Book review: Banking on the Future, by Howard Davies and David Green

The authors are too shy with their solution to dangerous boom and catastrophic bust.

by DeAnne Julius
Last Updated: 25 Oct 2010

A better title for this book would have been: All You Ever Wanted to Know About Central Banking and More. It summarises the basic theory of central banking and provides a balanced review of much of the recent literature. It contains elegant historical vignettes about central bankers of the past and detailed comparisons of the institutional architecture of the major central banks of the world. If you're curious about the origins of the Bank for International Settlements in Basle or how the Financial Stability Board differs from the Financial Stability Forum, this is your book. But it is stronger on the past than the future, and its recommendations are surprisingly mild in view of the severe financial crisis that the world has just suffered.

Although the authors say in the preface that this is not a textbook, in many respects it would make a good one. Large sections are devoted to reviewing the key academic papers and listing the arguments for and against certain policy stances. The reader is in the grip of a four-handed economist as the two authors wrestle with the evidence to form their own judgment.

The key chapter on how central banks should react to a build-up in asset prices is a case in point. It takes the reader through the views of key contributors to the debate: Bernanke, Cecchetti, Crockett, Goodhart, Greenspan, Heikensten, King, Roach, Taylor, Wadhwani, White ... to name a few.

After this exhaustive survey of the arguments, the conclusions reached by Howard Davies and David Green are sensible but disappointing: that 'central bankers must pay more attention to asset price bubbles than they have in the recent past', and that macro-prudential tools will also be necessary to prevent the build-up of bubbles.

They support the inclusion of a house-price element in the targeted measure of inflation, but do not opine on how that element should be calculated. They propose no specific changes in the political remit or institutional set-up in the UK to give effect to their recommendations. At the international level too, the discussion of capital and leverage ratios falls short of proposing specific minimum levels for the former or an operational definition of the latter. These are the practical questions of current debate in Basle.

The way different central banks responded to the unfolding financial crisis of 2007-09 is discussed at various points. In the case of the UK, a short section on the failure of Northern Rock in the summer of 2007 and the about-face on providing liquidity support by Bank of England governor Mervyn King are well documented. The authors are curiously circumspect in giving their own views. They speak indirectly: 'There were strong rumours that the Bank of England had been reluctant to provide support, and that the Bank, the FSA and the Treasury had taken very different views' and 'There was much criticism of the characteristics of the UK deposit protection scheme'.

The chapters on political accountability and leadership are perhaps those that add most to the extant literature on central banking. The tension between ensuring independence of a central bank and providing channels of accountability to the country's elected officials has been approached in different ways. The European Central Bank (ECB) has the strongest statutory support for its independence and, correspondingly, the weakest political accountability. This may have strengthened its ability to provide liquidity to the eurozone member banks in the early stage of the crisis. Its role was clear, it recognised the seriousness of the situation early and there was no question as to who was in charge.

By comparison, the tripartite arrangement in the UK between central bank, regulator and government provoked confusion, dispute and delay. Now, however, the situation in Greece highlights the inability of the ECB to fulfil the normal central bank role of 'lender of last resort' during a financial crisis. Whether the member governments can successfully take on this mantle remains to be seen.

As in business organisations, the culture of a central bank - and ultimately its effectiveness - is shaped by its leadership. Skills in personal diplomacy and the practical experience of financial markets often trump technical brilliance in a successful central banker. Assembling a diverse management team is also important. The authors note that in 2008, King insisted on his own choices for deputy governor and chief economist over the wishes of the Treasury and the Bank's Court of Directors. King's selections were economists in his own mould.

Term limits are suggested for governors, in view of the examples of long-serving leaders such as Montagu Norman and Alan Greenspan, whom the authors see as autocratic in their later years.

Inevitably, a book that is part textbook, part contemporary history and part policy assessment runs the risk of pleasing no one. Davies and Green provide much to inform and interest diverse audiences. It is a book to dip into, not read from cover to cover. It asks more questions than it answers. But it's a book that practitioners and students of central banking need to have on their shelf.

DeAnne Julius is chairman of Chatham House

Banking on the Future: The Fall and Rise of Central Banking
Howard Davies and David Green
Princeton University Press ú24.95

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