The tale of three central banks and parenting –

In the last day, we have heard and seen three very different approaches to solving or disciplining the credit crisis. The crisis has turned into a morality play whereby the market will have to be disciplined for bad behavior and schooled in the ways of proper lending and borrowing. Left to their devises, borrowers will overindulge and lenders will push money in the hands of the weak. (Contrast the belief that bankers never allowed enough credit in the 19^th century.) Central banks are placed in the role of being a parent to their exuberant market children. All central banks were moving to the same parenting book over the last few years through focusing on inflation targeting, but the crisis now shows closer monitoring of activities is necessary and central banks are showing distinct differences in their behavior. Contrast the Fed, Bank of England and the ECB.

The Bank of England has made it emphatic that it will not supply funds to relieve the problem in the LIBOR market. Their message could not be clearer. The banks are on their own to sort out the crisis. This is “tough love” central banking. You make bad decisions and you will pay a price and live with the consequences. You cannot learn if you do not suffer the consequences of your actions however harsh. There should be no reward for bad behavior. There is no moral hazard problem where the banks can expect to be bailed out by lower interest rates.

The Fed, on the other hand, has supplied funds to the banking system, lowered the discount rate and has stated that it will stand ready to provide funds in case of a crisis. They are the parent that shakes their head at bad behavior but help out their children in a crisis. Their love of the banking system is unconditional or with limited conditions, a slight premium at the discount window. For the good of the family, they will help out in a crisis when necessary. The Fed understands the consequences of its actions but hope that their children will learn on their own from their poor behavior. The Fed also realizes that the action of the banks will also have consequences outside the family. You may have to take action because it is in the best interests of the community even though it reinforces the bad bank behavior. The banks know that they will get help even though it may not be forthcoming immediately. Mom and Dad, while upset with their children’s behavior, will save the day. The banks can take risks because protection is available. The Fed may talk about “tough love”, but it’s all rhetoric. The issue is whether banks will learn from their mistakes if their central bank parent bails them out.

The ECB is the parent that talks tough, but still provides support in subtle ways just behind the scenes. They will explain that they have a strong stand on bad behavior. They will argue that they will change their parenting with more discipline and monitoring, but they are also willing to supply funds when necessary. They will not cave on the larger issues of controlling inflation but there is a sense that support is needed at the extremes. It’s harder for banks to get a true read on the ECB’s subtle behavior. Funding is available, but there will be punishment and closer monitoring but the long-term ECB strategy will not change. It is more situational parenting.

How will the banks turn out under these different parenting schemes? Each central bank believes their parenting of the banking system will lead to the best result, yet we can never know which is best in the short-run. Teaching tough love also is problematic if in the end the financial system is harmed. However, wavering or vacillating will result in an uncertain environment where banks will not know where are their boundaries. Of course, the most important issue is how you make the financial system work in a mature fashion and not like children.