Willem Buiter On Inflation, The Ongoing Banking Panic, And What Central Banks Should Do Now

Willem Buiter is a former member of the Monetary Policy Committee of the Bank of England, former Global Chief Economist at Citigroup, and former Professor at the London School of Economics, Yale University, Cambridge University, Princeton University, and Columbia University.

Aiden Singh: Western central banks are in a tough spot right now: inflation is still running high, but now the banking system has come under strain. Should they continue hiking interest rates?

Willem Buiter: They should continue hiking. Financial stability issues should be addressed, not with the short risk-free nominal interest rate - which is what the policy interest rate is - but with the size and composition of the balance sheet of the central bank. It has all the tools it needs to deal with a threatening or occurring banking crisis without having to sit on its interest rates. 

The Bank of England did that in fact: remember September 28th last year when they announced that they were going to have some temporary emergency purchases of gilts until October 14th to restabilize a dysfunctional gilt market. The next meeting of the Bank of England’s Monetary Policy Committee, they raised rates by 75 basis points. 

The ECB, yesterday, did the right thing when they put up the policy rate by 50 basis points because inflation is way above target there. I mean, headline inflation is 8.5% and even core inflation is, I think, around 5.6%, so they are way behind the inflation curve. So they hiked by 50 basis points and said that they stand ready to defend financial stability using the tools that they have, including this new and as yet unused Transmission Protection Instrument - the TPI. So they basically said ‘come and get it’ as Mario Draghi did back when there was a threat of a run on the banks and on the governments undermining the Eurozone. 

So I think you can continue to be serious about the inflation target through the interest rate while using the size and composition of the balance sheet to deal with financial stability issues. 

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Aiden Singh: So on the issue of inflation, it seems that you think that there’s still some work to do, that allowing what’s been done so far to take effect is not enough. Do central banks need to continue tightening to bring down inflation?

Willem Buiter: Oh yes. Even in the U.S., which has increased policy rates the most, we still have negative real rates even if you take core PCE inflation as your measure of inflation. So I think it is no longer just past supply shocks driving inflation; it is current excess demand, which can only be addressed by the policy authorities by squeezing demand using either fiscal policy, monetary policy, or both. 

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Aiden Singh: And there’s been some talk recently, so for example Professor Kenneth Rogoff has said, that when they set the 2% inflation target they set it too low, they should have set it at 3% or something else. What are your thoughts on this view?

Willem Buiter: I don’t think the inflation target is too low. I want the true inflation target to be one of price stability, so zero true inflation. Now we have so many biases in our actual real-world price indices that 2% HICP inflation or CPI inflation is probably pretty close to true price stability. And that’s what I think we should target.

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Aiden Singh: On the topic of financial stability and the bank failures that we’ve seen recently, do you think that the U.S. government’s response to the failures of SVB and Signature Bank - making depositors whole while allowing the banks to fail - is the correct one? 

Willem Buiter: Yes. I think this part of their response is inevitable. Yes, making all depositors whole does create moral hazard, but the risk of systemically threatening bank runs [from not doing so] is too high. At the same time, making sure that the shareholders and the unsecured creditors, and possibly even the secured creditors if the losses are big enough, of the banks take a hit and the top management gets fired at least provide some of the right incentives for proper bank management. 

They did more than that, of course. They [the Federal Reserve] also set up this Bank Term Funding Program where they make one year loans to banks where they value the collateral at par. I think that’s a mistake because that means that they’re providing collateralized lending to eligible counter-parties at subsidized rates. But lender of last resort operations, which is what these are, should be at penalty rates to discourage excessive risk-taking. In fact, the same applies now to loans at the discount window - here too, collateral will be valued at par. And of course a lot of this collateral, particularly of longer maturity, is currently priced way below par. So we’re having the central bank act not as the lender of last resort, but the lender of first resort which is not the position it should take if its wants to discourage moral hazard. So I’m in favor of creating the Bank Term Funding Program, but it should have been on modestly punitive penalty terms, not on subsidized terms.

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Aiden Singh: Treasury Secretary Janet Yellen has said recently that, should other banks fail in the future, uninsured deposits will only be covered in the event that a failure to do so would create systemic risk. Would this be a good policy?

Willem Buiter: I think it would be a mistake and I don’t think they’ll make it. Having bailed out the depositors for SVB and Signature Bank and undoubtedly having put pressure on the 11 large banks that placed $30 billion worth of deposits with First Republic, I think we are effectively in a regime now, in the U.S., where all deposits are de facto, if not de jure, insured.

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Aiden Singh: On the topic of First Republic and the 11 institutions that made those deposits with it, that rescue was announced yesterday and yet today shares in the bank sold off by 30%. So it seems that this rescue program didn’t assuage markets. Do you think that this sort of program to rescue banks that are in trouble is sufficient or do you think that something bigger is needed?

Willem Buiter: Market panics, runs, are impossible to predict. It might have happened that this intervention by these 11 large banks was sufficient if confidence had been restored. But these bank runs and value impairments are self-fulling prophecies. So I think the authorities have to make clear that they stand ready to intervene to keep depositors whole if they want to prevent bank runs; there’s no alternative. You can move to the abolition of fractional reserve banking and stop the problem of bank runs, but this is not, I think, a likely option. So I think the authorities have to recognize that, yes they can, and probably should, try to get the banking sector itself to sort out its problems, but they should not count on this being effective. And they should always be ready and always have the willingness to lend and purchase on standby permanently and on short notice to prevent a destabilizing run on the banks. You cannot rule them out any other way. 

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Aiden Singh: Do you think something like having the Chairman of the Fed come out and say we’ll do whatever is necessary to ensure financial stability and make a big public pronouncement would help ease the run?

Willem Buiter: Yes, it will. It worked with Mario Draghi. I think the fact that the ECB has raised rates but at the same time made these clear statements that it stands ready to defend financial stability and to prevent runs on the banking system and that they believe the banking system is fundamentally sound, these statements help.

They do, again, have to be backed up with tools - with the willingness to lend and to purchase illiquid financial assets if it's systemically important to do so. But sometimes, if there’s enough credibility, words and a clearly stated intent and willingness to act can be enough - you don’t have to actually engage in the lending operations or asset purchases.

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Aiden Singh: Do you think that the financial system is better positioned to cope with the collapse of banking institutions today than it was in 2007-2008?

Willem Buiter: Oh yes. The reason is that we had 2007-2008 and some learning took place. Not enough; clearly some bankers haven’t learned. The irresponsible lending and investment behaviour by SVB and the other banks that went belly up is evidence that only limited learning has taken place in certain corners. The decision by the U.S. Congress to revoke the most stringent terms of the Dodd-Frank Act for banks with a capitalization of less than $250 billion was a clear mistake; it was an invitation to financial instability. They have to reimpose the full Dodd-Frank Act on all banks, in principle. There may be some minimum size threshold, but it should at least be one decimal place less than $250 billion. But yes, the authorities know what can happen if they don’t intervene in time. They had a disorderly collapse of a critical investment bank [Lehman Brothers] in 2008 and they are making sure, so far, that all the bank resolutions do appear to be orderly. And I think that is the right way to approach this problem. 

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Aiden Singh: So just to summarize, if President Biden calls you or Janet Yellen calls you or Jerome Powell calls you and says ‘hey, what should we do,’ your answer would be 1) guarantee all deposits, 2) come out and make public pronouncements that we’ll do whatever it takes to defend the financial system, and 3) back that up with legitimate programs. Does that pretty much sum up your advice?

Willem Buiter: Yes. And also, when you act as the lender-of-last resort, for example though the Bank Term Funding Program and through the discount window, do so on penalty terms. Do not completely forget the moral hazard issue; it is an important one. I don’t think there is an alternative to full deposit guarantee, but at least in those areas where there is a policy choice, make sure the incentives point the right way. 

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