E Central Banker ProCyclical Craziness

Central banks are engaged in procyclical behavior, which makes absolutely no rational sense. After this behavior is discussed, the Basel 3 solutions are discussed at the end of this article. Maybe an exposed  Fed could even be redeemed. Procyclical behavior is really bad, and must be changed.

Market Monetarist Lars Christensen  said this about central bank behavior, and this pretty much defines what that behavior is:

Concluding, central banks during booms tend to take on more risk – they overweight risky assets – while they during busts tend to reduce risk – underweight risky assets. Hence, central banks consistently act in a procyclical fashion.

This is of course is not only bad in terms of ensuring the highest and most stable return at the lowest possible risk, but it also adds to the swings in the economy as the central bank will add liquidity to the financial system during booms and redraw liquidity during crashes.

So, it is not a stretch when I write that the Fed is responsible for the housing bubble and crash. That is consistent with central bank procyclical thinking. Bubble/bust exaggeration is built into the system. Banks are like the guy who buys high and sells low, or you could say banks are like momentum players. Neither of those results healthy economics, in healthy price discovery. If the American people had an understanding of this central bank process, they would probably call for the overthrow of the fed.

I have argued about the actions of the Fed creating the housing bubble and then crashing the economy both here and here.

Moving on, we can see that even Wikipedia gives the same definition of procyclical behavior. 

Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. Of course, since effects of particular policies are often uncertain or disputed, a policy will be often procyclical, counter cyclical or acyclical according to the view of the one judging it.

Thus the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn.[5]

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Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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