Central bankers must have the courage to act before a crisis: Don Pittis

Are central bankers always destined to be too late?

This weekend, two of that august fraternity were strutting their stuff. Former U.S. Fed chairman Ben Bernankewas busy promoting his new book calledThe Courage to Act.Meanwhile, Bank of Canada governorStephen Polozwas givingspeechestitledIntegrating Financial Stability into Monetary Policy.

And in different ways, thetwo treadthe same ground: how difficult it is to rein in a housing boom before it turns into a crisis.

• Stephen Polozsays Bank of Canada not responsible for record debt
• The Current:Ben Bernanke's insider'saccount ofa financialmeltdown

The title ofBernanke'sbookhas already beenpilloried for its hubris.

Voices had been raised for years that U.S. interest rates were toolow and that it was driving house prices too high, distorting the economy. But as Bernankeadmitted in aninterviewthat playedTuesday on CBC Radio's The Current, he didn'tact untilit was far too late.

Greater than housing

"It wasn't until August of 2007 that we began to appreciate that the ramifications of the losses on sub-prime mortgages were goingto be much greater than just the housing market," BernanketoldThe Current host Anna Maria Tremonti.

Of course by that time, there was really little the U.S. central bank could do to prevent the bubble from popping, setting off a global financial meltdownand necessitating a multibillion-dollar bailout of the banks that had contributed to the crisis.

Years of low interest rates had allowed consumers to borrow recklessly. After they had access to that money, they used it to overinflate the entire economy, buying consumer goodies and bidding up the price of real estate.

By then, it was too late to raise interest rates. Itcould have been done several years previously, slowing the boom before it became dangerous. So why didn't Bernanke, or his predecessorAlan Greenspan,act then?

There may be clues from listening to our own central banker's speech this week.

"It is not the role of monetary policy to protect individuals from making bad choices," Polozsaid in both Washington and to the IMF World bank meeting in Peru.

If it were merely a case of individuals, itwould be a smallerproblem. It is likethe classic insurance case of discrete versus connectedrisk.

If a local company insures individualhomeowners against fire, it is inevitable that some houses will burn down. But everyone else's insurance premiums will cover that occasional eventuality. But if a forest firesweeps through or a plague of arsonists set a city-wide conflagration,the local insurance company could go broke.

A widespread property meltdown is much more like the second case. As in the U.S., a crashin the Canadian property market, should it happen, would likely have an impact much wider than a few individual homeowners.

Interestingly,Poloz does not deny that such a connected risk may be dangerous.

"It is possible that the sum of those bad decisions could threaten financial stability or the economy as a whole, and so we monitor the situation as a matter of course," said Poloz."But there is no reason to assume that, in all circumstances, equilibrium will devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis."

For now, Poloz puts his faith in "macro-prudentialpolicy," that is, rules for and advice to borrowers to discouragethem from running up excessive debt.

Hands are tied

But when it comes to raising interest rates to prevent a crisis from happening, he insists it's too early. The central bank is bound first by its instructions to hold inflationat or around two per cent as its single criteria for altering interest rates.

As a policy for holding inflation down,that has proven to work well. When inflation rises, higher and higher rates have been clearly shown to, eventually, get rising prices under control.

But when, as now, inflation stays stubbornly low despite the rising costs of housing, the central bank finds it difficult to act.

• Central bankers can't fix the economy
• Central bankers move from shadows to spotlight

Some might say the bank'smethod of calculating inflation is the wrong one. Others might point out that its overarching mandate is to "promote the economic and financial welfare of Canada,"which could be seen as overriding any restriction on rates and inflation.

Certainly after a crisis happens, banks are willing to throw out many rules in an effort to end it. In the U.S. and European and Japanesecases, theypumpedtrillions of dollars into the economy to rescue their banks and restart consumer demand.

However, we have seen the damage of firefighting after the fact rather than prevention. It can createhuge economic distortions that continue to plague the world.

Not only have developing countries like Canadian homeowners run up dizzying loans that they may have trouble repaying, but Bernankealsoadmitsthe financial medicine created domestic distortions.

"What you've seen in the United States is that in this recovery that a lot benefits of growth have gone to the higher income, higher wealthpart of the population," Bernanke said.

In the current Canadian election, the danger of a teetering housing sector facing the riskof collapse has been an unpopular point of discussion. No politician wants to be the messenger bearing bad news.

It may be that whether politicians or central bankers, no one wants to risk the wrath of homeowners and investors for ending a boom too early. It's safer to blamebad consumer decisionsand unpredictable market forces for a popping bubble. Then after the fact, theywill have thecourage to act.

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