Central Banker ProCyclical Craziness

Central banks are engaged in procyclical behavior, which makes absolutely no rational sense. After this behavior is discussed, the Basel 3 solutions are discussed at the end of this article. Maybe an exposed  Fed could even be redeemed. Procyclical behavior is really bad, and must be changed.

Market Monetarist Lars Christensen  said this about central bank behavior, and this pretty much defines what that behavior is:

Concluding, central banks during booms tend to take on more risk – they overweight risky assets – while they during busts tend to reduce risk – underweight risky assets. Hence, central banks consistently act in a procyclical fashion.

This is of course is not only bad in terms of ensuring the highest and most stable return at the lowest possible risk, but it also adds to the swings in the economy as the central bank will add liquidity to the financial system during booms and redraw liquidity during crashes.

So, it is not a stretch when I write that the Fed is responsible for the housing bubble and crash. That is consistent with central bank procyclical thinking. Bubble/bust exaggeration is built into the system. Banks are like the guy who buys high and sells low, or you could say banks are like momentum players. Neither of those results healthy economics, in healthy price discovery. If the American people had an understanding of this central bank process, they would probably call for the overthrow of the fed.

I have argued about the actions of the Fed creating the housing bubble and then crashing the economy both here and here.

Moving on, we can see that even Wikipedia gives the same definition of procyclical behavior. 

Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. Of course, since effects of particular policies are often uncertain or disputed, a policy will be often procyclical, counter cyclical or acyclical according to the view of the one judging it.

Thus the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn.[5]

Indeed, countercyclical behavior makes a lot more sense. This Wikipedia definition in the same article comes close to capturing the definition but monetarists have a slightly different application that I will share after the quote:

 Keynesian economics advocates the use of automatic and discretionary countercyclical policies to lessen the impact of the business cycle. One example of an automatically countercyclical fiscal policy is progressive taxation. By taxing a larger proportion of income when the economy expands, a progressive tax tends to decrease demand when the economy is booming, thus reining in the boom. 

Since Keynesian Economics does not always work, many economists have turned to monetarism in the belief that monetary policy can work, and even give fiscal benefits. I wrote a couple of articles about some new thinking about this view here and here.

This monetary stimulus, based upon the issuance of a large infusion of base money by the central bank, could really help the economy with tax breaks, while still funding government without budget cuts. In a slowing cycle, this would be countercyclical. It would be not be QE, but would be better than QE as it would be done without taking scarce long bonds out of the system, and it would be for everyone, not just the banks or wealthy holders of assets. This action could redeem the Fed in the eyes of the people.

Even Basel 3 acknowledges the need to reduce procyclicality. Well, even a 6th grader could see that is needed. The Fed could have done things to help out in 2007-2008.  The Fed could have bought bad paper. The Fed could have minimized the credit crisis. Before that, the Fed could have restrained the bubble just a little. But procyclicality prevented those actions. And it damaged the middle class and confidence in the economy by main street. Main street has been shunning the markets for this very reason. Procyclicality hurt the nation, both in the Great Depression, and in the Great Recession.

Bankers should be restrained by law from withdrawing liquidity in a downturn and increasing liquidity to the moon in booms. It is just a form of manipulation of the markets, in my view. It is not healthy and not even moral.

So, though I would not hold my breath, I am encouraged by the apparent goal of the BIS speaker, Mr Caruana, in encouraging the limiting of procyclical behavior by establishing a countercyclical buffer for the banks:

  On the procyclicality aspect, Basel III will promote the build-up of buffers in good times that can be drawn down in periods of stress. First, as I already noted, the new common equity requirement is 7%. This new higher level includes the capital conservation buffer of 2.5%,and will ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of stress without going below the minimum capital requirements. This will reduce the possibility of a self-reinforcing adverse cycle of losses and credit cutbacks as compared with previous arrangements.

Second, a key element of the Basel III rules to limit procyclicality will be the countercyclical capital buffer, which has been calibrated in a range of 0–2.5%. This countercyclical buffer would build up during periods of rapid aggregate credit growth if, in the judgment of national authorities, this growth is aggravating system-wide risk. Conversely, the capital held in this buffer could be released in the downturn of the cycle. This would, for instance, reduce the risk that available credit could be constrained by regulatory capital requirements. The intention is thus to mitigate procyclicality and attenuate the impact of the ups and downs of the financial cycle.

Whether Basel 3, put off until the end of this decade, will come up with real changes in bank behavior, in their own behavior, remains to be seen. We can only hope this would happen. Crashes of bad credit offered are going to happen. But to then crash entire system when the bad credit goes down, all in the name of procyclicality, is just bad behavior on the part of the elite, who have learned to game the central banks.

One wonders if the central banks will have the will to actually stop their procyclical behavior, or will we just be fooled again. The Fed helped America out in World War 2. It is time to help with a monetary infusion in the very next downturn. It could be the Fed's last chance to get it right.

Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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