Central Bankers Who Appreciate the Distortions They Can Make

Central bankers in the U.K. and Canada are being thoughtful. They are thinking through the implications of trying to stem the current credit squeeze. Too bad there is not more of this discussion occuring at the Fed and ECB. The Financial Times reports:

A clear divide between the world’s leading central banks emerged on Wednesday over how best to respond to the credit squeeze and the abnormally high interest rates for lending between banks for periods of more than a month.

The European Central Bank pumped an extra €75bn ($103bn) into the financial system for a fixed period of three months in a bid to cut the interest rate gap between overnight funding and lending over longer maturities.

In contrast, the governors of the Bank of England and the Bank of Canada publicly doubted whether such action would work. Mervyn King, the Bank of England governor, also warned in a written submission to the UK parliament that this approach risked encouraging “excessive risk-taking and sows the seeds of a future financial crisis."

The ECB said last Thursday that it would pump three-month money into the system to “support a normalisation of the functioning of the euro money market”. Both Mr King and David Dodge, the Canadian central bank governor, said commercial banks were well capitalised and strong enough to absorb the assets of troubled off-balance sheet investment vehicles that need to be brought on to their books.

Speaking in London, Mr Dodge said he thought investors would be more careful to understand what is contained in complex products in future. “The responsibility does rest on the investor to make sure he or she understands the risk in the product they are buying,” he insisted.

The Federal Reserve, meanwhile, appears to occupy the middle ground. It has not extended the duration of its money market operations, but it has made 30-day money, renewable at the borrower’s request, available through its discount window.

Policymakers are expected to step up calls for more transparency in structured finance when European finance ministers meet in Portugal on Friday. Discussions also continue over possible responses, such as a review of bank capital standards or efforts to pool distressed assets.