts of society – although even as we try to change the politics, or create better options, there is no point pretending the politics are other than as they are.

UPDATE: Meant to include a mention of the NZ government’s choice – incredibly, on the advice of both the RB and The Treasury – to bail out all policyholders in AMI when that insurer failed after the Christchurch earthquakes. Not only were there no risks of contagious runs – insurance just isn’t like banking – but even if you thought there was a case for bailing out the less-wealthy policyholders, how could it possibly have been a wise, or priority, use of public money to be bailing out people with insurance on a high-end house who, at worst with a severe haircut, might have had to lower their housing sights.

I mean, in this country – as no doubt most – you can be charged by the state for serious offences and a couple of years later acquitted, or wrongfully imprisoned for multiple years and still find it a major hurdle to get serious economic compensation. (To be clear, I do favour erring on the generous side when mistakes are made when the coercive powers of the state are exercised in such ways.)

Bank failure

Sometimes spotting potential bank failures must be hard. One might think of really serious undiscovered fraud, or the weak controls that enabled a rogue trader such as Nick Leeson (who brought down Barings).

But if you were given the following set of facts about a bank:

  • very rapid growth over a short period
  • a heavy reliance on deposits withdrawable on demand,
  • perhaps especially a heavy reliance on uninsured deposits or similar funding,
  • a huge (and unusually large) share of the asset portfolio made up of long-term fixed rate bonds,
  • a position greatly expanded at a time when short and long term interest rates were at record lows.
  • no sign of any extensive use of interest rate risk hedging.

then even if you had reason to believe that the quality of the loans the bank had made were fine, the alarm bells should have been ringing very loudly.   It was a highly risky, nay reckless, way to run a bank.

That was, as I understand it, more or less the picture of SVB Bank, which was closed down by regulators on Friday.  If, like me, you’d never heard of SVB Bank a week ago, it doesn’t really matter.  It was a fairly big bank (second largest actual deposit-taking bank ever to fail in the US, even if small by the standards of JP Morgan or Bank of America) and it seems to have been boringly reckless.  Perhaps when the eventual book is written –  significant US bank failures usually prompt some author into print –  some good stories will emerge, but on the face of it (and there are dozens of articles over the weekend you can look up) the failure was depressingly vanilla in nature.  Chasing yield and coming a cropper,  Since the occasional headline-grabbing bank failure is a useful reminder of risk –  and that people, including very highly paid ones, make bad choices –  perhaps it is not even a bad thing that it happened (and deposits of up to $250000 each are covered by insurance).   Whether one goes that far or not, it is an episode that seems to reflect very poorly on the management and Board of SVB. but also on the bank’s regulators (in this case, primarily the Federal Reserve).    People, perhaps fairly, note limitations in the US regulatory system (and bank accounting standards), and the lobbying SVB Bank itself had engaged in to avoid being covered by some rules that apply (in the US) only to systemically significant banks.   But I am left wondering whether the relevant Fed examiners were asleep at the wheel.  After all, a smart and energetic young Fed analyst who’d never gone beyond publicly available information should have been able to look at the stylised facts above and yell “whoop, whoop, pull up”.    You might have hoped that when the CEO of SVB was (until Friday) on the board of the San Francisco Fed –  boards that from a policy perspective are more ornamental than substantive – that that alone would have meant a more than usual vigilance by Fed staff on risks associated with that bank.  But apparently not.

Anyway, my point wasn’t mainly to add to the oceans of SVB commentary, but to have a look at the big New Zealand banks.  They’ve been under fire lately, and they certainly do seem to be quite profitable businesses (although I’ve always been cautious about that view, including because the NZ subs are not charged for the (considerable) implicit parental support, without which their market funding costs would be higher) but for decades none of them has failed, or even come close.

There is, of course, an old line that part of the general way banks operate is to “borrow short and lend long”.  As the Governor put it in his speech a week or so back, hardly any bank in the world holds enough liquid assets that it could immediately meet all claims if they suddenly came due to today (even the ones that legally could be redeemed today).  Banks hold portfolios of liquid assets –  themselves voluntarily, and under regulatory duress – to limit liquidity risks, and when there is no question about the quality of a bank’s assets, banks also expect liquidity support (at a price) from central banks if they were to face unexpectedly intense liquidity pressures.  The fact that lender of last resort capability is known to exist is one reason why regulatory agencies need to impose liquidity requirements (otherwise holding more higher-yielding less-liquid assets will seem attractive to some bankers).

But bank runs (a) aren’t common, and (b) don’t typically strike out of the blue on innocent well-managed banks, so typically the much more important issue is around risks which threaten to impair a bank’s capital and undermine the prospect of depositors and other creditors being able to get all their money back when it falls due.  And the issue here is not so much what happens to measures of capital as regulators or accountants state them but about the underlying economic value.  Accountants and regulators may not require some assets –  some long-term bonds for example – to be marked to market, but whether the current market value of an asset is in the books or not does not change the facts of a potentially impaired market value.

SVB Bank seems to have been running massive and unhedged interest rate risk.  They had purchased huge volumes of long-term fixed bonds (mostly federal agency mortgage securities) and had, on the other side of their balance sheet, mostly short-term deposits repricing quite frequently.  You could hold a 30 year bond to maturity and know exactly what you will get back for it (assuming the issuer does not default) but it isn’t much comfort to you, or your creditors, if in the meantime your funding costs (deposit rates) have risen very sharply.   SVB seems to have been an extreme example even by US standards, but holding some, reasonably material, interest rate risk position doesn’t appear to be that uncommon in US banks, especially regional ones. 

But not in New Zealand.  Here is the market risk note in ANZ”s latest New Zealand disclosure statement.

ANZ disclosure

In the years shown ANZ took almost no active trading risk (first table) and even the second table (non-traded market risk) is very small for a bank its size.  That is all summarised in the final table.  A 5 percentage point parallel shift upwards in the interest rate yield curve looks as though it would make less than a 5 per cent difference to the bank’s net interest income.  About 6 per cent of ANZ’s capital is held to cover market risk.  

And here is the table summarising the time to reprice for both assets and liabilities

ANZ disclosure 2

On average, liabilities do reprice sooner than assets (check the “up to three months” column as an example) but note too the use of hedging instruments (primarily interest rate swaps): the bank seems to have had a lot of mortgages repricing between 1 and 2 years from balance date and not many liabilities repricing in the same period, but used swaps to substantially reduce the scale of the interest rate risks the bank was exposed to.  

I didn’t check all the other big banks –  although a quick look at ASB’s disclosure statement look very similar –  but I’d be surprised if there was anything very different in any of them.  It is the way banking is done in New Zealand (and a product of some mix of market, self and regulatory discipline).  Consistent with this, neither net interest margins nor returns on equity (with risks properly accounted for) are very sensitive at all to changes in the level of interest rates. 

But if you ever have money with a bank with the sorts of characteristics I listed at the start of this post –  and thus extremely exposed to any material change in the overall level of interest rates – you’d probably be well advised to get it out, very quickly.

But the other lesson from the events of the last few days is probably if you were counting on a public-spirited regulator to spot problems early and act decisively, well….at best that is quite a gamble too.  But if regulators can’t do better than what seems to have been on display in SVB you do wonder quite why we pay their salaries.

Central bank losses and the BIS

The Bank for International Settlements (BIS) is a club of central banks. That isn’t a pejorative label, just a straight factual description. 63 central banks (including the RBNZ) are the shareholders and the institution exists primarily to generate material for, and host meetings of, central bankers. They collate statistics and generate research with a central banking focus. They still provide some financial services to central banks. The chief executive (“General Manager”) is chosen from the ranks of highly-regarded senior central bankers (the current incumbent, Agustin Carstens was (among other things) formerly Governor of the Bank of Mexico and Deputy Managing Director of the International Monetary Fund).

As I mentioned in yesterday’s post, Adrian Orr had been citing material published recently by the BIS in defence of his suggestion that central bank losses from discretionary interventions really don’t matter and are more of an “accounting issue” than an economic one. When that material came out last month I drew attention to it, and (briefly) to the limitations, on Twitter, but since the Governor suggests that the BIS has the answers I thought it might be worth taking another look and unpicking what is, and isn’t, there in the two short BIS pieces. The first is an op-ed from Carstens, published in the Financial Times but the full text of which is on the BIS website and the second is a six page note by several BIS staff “Why are central banks reporting losses? Does it matter?

The Carstens op-ed is short enough I can take it paragraph by paragraph.

It begins with the title “Central banks are not here to make profits”. That is both true and a distraction. First, hardly any aspects of what governments do exist to make money, Second, unlike most arms of government, central banks should typically be at least modestly profitable (as monopoly provider of zero interest banknotes and of residual liquidity to the financial system). Third, when discretionary interventions are being considered the likely profits or losses, and the associated risk to taxpayers, should be at least one part of the full assessment of the pros and cons. And, finally, when interventions are being evaluated ex post, financial outcomes should be at least one part of a full assessment. Costs and benefits both matter.

As context here, one might note that the Reserve Bank of New Zealand, which used to have a low-risk small and stable balance sheet, made a profit each and every year for decades (without support from taxpayer indemnities). It was the normal state of affairs (seignorage earnings, with some volatility up and down as the proceeds of the note issue and the Bank’s equity were typically held in government bonds).

But on to the text

Unlike businesses, central banks are designed to make money only in the most literal sense. They have a mandate to act in the public interest: to safeguard the value of the money they issue so that people can make financial decisions with confidence. The bottom line for central banks is not profit, but the public good.

As noted, this does not mark out central banks from other government entities. Resources used, risks assumed, need to be rigorously evaluated along with programme effectiveness.

Today, following an extraordinary period in economic history, some central banks are facing losses. This is particularly true if they bought assets such as bonds and other securities to stabilise their economies in response to recent crises. Many will not contribute to government coffers for years to come.

“believing that by doing so” they would stabilise their economies. Note that in a formal sense that final sentence is not true of the RBNZ, since the Crown indemnity means losses from their interventions are borne directly by the taxpayer, not via impaired central bank capital. More generally, whatever the formal arrangements – and they differ widely across countries – mark to market accounting reminds us that the best guess is that large losses have already happened.

Does this mean that central banks are unsound? The answer is “no”. Losses do not jeopardise the vital role played by these institutions, which can and have operated effectively with losses and negative equity. And the unique nature of central bank tools means that sometimes losses are the price to pay for meeting their objectives – to support growth and jobs, ensure stable prices and help keep the financial system safe and stable.

In normal times, it is possible for central banks to both fulfil their mandates and earn profits without taking on significant financial risk. Traditionally, being the unique issuer of money provides a reliable revenue stream. But central banks with large foreign exchange reserves, built to cushion external shocks, will often experience ups and downs in income from exchange rate fluctuations. This means they sometimes make losses when pursuing their goal of a stable currency.

Agree entirely with the first two sentences, but they aren’t really the point and I’m not aware of any serious observer arguing to the contrary. The third sentence is much much more arguable, and neither in the brief op-ed nor in the longer Bulletin does the BIS really defend the claim. Most discretionary central bank interventions, if justified at all, should be stabilising and thus profitable (eg the Bank of England bond market interventions late last year). As Carstens notes, for countries with large foreign reserves holdings, exchange rate fluctuations will typically generate substantial year to year gains and losses simply from passive holdings but if that is an issue for Switzerland (where the BIS is based) it isn’t for most of the advanced country central banks we usually compare the Reserve Bank to. And there is likely to be a difference in how one sees passive structural positions and active discretionary interventions.

In times of crisis, central banks may also need to take on additional risks. And they do so with their eyes wide open. One example is the purchases of government bonds, including those made during the great financial crisis and more recently during the Covid-19 pandemic, in order to avert economic disaster by supporting financial stability, keeping credit flowing and boosting economic activity.

All this simply asserts what it does not show. But there is also an important distinction, not drawn here, between interventions to help restore market functioning (the initial QE back in 2008, and the initial bond buying in March 2020) which, support them or not (there are, after all, some moral hazard risks), should typically be expected to be profitable, perhaps even on a risk-adjusted basis, and large scale bond-buying with the goal of influencing the entire level of the yield curve. There is little evidence that many central banks (notably the RBNZ) really did much serious advance analysis on the use of this tool, the financial risks associated with it, the likely effectiveness of it, let alone exit strategies. In a NZ context, we should give no weight to the suggestion in the final sentence that the LSAP was necessary to “avert economic disaster”.

In the last decade, with inflation and interest rates low for a long period, these bond purchases boosted income. In fact, some central banks were able to transfer unusually large profits to governments. But in the wake of the pandemic and given the invasion of Ukraine by Russia, inflation has returned. This requires higher interest rates to contain spiralling prices – and exposes central banks to losses related to assets purchased in past successful rescue efforts.

Here Carstens touches on one of the problems with the 2020 QE interventions: central banks, including our own, seem to have been lulled into a degree of complacency about the risks they were taking on by the fact that QE done in other countries in the wake of the 2008/09 recession had not ended up costing central banks or taxpayers lots of money because the longer-term trend of falling real interest rates had continued. There was, however, no reason to suppose it would do so indefinitely, and a continuation was in any case less likely with bond yields near 1 per cent than with bond yields at, say, 5 per cent.

Central banks should put purpose above profits. Would it make sense for a central bank with large foreign currency reserves to increase their value by haphazardly triggering a devaluation of its own currency just to generate a windfall? Or for a central bank with domestic currency assets to keep interest rates low, even in the face of high inflation, just to preserve low-cost funding and generate profits? Such actions would be wildly inappropriate, violate their mandates and destabilise the economy.

By this point in the article, handwaving and straw men are well and truly to the fore. The issue is much more about the risk analysis – financial and otherwise – undertaken before the initial discretionary intervention (and at each stage of it), not how one clears up the mess afterwards. No one I know has suggested central banks should not allow interest rates to rise simply to protect their own financial positions, but there are serious questions about whether those (known to be) highly risky asset swaps should have been done in the first place.

The soul of money is trust. To operate effectively, business must maintain the trust of investors. And central banks must maintain the trust of the public.

Governments also have a role to play in the face of today’s central banks’ losses. Because these institutions are ultimately backed by the state, trust in money requires sound government finances and good financial management.

Blah, blah, blah. But one might add that maintaining the trust of the public in a modern era typically involves both demonstrated competence, openness and transparency, and acknowledgement of errors – not just patting people on the head and telling them “don’t worry, its complex, we are the experts and we have it in hand” even as staggering real losses are run-up and realised.

And finally

Losses matter because they may inflict a bruise on public finances but a far greater injury would result from central banks neglecting their mandates in order to avoid a loss. The public, via elected officials, have given central banks the job of price and financial stability because of their enormous societal benefits. Now, and in the long term, the costs from central bank losses are insignificant compared to the costs of runaway inflation and prolonged economic crisis.

Perhaps that first phrase is key. Losses matter, they are real. Nowhere does Carstens suggest they are “just an accounting issue”. The rest of that paragraph is really just handwaving and distraction, culminating in that outrageously misleading final sentence which seeks to suggest that there is some inescapable tradeoff between “insignificant” central bank losses and “runaway inflation and prolonged economic crisis”. There simply isn’t – and starkly there clearly wasn’t when central banks like the RBNZ launched and kept up their highly risk bond buying in 2020. With hindsight – and no matter what people might have claimed to believe back then – large scale bond-buying kept on well into 2021 or in some cases 2022 did not keep us from “runaway inflation and prolonged economic crisis”. Instead, overall central bank responses to Covid delivered us a really severe outbreak of (core) inflation, which central banks are now grappling to get back down again.

The Carstens piece is best seen as distractive spin for central banks by the chief executive of their own club. That needn’t necessarily mean there are no useful points their own lobbyist could ever make, but there were almost none relevant to the issues at hand, or the challenges that have been posed to Orr, in this piece.

More generally – and if this is a central bankers’ conceit, they probably aren’t the only interest group to suffer this fault – there is no sense anywhere in the Carstens piece that central banks might ever make mistakes, that some interventions might be worthwhile and appropriate and others not. But when central banks have done even their core job so poorly over the last couple of years – see core inflation rates across much of the world – the absence seems particular notable.

I’m not going to attempt a similar paragraph by paragraph treatment of the longer BIS staff note. It has some useful material in it, particularly for those less familiar with these issues, even if it has a strong focus on “whether losses matter for a central bank” (as they note, losses do not compromise a central bank’s technical ability to fulfil its mandate), rather than whether they matter for taxpayers, citizens, and those wishing to hold a central bank to account. I wanted to pick up briefly just the last couple of paragraphs, on how central banks should respond to losses.

“Effective communication” does not include trying to spin public audiences or MPs with assertions that real economic losses – that leave taxpayers poorer – are “just an accounting issue”. It should not include handwaving assertions about the wider benefits being “multiples” of the losses. It should include careful analysis and research evaluating the actual macroeconomic impact, including by comparison with the gains that less financially risky interventions might have offered. It should include careful ex ante disclosed risk analysis (the case for which was all the stronger for central banks coming late to the QE party, like the RBNZ or RBA). And it should include explicit recognition by central banks that they can, and sometimes do, make mistakes, even substantial ones. None of that has characterised the Reserve Bank of New Zealand through this episode.

And what of that final paragraph? It has the feel of editorial spin. Although it has become common in this field to claim that big financial losses are sometimes the price that has to be paid, there is rarely any rigorous attempt made to demonstrate the truth of that claim in respect of discretionary ad hoc interventions like the LSAP (or peer programmes abroad). Central banking done well should be profitable, from the nature of the institution – not because a central bank sets out to maximise profits (such a beast would be dangerous indeed) but because of its position in the market/economy and the monopolies the state gives it central bank.

Finally, and reverting specifically to New Zealand, one of my consistent criticisms of the LSAP programme is that there is no evidence in any of the material that has been released that the Reserve Bank or Treasury ever conducted or provided a robust analysis of what could go wrong when seeking the approval of the Minister of Finance for such huge punts on the bond market (and punts they were).

As just one example, consider this Treasury report to the Minister dated 1 May 2020 (so six weeks after the LSAP had been launched, and well after the initial US-led disruption to bond markets had settled down), in support of the Reserve Bank’s bid to expand the LSAP programme, and increase the associated financial risks. Here is the relevant bit of the financial risks section

Written in a way to suggest the programme was more likely to make money than lose it (despite the record low interest rates at the time) and with a “large but plausible” downside scenario involving the OCR only getting back to 1 per cent by this year, with no attempt at all to offer tail risk estimates of the extent of the possible loss. It simply isn’t the sort of analysis that should prompt any degree of confidence in either the Reserve Bank or the Treasury.

But this is the sort of stuff that Orr apparently stands by 100 per cent, with no regrets for anything he or the MPC were responsible for.

Central bank inadequacy and spin

Last Friday the Reserve Bank Governor, Adrian Orr, gave a keynote address to the Waikato Economics Forum. This event seems to have become part of the annual economic policy calendar, with Waikato University boasting that

The forum will bring together an outstanding lineup of top economists, business leaders and public sector officials, who will share their expertise on how we can address the major challenges facing our country today.

Sold that way, you might have thought that when a really senior and powerful public official turns up for a keynote address to an assembled economically literate audience he’d have delivered some fresh and interesting insights, going rather deeper than he might to, say, a provincial Rotary Club. Doubly so when in that official’s area of policy responsibility things have proved so challenging in the last few years, when so much taxpayers’ money has been lost, and when core inflation is so far outside the target range the government has set. It was just a couple of weeks after the latest Monetary Policy Statement, so would have been a great opportunity for the Governor to expand on the issues and shed light on how, and how rigorously and insightfully, he sees things .

Instead we got “Promoting economic wellbeing: Te Pūtea Matua optimisation challenges”, a title that held out little or no hope and offered less across a sprawling 12 pages of text. Attendees must have wondered whether it had really been worth getting out of bed early enough to hear the Governor at 7:40am. As for me, I read it twice, just to be sure.

Faced with major policy failures – and the core inflation outcomes cannot really be considered anything else, no matter how many allowances might be made – there is not a single fresh or interesting insight in the entire speech, In fact, it is the sort of address one of Orr’s junior staff could easily have given, as a “functions of the Reserve Bank” talk, to a Stage 2 university economics class.

Perhaps it would be one thing if (a) little or nothing interesting was going on in the economy or with inflation, or (b) if the Governor and other members of the Monetary Policy Committee were giving speeches on monetary policy matters every couple of weeks, although one might still – given the character of the audience – have reasonably expected more, including because good and thoughtful speeches offer insights into the quality and character of decisionmakers and their advisers. As it is, a great deal is going on, a great deal that has taken the Bank (and most others) by surprise, and that is still ill-understood (eg why did almost everyone get it wrong, what did we miss, what do we learn?), and serious speeches by MPC members on things to do with monetary policy, inflation etc are – unlike the situation in most other advanced countries – very rare. As far as I can see, the last serious monetary policy speech the Governor gave was to the Waikato forum a year ago, the chief economist has not given any speeches on monetary policy or inflation (nor, perhaps mercifully, has his boss), none of the external MPC members has ever given a speech on these topics or put their names to specific views or lines of analysis/reasoning/evidence, and the Deputy Governor’s last speech on monetary policy was 18 months ago, when the Bank was barely worried about inflation at all.

It is inexcusable in people who wield so much power, perhaps for good longer term but certainly for ill in the last couple of years. And it seems to speak of some combination of the utter arrogance Orr routinely displays when he does speak, and the probable absence of any fresh or interesting analysis in the entire institution. If they had such insights, such research, such analysis, surely they’d be wanting to impress us with it? But the Bank now publishes hardly any formal research and it is rare to find even an insightful chart in an MPS. If spin seems to be the order of the day, and it so often does (see below) they aren’t even very good at generating supporting material, let alone providing any serious accountability.

There really wasn’t much interesting in this keynote address at all, but I did want to highlight just a few of the spin lines.

On the straight economics there was this

Low and stable inflation is a necessary outcome for economic wellbeing in the longer term

I’m deeply committed to the case for price stability (ideally, an even lower inflation target than we have now) but this is simply overblown nonsense, which discredits the case for low and stable inflation. A more serious Reserve Bank in years gone by might, much more reasonably, have framed the point simply as “tolerating high inflation won’t make us any richer, and will come with all sorts of distortions and costs, and in the longer term if price stability doesn’t determine whether or not we are prosperous and productive, it is still the best limited contribution monetary policy can make.

Then there was the corporate spin

Looking ahead, in striving to be exceptional in our work,

Perhaps it is good to aim to be exceptional (although few people or institutions ever are), but…..the Orr Reserve Bank, when we get speeches like this, and few of his decisionmakers ever expose themselves to any sort of serious scrutiny, and when leading from the top the Governor is reluctant to ever express regret for anything he/they might have done, or failed to do. Great institutions – especially powerful public ones – acknowledge openly and learn from their mistakes.

I’ll skip the empty waffle about climate change (“we have a key part to play”) or the political posturing about the Treaty of Waitangi (which is apparently part of a “move from being a good to a great Central Bank” – who granted them even a rating of “good?)

At the end of the speech there is a section headed “Our research programme”, where Orr asserts

Te Pūtea Matua has a long tradition of pursuing policy-relevant research and as a full service central bank our research programme covers all three strands of work we are tasked to deliver.

It used to be true that the Bank had a strong record of policy-relevant research on things around monetary policy, inflation, and the cyclical behaviour of the economy. But no more – just check out how little research they’ve published in those areas in recent years, It has (sadly) never been true that the Bank has had any sort of sustained tradition in policy-relevant research around either its mushrooming financial regulatory and stability responsibilities (in fact, there were conscious decisions by successive Governors not to invest in such research), or its cash responsibilities, and there is no sign that has changed for the better. Instead, we just get spin like this.

And then in conclusion Orr asserts that

We are a learning institution and we enjoy collaboration.

Learning institutions engage, learning institutions aren’t prickly and defensive, learning institutions don’t just make stuff up, learning institutions don’t claim to regret nothing, learning organisations – especially amid the biggest surprises/policy failures in decades – don’t give keynote addresses like this. And collaborative institutions don’t engage in the sort of defensive abuse Orr is sadly all too well known for.

Learning organisations, agencies that are exceptional in their work, great central banks, don’t just make stuff up. Orr does.

The Herald’s Jenée Tibshraeny had a nice piece yesterday on just the latest example, from the question time after Orr’s Waikato speech. He was asked a question about central bank losses from things like the LSAP bond-buying programme (about 1.03 hrs into the video of the day), specifically citing the (recently newsworthy) losses the German central bank had been recording and disclosing. Instead of responding seriously and substantively, Orr blustered, attempting to imply that these were really just accounting issues (as if good record keeping doesn’t matter), muddying the waters by getting into questions about how much central bank equity matters, and condescendingly suggesting that while such issues “hurt the brain” people need to start exercising their brain, and “calm down”. The questioner himself clearly wasn’t satisfied, and asked a follow-up, but Orr simply talked out the clock, even suggesting (astonishingly) that the BIS – a bunch of technocrats in Basle – had explained it all for the public.

There are two points people like the BIS have made that are of course true, and as general points have never really been disputed by serious commentators and observers.

First, central banks don’t exist to maximise profit. They exist (in their monetary policy functions) to deliver low and stable inflation, and

Second, central banks can in principle function perfectly well with low, zero, or even negative equity (I spent a couple of years working for one that not only had negative equity but wasn’t even able to produce a proper balance sheet for a prolonged period).

But harping on those sorts of points is simply irrelevant in the face of the huge real losses to taxpayers that central banks have sustained in the last couple of years.

In New Zealand’s case, as it happens, the negative (or impaired) equity issue doesn’t even arise, since the Bank in advance wisely sought a government indemnity for any losses the LSAP might lead to. As a technical matter they didn’t need to – they could have run through all the equity the government had given them and recorded huge negative equity. Nothing about the Bank’s ability to function would have changed one iota, but some hard questions no doubt would have been asked, and Orr reasonably enough preferred to have any blame shared.

But none of that changes the fact that the MPC’s choices around the LSAP – signed off on by the Minister of Finance, with Treasury advice – have cost taxpayers in excess of $9 billion: not “just accounting issues” but real losses. That is what happens when a government agency (central bank) does a huge asset swap, transforming much of the government’s long-term fixed rate debt into effectively floating rate debt just before short-term rates rocket upwards. Had the LSAP programme never been launched – or even if it had been halted a few weeks in once bond markets had settled down from the US-led turbulence of March 2020 – taxpayers and the Crown would be that much better off, in real purchasing power terms. And none of Orr’s spin and distraction – and none of the BIS material – ever seriously engages with those real losses. Instead they respond to points that are not those serious critics are making.

And if one happens to think the LSAP made a meaningful economic difference – as Orr still seems to claim – then that only reinforces the point, since it added to the level of stimulus that helped deliver the core inflation, miles outside the target range, that central banks are now struggling to get under control and reverse. Better not to have had the real economic losses, and of course with hindsight we know the level of monetary stimulus was too large for far too long.

(As I’ve argued in numerous posts here over the last 3 years, I don’t believe the LSAP made much meaningful difference to anything – simply added huge risk, without any serious advance risk analysis, culminating in huge losses. I was encouraged to see in Tibshraeny’s article that the former Deputy Governor, Grant Spencer – able economist and former bank treasurer – seems to have the same view

“The main benefit was that it smoothed the disruption to the bond market that occurred in April/May 2020 when there was some real volatility in the bond market and bond rates spiked up,” Spencer said.

“After that, the rest of the purchases, I would say, had very little effect on the term structure of interest rates.”

Well quite. The initial intervention may not have been necessary but could have been highly profitable on a small scale. The latter purchases made no difference to short to medium interest rates (set by the OCR and expectations about it) and little to longer-term rates. Had they wanted short rates lower, the OCR could always have been cut by another 25 basis points, at no financial risk to taxpayers.

Orr seems to have backed away somewhat from a line he gave Tibshraeny in an interview last year, where he claimed that the macro benefits of the LSAP programme were “multiples” of the losses (and the Bank’s five-year monetary policy review last year provided no serious support for such claims) preferring now just to rely on bluster, distraction, and the hope that people will eventually get tired, or confused, and forget.

Orr’s comments on Friday reminded me that I’d heard that Orr had also been trying on the handwaving “it’s just an accounting issue” at FEC after the recent Monetary Policy Statement. I hadn’t listened in at the time and finally did so this morning.

If National Party members don’t always ask very good questions on this issue, at least they show no sign yet of being willing to let it go. In doing so, they bring out Orr at his prickly, blustering, and basically dishonest, worst.

Willis asked if it was not regrettable that there had been a direct fiscal cost from the LSAP programme of about $9bn. Orr’s response was a single word: No.

Willis followed up asking if he was really saying that these losses were justified. This time, she got a three word response “Yes, I do”.

Orr went on to state that he “100% stood by” the LSAP and its losses, getting a bit more expansive and asserting/reminding the Committee that central banks could operate with negative equity – as noted above, this is pure distraction in the NZ context since the Reserve Bank’s capital was not impaired at all (although taxpayers’ “equity interest” in the NZ government was) – and explicitly going on to assert that it was “an accounting issue not an economic one”. As applied to the LSAP, that is simply false, yet another outrageous attempt to mislead Parliament.

And he wasn’t finished. Willis asked if he was saying he had no regrets at all. His response? “Those were your words”, before falling back on his regrets for things he had no responsibility for – regrets Covid, regrets Ukraine, regrets Gabrielle, even passively regrets that New Zealanders are experiencing high inflation – but no regrets for any choices he made might have actually made, not ones that costs taxpayers $9 billion, and certainly not ones that led to core inflation of about 6 per cent and likely “need for” a recession. Spinning again, he repeated the line he is fond of that if they’d tightened one quarter earlier it would have made very little difference. No doubt so, but the big mistakes – perhaps pardonable, perhaps even understandable, but big mistakes nonetheless – weren’t about one quarter, but about fundamental misjudgements in 2020 and early 2021, on things Parliament has delegated Orr and his MPC responsibility for, as supposed technical experts. And yet they refuse to take any real responsibility, falling back on attempts to distract MPs and avoiding serious engagement with anyone else.

There has been a lot of focus in the last week or so on Rob Campbell’s mistakes, for which he has rightly paid a price and no longer hold Crown appointments.

But Orr managed to lose billions – having done no advance risk analysis, having talked rather negatively on bond-buying strategies only a few months prior to Covid – and delivered us very high core inflation, core inflation reflecting largely domestic demand imbalances well under Reserve Bank monetary policy influence, refuses to engage seriously, actively and repeatedly misrepresents things and misleads Parliament, and treats those to whom he is accountable with prickly disdain and no respect whatever, and yet keeps his job, and starts a second term later this month. It is a sad reflection on how degraded New Zealand politics and policymaking has become when accountability now appears to mean so little.