The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  The question is, are they? Zhou’s Western tastes and academic background may have limited his influence outside the central bank. “Within the PBOC, Zhou Xiaochuan has a very high authority,” said one former official of the central bank. “But outside the financial system, he lacks—I wouldn’t call it ‘ability,’ but the ‘style’ of how traditional Chinese bureaucrats take care of things in the process of interfacing with other ministries and crafting policy. Sometimes, with such a strong academic background, it’s unavoidable that you get a little more academic. But to be a bureaucrat, you not only have to be technical, but you have to be able to work together with people while reaching your own goals.”

  • • •

  At 6 a.m. New York time on November 30, 2011, the PBOC published an announcement that hit the financial wires like a bolt of lightning: It was cutting by half a percent the proportion of their assets that Chinese banks must hold in reserve. At a time when Europe was struggling with its crisis response and the global economy seemed to be slowing, China had elected once again to open the throttle of growth.

  Traders weren’t the only ones who were surprised. So too were the leaders of the other global central banks. That very day, just two hours after the PBOC statement, the leaders of the U.S., European, British, Japanese, Canadian, and Swiss central banks issued their joint announcement of cutting rates on swap lines, which they had developed through weeks of conference calls and coordination. Leaders of those banks had no idea that Zhou and the PBOC were poised to make a move of their own. It was a happy coincidence that the move happened on the same day and was in the same direction toward easier policy. In financial markets, there was a sense that a cavalry of the world’s central bankers were all galloping to the rescue together.

  But the reality is that the PBOC had done its own thing, in its own way, without involving its counterparts outside of China. Zhou and his predecessors have long attended Bank for International Settlements gatherings and met with their international colleagues in other global settings. Since 2009, Zhou was even included in the private Sunday night dinner in Basel with the other top central bankers. He speaks excellent English and was viewed as a thoughtful economist and a jovial presence. More importantly, Zhou’s fellow central bankers saw him as part of a reformist wing of the Chinese leadership that, if it eventually prevails, will bring China more fully into the club of global leaders and help create a more peaceful and prosperous world.

  But as of 2012, there remained a measure of distance and doubt between Zhou and the other central bankers. A big part of it was that they knew he didn’t have the power to act on his own the way they did, that his actions had to be approved by his nation’s high political authorities. He couldn’t commit to a coordinated policy even if he wanted to. On October 10, 2010, during the annual meetings of the International Monetary Fund and the World Bank, Zhou said that China wouldn’t be raising interest rates within the year. Nine days later, the PBOC hiked its benchmark interest rates by a quarter percentage point. Some in the media accused Zhou of “trickery,” but more likely, he simply hadn’t yet been told of the decision by the Standing Committee. Similarly, knowledgeable sources say, the PBOC wasn’t informed of a June 7, 2012, interest rate cut until very shortly before it was to be announced, possibly even the same day.

  One senior official of a Western central bank said that while there’s implicit trust among counterparts at the likes of the Bank of England or Federal Reserve that news of an upcoming policy change won’t leave their close-knit community, they worry about sharing information with a representative of the surveillance state that is China. Might information about an upcoming policy move told to the PBOC governor make its way to the portfolio managers who oversee China’s vast reserves? There has been no evidence that it has happened, but some Western central bankers don’t have total confidence it couldn’t.

  Zhou’s speech at the purple-lit Caixin Summit in 2010 showed his delicate balancing act of trying to maintain strong bonds both with the Boys in Basel and within the Chinese government. Addressing the Fed’s decision to undertake QE2 a few days earlier, which his own government was fiercely criticizing, Zhou mentioned that he had discussed the matter extensively with Ben Bernanke at BIS meetings, and that “in the communication process, we felt that many of their comments were actually understandable.” He then explained the rationale for the move in language that tracked almost precisely with how Bernanke had talked about it: “The Fed has the mandate to create jobs and maintain low inflation in the United States. Given the fragile economic recovery, relatively high unemployment rate, low inflation rate, and the U.S. federal funds rate close to zero, it is understandable that the Fed has adopted the quantitative easing monetary policy.”

  Then Zhou explained the Chinese position: that because the dollar is the international reserve currency, the United States has a special responsibility, one that it hadn’t upheld in the run-up to the megacrisis. “The U.S. dollar has global impacts,” Zhou said. And even if QE2 is in the best interest of the United States, “it may not necessarily be optimal for the world, and may have some side effects.” Rather than staking out a strong position, allying himself with either his friend Ben from Basel or the Chinese political leaders who were openly using QE2 as a cudgel to throw at the United States, Zhou finished up with this bold statement: “To sum up, multiple angles are needed in the comprehensive analysis of the QE2’s global impacts.”

  Zhou’s term as governor for the PBOC was set to expire in December 2012, after a decade in office. China economy watchers spent the better part of the year trying to read the tea leaves as to whether he would enjoy a comfortable retirement or be promoted to a higher office in the new government coming in, with the conventional wisdom on this question going back and forth several times over the course of the year. He ultimately was not tapped to receive a promotion in the new government. But though his run at high levels in the Chinese government appeared to have come to an end, Zhou’s legacy was shaping the course of modern China, even despite limited authority. He helped avert a deep economic downturn. He helped persuade his political overlords to reverse easy-money policies as a bank lending bubble emerged. He made great strides in encouraging the development of China’s financial markets and the freer flow of capital across his nation’s borders. At a time when the Western economies were flailing, their entire philosophical underpinnings coming into question, China was an unlikely source of strength for the global economy. And that success, at least through 2012, was vindication for Zhou and his band of haigui technocrats.

  But the nation still has deep-seated economic problems and risks that may curtail its emergence as a preeminent economic power. The boom of the past decade was rooted in investment, particularly in infrastructure and housing. Might billions of yuan have gone toward projects that weren’t in fact economically justified and will never pay off, leading to bank losses and a new crisis? Might the run-up in housing prices have gone far beyond what’s justified by fundamentals, as it did in many Western countries in the mid-2000s? And while large, state-owned enterprises have had easy access to bank lending, small and medium-sized businesses, at least those without deep political connections, have had a much harder time gaining access to capital. Zhou spent his time as a senior official trying to change that, with only mixed success.

  Beyond this is the question of how far China’s financial system can take the nation. It was quite effective through the years of global crisis. But as messy as market capitalism can be, the system that evolved in the Western powers over the centuries has created more wealth than any other. Even after its great recession, in 2011, the United States had a per capita economic output that was nearly six times that of China’s. The crisis certainly exposed the weaknesses of free-market capitalism. But as reformers like Zhou try to create a new economic and political system in China, they face a great challenge: They must grapple with the reality that for the most complicated medical problems—a
nd the Chinese economy at the start of the twenty-first century is nothing if not complicated—herbal medicine usually doesn’t cut it.

  What Zhou spent his decade at the PBOC doing—and his successor and other reformers will now take up—wasn’t as simple as trying a few traditional remedies. His accomplishment, rather, was to take the best lessons of his own tradition and merge them with the lessons of the West, of cancer treatments and heart stents and gene therapy. Can the unique aspects of China’s culture, politics, and economic system be merged with the pieces of financial infrastructure that have helped create untold prosperity for people who live in the more advanced industrial nations, such as a market-based system for allocating capital and a powerful, independent central bank? The economic future of billions depends on the answer.

  Afterword: Back to Jackson

  On August 30, 2012, seven years after they had toasted Alan Greenspan and five years to the day after they had gathered in the Grand Tetons to discuss housing finance amid the first ripples of megacrisis, the world’s central bankers returned once again to the Jackson Lake Lodge to consider the world they had created. Both the tributes of 2005 and the warnings of 2007 seemed very far off indeed.

  For the first time since the creation of the European Central Bank, no member of its Executive Board had made it to the conference: Mario Draghi and his colleagues were too busy back in Frankfurt developing their newest plan to combat the eurozone crisis. The officials who did make the voyage seemed exhausted, worn down from their many years of late-night decision making. Even the scene in the Blue Heron Lounge in the evenings was subdued, without the usual tables full of attendees shrugging off their jet lag to enjoy a little backslapping camaraderie.

  The Friday night entertainment, too, seemed somehow less vibrant. In 2007, the horse whisperer had demonstrated how to break a wild mare. The same technique, he had said, could be applied to inspire trust and confidence in nonequines, too—which prompted one audience member to quip, “What about the commercial-paper market?” This year, local ranchers brought in artificial cattle made of wood and cloth and taught the central bankers how to lasso them. One Fed official yanked the rope so hard after successfully roping one of the “bulls” that its plastic horns came off. If there was an economic analogy here, no one wanted to joke about it.

  Each of the major central banks had taken steps beyond any it would have considered possible a few years earlier. The ECB had bought the bonds of eurozone states, violating the spirit if not the letter of its founding treaty, and inserted itself deeply into the budget, tax, and regulatory decisions of several democracies. The Federal Reserve had rescued investment banks and insurance companies, maintained zero interest rates for four years and counting, and bought $2 trillion in bonds through quantitative easing. The Bank of England had joined the ECB in becoming uncomfortably entangled in politics and the Fed in vastly expanding its balance sheet.

  And all for what? The economies of the major Western powers were a shambles, with the United States, Britain, and all but the strongest European nations producing well below their potential. In the summer of 2012, there were thirteen million more people jobless in the European Union and the United States than there would have been if pre-2007 trends had continued. A generation of young people faced poor career prospects; a generation of retirees saw its life’s savings damaged by the crisis. In some European countries, extremists were on the march, most dramatically in Greece. By the fall, members of the neo-Nazi Golden Dawn party would be launching violent attacks on immigrants and other non-Greeks with chilling frequency. The streets of Spain and Portugal and Italy similarly roiled with discontent, though of a more peaceful variety.

  In Jackson Hole, Michael Woodford, a Columbia University economist who was among the most esteemed academic monetary theorists in the world, took the stage underneath the lodge’s elk-antler chandeliers to deliver a presentation with the dry title “Methods of Policy Accommodation at the Interest-Rate Lower Bound.” Without quite saying so explicitly, the owlish-looking Woodford suggested that the Fed and the BOE’s approach to interest rate policies during the crisis had been all wrong.

  “The results that we have do not imply that the task of a central banker under current conditions is an easy one,” he said. “There seem to me to be fewer options that are likely to be effective, and that are likely to be attractive on other grounds, than central bankers sometimes suggest when seeking to reassure the public.” Over the course of thirty-nine thousand words, Woodford noted that central bankers again and again had taken discrete policy actions, but done little to shape expectations for the future more broadly.

  All the quantitative easing in the world, he argued, would have little effect in isolation. People across the American, British, and, to some degree, European economies were convinced that the minute there was some improvement, their central banks would cease their stimulative monetary policies. Without knowing exactly what policies their banks would enact as a next step, they had no reason to believe that their economies would ever really take off and grow. And the Fed’s “guidance policies” of stating an expectation of low interest rates until some future date were equally problematic: The central bank had essentially said that it expected the economy to be so lousy that it would keep rates low for years—hardly the kind of prediction to inspire confidence.

  Think of the central bank as the driver of a car who pushes the accelerator all the way to the floor, and then lifts his or her foot every time the car goes a bit faster. The key to getting up to highway speed isn’t just to put the pedal to the metal, but to keep it there for a while even after the car starts speeding up.

  “It does not make sense to suppose that merely expressing the view of the economy’s future path that the central bank would currently wish for people to believe will automatically make them believe it,” Woodford said. “If speech were enough, without any demonstrable intention to act differently as well, this would be magic indeed.”

  Among Woodford’s audience of weary and frustrated modern-day alchemists, there must have been more than one who wished, just for a moment, that the wave of a wand could make it all disappear.

  • • •

  I never plan my holidays ahead and I only ever go away for a few days,” Mario Draghi said in a July interview. “One thing is certain: I will not be going to Polynesia. It’s too far.” So was Wyoming, it turned out.

  Draghi had decided that it was time to force an ultimate reckoning with Europe’s woes. There’d been nearly three years of halfhearted and timid responses, of kicking the can down the road over and over again. The ECB had tried twice to restore the economy to health with its Securities Markets Programme of bond purchases and twice more with its “long-term refinancing operations,” which funneled hundreds of billions of euros into the continent’s banks. But each had been more painkiller than cure, simply delaying the kinds of hard choices facing Europe. Draghi wanted a more permanent answer to the questions of what the eurozone of the future would look like and what the ECB could do to ensure that it came to be.

  Since June, Draghi had been directing ECB staff and key allies on the Executive Board, Jörg Asmussen and Benoît Cœuré, to begin developing plans for how the central bank might defend the European idea in a more systematic way. At the same time, he began a deft diplomatic campaign. He briefed German finance minister Wolfgang Schäuble and top aides to Chancellor Angela Merkel about the evolving plans, hoping to ensure that he could count on having the German government’s support. He met with some of the central bankers who had been opposed to the previous bond-buying efforts, such as those from Finland, the Netherlands, and Austria, in hopes of persuading them to come around on a more all-encompassing program. Private dinners, solicitous phone calls, visits on the sidelines of summits and international meetings—whenever he had a chance to buttonhole someone whose support might be helpful for the plan he had in mind, Draghi took it.

  While he pursu
ed those efforts privately, he stuck a marker in the ground publicly. The setting was the Lancaster House, a grand mansion in London’s West End overlooking Green Park. Draghi’s speech to the Global Investment Conference there on July 26 had been drafted as a thorough overview of the European economy and its challenges, largely without laying out any new ideas. But Draghi scribbled an extra couple of sentences onto his typed script. They weren’t included in the version of the speech handed out to reporters, so the ECB later had to publish the updated speech on its Web site as “Verbatim of the remarks made by Mario Draghi.”

  Draghi essentially took it upon himself to preannounce that something big was on the way. Without having discussed with his Governing Council colleagues, he made the audacious pledge that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” He led every interested party—the financial markets, the political leaders, his own colleagues—to count on a major new action by the ECB. The outcome was preordained, he was effectively saying.

  The ECB had already intervened with hundreds of billions of euros, but without any overarching strategy, only at the last possible moment, and constantly pulling away whenever conditions seemed to be improving. The central bank would be better off, Draghi argued, setting clear criteria as to what it would do and under what conditions. Once those rules were set, it would be willing to deploy potentially unlimited funds.

  Most of the press coverage of the London speech focused on the “whatever it takes” line. But the speech had a coda that was in many ways more important, if much harder to parse. If some countries’ bonds carry higher interest rates because their governments have a higher risk of defaulting, that’s simply the market at work, assigning risky nations higher “risk premia,” Draghi argued. But if those higher rates are due to a risk of “convertibility,” or fears that the euro could implode, it’s a different matter. “To the extent that these premia do not have to do with factors inherent to my counterparty—they come into our mandate,” Draghi said. “They come within our remit.”