Did the Bank of England cause the boom and bust?
How much were central banks, notably the Bank of England and the US Federal Reserve, to blame for the financial boom and bust that's landed us with years of economic stagnation?
To date, most of the blame has been attached to the recklessness of bankers and myopia of financial regulators, such as the Financial Services Authority.
But central bankers have typically been tarnished only with failing to see or shout loudly enough about all that excessive and under-priced lending that took place in the run-up to the crash of 2007-8, rather than having directly contributed to it.
Which is why a recent speech by Paul Tucker, deputy governor of the Bank of England, is so striking. Under the racy title of "National balance sheets and macro policy: lessons from the past", he says there is evidence that cuts in central banks' policy rate, what's known as the Bank Rate in the UK, contributed to the lethal process of investors taking ever greater risks to earn a miserly increment of extra return.
He doesn't put it quite like that. What Tucker says is that "the possibility that monetary policy can affect risk premia should be taken seriously". But it amounts to the same thing.
And he also makes two related points. First he says research suggests that "for all major asset classes the principal drivers of fluctuations in asset returns are shifts in risk premia rather than in expected cash flows" - or, to put that in cruder terms, the price of assets such as shares and bonds responds more to changes in investors' appetite for risk than to their rational calculations of the future stream of dividends to be paid by companies, or the extent to which rents on properties are likely to rise.
Secondly he says that "shifts in risk premia are key factors in macro-economic fluctuations". Or to put it another way, if banks are lending too much too cheaply, that can lead to boom and bust. Doh!
All of which he describes as a "big deal".
The 'financial Martin Luther'
Hmmm. I know some of you will be wondering why there has apparently only recently been an outbreak of common sense at the Bank of England.
But it is important to understand that central bankers and economists can be theological. And built into their financial theology, built into their forecasting models, is that interest-rate changes by the likes of the Bank of England have no impact on risk premia - and Tucker is now saying that is almost certainly wrong.
Think of him as a sort of financial Martin Luther, recognising that the financial priesthood at the Bank of England may not have been as infallible as it thought.
Now under the traditional theology, if the Bank of England cuts its overnight bank lending rate because it fears inflation is falling too far below target, and markets believe that what the Bank of England is doing is credible (ie the policy change will work), that should have no impact on the real yield on ten-year government bonds - which is another way of saying it should have no sustained impact on the real interest rate when borrowing for ten years.
But that theory turns out to be not the way that the world actually works.
Analysis by the Bank of England shows that when it cuts its short-term interest rate, that leads to a significant reduction in the implicit ten-year interest rate that is unrelated to changes in inflation expectations: the cut in the Bank Rate brings down the long-term real interest rate, which is something it is not supposed to do (a pillar of central bank theology is that monetary policy is not supposed to affect real economic activity or relative prices, such as relative interest rates).
There could be two explanations for the way that cuts in short-term nominal interest rates reduce long-term real interest rates. First, investors may believe that the world has become safer and more stable, and are therefore prepared to take more risk.
Or - and this appears to be what is actually happening - when short-term interest rates are cut, investors become so desperate for income that they are prepared to take disproportionately greater risks by lending and investing for longer periods to obtain a little bit more return.
To use the jargon, when the Bank of England and the Federal Reserve cut interest rates in the years before the 2007/8 crash, they exacerbated what became known as the search for yield - or the propensity of investors to take increased risks for only marginally higher rewards.
And, of course, the central banks also inadvertently encouraged the associated and reckless practice of the banks to manufacture all those newfangled and dangerous new products, the CDOs and so on, that responded to investors' greater appetite for risk.
A couple of conclusions follow from this. First, that the Bank of England and the Federal Reserve should accept their share of the blame for the unsustainable lending bubble that was pumped up in the years before the crash (unless you think that theological blindness for what they were doing is a legitimate excuse).
Second, that the reform of the Bank of England by the Chancellor, George Osborne, to create a new Financial Policy Committee that sits alongside the existing Monetary Policy Committee may be sub-optimal.
A single super-committee?
Tucker's analysis implies that the distinction between delivering financial stability and monetary stability is an artificial one.
If he is right that changes in the Bank Rate are an important determinant of risk premia - and to be frank all evidence and common sense is with him on this - then maybe the tool kit for delivering financial and inflationary stability should not be divided between two committees, whose activities could be mutually destructive (even when both are chaired by the governor).
Perhaps there should be a single monetary and financial stability super-committee.