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Updated Wednesday, September 8, 2010 11:05 am TWN, By Andrew Sheng, Special to The China Post

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Central bankers need to follow Hoenig's lead on 'hard choices'

Central bankers are a conservative breed — they seldom talk bluntly. However, the President of the Federal Reserve Bank of Kansas, who hosts an annual exclusive Jackson Hole Economic Symposium in August for central bankers, recently gave a brave speech called “Hard Choices.” You know you are considered a respected central banker when you are invited to the Annual Jackson Hole conference. Needless to say, I have never been invited there.

The first hard choice is regulatory. President Hoenig considered that the “too big to fail” problem will not go away easily. He said, “The Basel Committee just announced an agreement to establish for our largest global banks a Tier 1 capital-to-asset ratio of 3 percent. This is a 33-to-1 leverage ratio. Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio. It leaves a small cushion for error and is a level of risk that I judge unacceptable.”

Thank you for telling the truth, Hoenig.

The second hard choice is monetary. Paul Krugman warned that “deflation is a serious risk and that the U.S. could become another Japan, which must be avoided at all costs.” Hoenig dissects that hard choice: “But as much as I want short-term improvement, I am mindful of possible longer-term consequences of zero interest rates and further easing actions. Rather than improve economic outcomes, I worry that the FOMC is inadvertently adding to “uncertainty” by taking such actions.”

He correctly diagnosed that “the financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations.

In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-1991 and 2001.

If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.”

He advocates “dropping the “extended period” language from the FOMC's statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return.”

In other words, he favors easing off “quantitative easing” by getting the market back to normal. “A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty.”

I congratulate Hoenig for his frank and realistic assessment of the current dilemma of excessive low interest rates. Unfortunately, I am not sure that his central banking guests may want to follow his advice. A great pity if they don't.

Andrew Sheng is the author of “From Asian to Global Financial Crisis,” published by Cambridge University Press, and an adjunct professor at University of Tsinghua, Beijing, and University of Malaya, Kuala Lumpur. He was formerly the chairman of the Securities and Futures Commission, Hong Kong.

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