What Do Central Banks Do Best?
John Cochrane has analyzed the implications of the expansion of the Federal Reserve’s activities from its traditional targeting inflation and unemployment to its more recent allocating credit to sectors of the economy by acquiring non-traditional financial assets such as mortgage backed securities. Ben Bernanke offered a justification for buying non-traditional assets Friday at the annual Monetary Symposium at Jackson Hole, Wyoming by referring to the premise that different classes of financial assets are not perfect substitutes in investors’ portfolios and effective financial accommodation given the magnitude of the crisis could thus not be achieved by purchasing Treasury debt alone. The ECB has bought government debt of Greece, Portugal, Spain and Italy and also extended the range of assets it has acquired by reducing the rating threshold for asset-backed securities eligible as collateral in its refinancing operations. It has also allowed national central banks of the Eurosystem to accept as collateral additional performing credit claims such as bank loans. The ECB is now under strong pressure to conduct large scale purchases of government bonds in order to hold down interest rates in Spain and Italy. Cochrane warns that this “mission creep” by the central banks is a slippery slope that could be risky. To evaluate these actions, it is instructive to ask both why the “mission creep” has taken place and what tasks have central banks performed best in the past.
Actions by central banks not a substitute for action by politicians
In both the Eurozone and the US the central banks have been facing inaction or at least insufficient efforts by the politicians to address the causes of the crisis. In November 2011 when Italian ten-year bond yields had exceeded 7.3% and those of Spain reached 6.7% the politicians in the EU were falling significantly short of market expectations. A statement of the European Council on December 9, 2011 revealed that their idea of tackling the crisis amounted to agreeing on a new “fiscal compact” and vague statements about enhanced governance and deeper integration in the internal market. Before that the idea of leveraging the European Financial Stability Facility had been agreed upon on November 29 while the specific mechanism of implementation was lacking. Approval of a previous extension of the EFSF mandate had taken 4 months. It is apparent that the ECB in this situation faced strong pressure to provide some relief to investors. Its two LTROs in February were a success and both Spanish and Italian ten-year yields fell below 5% for a brief period at the beginning of March 2012. However, politicians did not act until bond yields went up again and exceeded 6% for Italy and 7% for Spain in June 2012. Only then a proposal to move towards a banking union was put forward. In the US the Fed is also feeling strong pressure to act, perhaps best exemplified by the “Get to work, Mr. Chairman” remark made by Senator Schumer to Ben Bernanke in July.
Targets for central banks
Historically governments have assigned three alternative tasks to their central banks. Achieving low inflation has been a common target, and the United States and some others have combined low inflation with low unemployment, under the assumption that there exists a long-run tradeoff that the central bank is able to exploit. Lending to the government to finance budget deficits is a second task that has been especially common in low income countries. This target has been implemented by making the central bank subordinate to the nation’s Treasury or Finance Ministry. A third target has been allocating credit to specific borrowers by having the central bank purchase bonds or other liabilities of the preferred borrowers. Cochrane has discussed the problems caused by replacing a competitive credit market with credit allocation targeted by the Fed. He suggests that having the Fed pick winners would transform them from a central bank to a central planner. The ECB faces a similar issue when it decides whether to buy bonds issued by a specific troubled debtor.
US experience with credit allocation
In the US the Fed had not been obliged to finance budget deficits or allocate credit. Until recently it only purchased US government bonds in its open market operations. However, since the crisis of 2008, the Fed has acquired large quantities of non-traditional assets, including mortgage-backed securities. If the Fed is to allocate credit across the economy, why stop with housing? There will be lobbying for access to favored credit from many sectors of the economy, and Aizenman and Noy have discussed the subsidization of housing in the US versus education in Germany. If credit decisions are to be based on political clout rather than productivity why not choose the automobile producers, who have demonstrated their political clout with the bailout of General Motors? If the Fed is to buy non-traditional assets, why not buy General Motors bonds, since the US Government is already a major shareholder? Ford and Toyota of America would object, but the decision would be political rather than economic. The issue of which firms and industries to subsidize has even greater relevance in Europe, where government ownership of businesses has gone further than in the US.
Evidence of central bank success
What have central banks done best? When governments have given central banks inflation targets that allow them to subordinate goals such as financing budget deficits and allocating credit to preferred borrowers or even better, prohibit debt monetization outright, they have been relatively successful in achieving low inflation. The Fed has achieved low inflation rates in recent decades, and the ECB has earned some credibility by satisfying its inflation target consistently since 1999. Nearly all high income countries have achieved low inflation in recent years by by giving their central banks independence that allows them to subordinate the goals of financing deficits and allocating credit. Conversely, countries without central bank independence have been less successful at achieving low inflation. Turkey is a prominent example. When its central bank was legally obliged to finance budget deficits, the inflation rate averaged over 50% and in 1994 it exceeded 100%. After a major reform that gave independence to the central bank in 2001, inflation has dropped sharply, and since 2005 it has averaged less than 10%. There has been no demonstrable inflation-unemployment trade-off, as Turkey has been one of the faster growing countries in the world. Similar results have occurred in other countries where central banks have been obliged to print money to satisfy budget deficits. A recent extreme case has been the hyper-inflation in Zimbabwe. Using the central bank to allocate credit has been most common in low income countries lacking a developed monetary policy transmission mechanism, for example, India, and can hardly be regarded as a success story. The Central Bank of Argentina has also had significant influence on credit allocation decisions in the past. Direct allocation of credit has often been associated with crony capitalism and corruption as loans have gone to sectors with political clout rather than those with high productivity. A recent example is Egypt under Mubarak’s rule.
Reforms start where the money ends
Another aspect to note is that good strategy is often made under significant pressure or even when facing existential threats. One frequently quoted example from the corporate world is Steve Jobs turning around Apple in 1997 – 1998 when the company was on the brink of bankruptcy (Rumelt, 2011). Another one is Honda entering the US market with its small 50cc bikes in the early 1960s (Mintzberg et al., 2005). There is also evidence suggesting that states are best at implementing reforms under pressure. Singapore embarked on a comprehensive set of reforms after it was expelled from Malaysia in 1965. More recently, following the Rose Revolution in 2003 Georgia pushed through an impressive set of reforms that lifted it in the World Bank’s Doing Business Ranking from 100th place in 2005 to 18th place in 2007. While this does not prove that situation necessarily needs to be grave for reforms to happen, the central banks flooding the governments with cash is likely to at least postpone much needed reforms as the recent experience in the EU shows. As the prime minister of Latvia, Valdis Dombrovskis has put it, “reforms start where the money ends”.
The currently ongoing expansion of the duties of central banks is a slippery slope. Actions by central banks cannot be a substitute for action by elected politicians and too much policy accommodation might put reforms to a halt or at least slow them down. Historical experience in many countries points toward greater success for central banks that concentrated on achieving low inflation than those that used the power of money creation to finance budget deficits or allocate credit toward politically favored sectors. Leaders of the Federal Reserve and the European Central Bank should continue putting pressure on politicians to act and guard against actions that have been shown to be counterproductive in other countries and other time periods.
Aizenman, Joshua, and Ilan Noy. 2012. “Reflections on the Curious Contrast of Public Policies between Germany and the US: Real Estate versus Human Capital”. VoxEU.org, August 25.
Bernanke, Ben. 2012. “Monetary Policy since the Onset of the Crisis”. Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 31.
Cochrane, John. 2012. “The Federal Reserve: From Central Bank to Central Planner”. Wall Street Journal Sept 1.
Doing Business. 2008. The World Bank and the International Finance Corporation.
Doing Business. 2007. The World Bank and the International Finance Corporation.
Dombrovskis, Valdis. 2011. Speech at the Session of the Saeima on December 8, 2011.
European Council. 2011. Statement by the Euro Area Heads of State or Government, Brussels, December 9.
Forbes. 2012. “Senator Schumer To Ben Bernanke: Get To Work Mr. Chairman”, July 17, 2012.
Mintzberg, Henry, Bruce Ahlstrand and Joseph Lampel. 2005. “Strategy Bites Back”, Prentice Hall, pp. 207-212.
Rumelt, Richard P. 2011. “Good Strategy / Bad Strategy”. Profile Books. pp. 11-15.
9 Responses to “What Do Central Banks Do Best?”
As far as i am aware Zimbabwe and Turkey have privately owned central banks. It is likley innappropriate to extrapolate the performance of private and publicly owned central banks.
What i meant to say is that you cannot judge public central banks by what privately owned central banks do or achieve. Richard
I would agree with the conclusions here. There is already too much crony corporatism in the EU. Their socialization of banking losses on EU taxpayers is a sinister example. The EU is hardly a model of successful economic growth and full unemployment. Indeed it is becoming more and more a black sheep case to avoid.
I think it is governance, not ownership that is important here. Politically independent central banks have been much better at maintaining price stability. At the same time the more they enter the domain of credit allocation, the more likely they are to face political pressure. In the end they might even lose their political independence, which, in turn, would make the price stability objective more difficult to achieve.
Governance is more important than public or private ownership. In the U.S., the regional Federal Reserve banks are privately owned, but the Federal Reserve System that makes monetary policy is heavily regulated by the government. Congress passes laws that the Fed must obey, and members of the Board of Governors are nominated by the President and confirmed by the Congress. It is valid to compare policies of the Fed and those of other central banks with different ownership structures.
In Turkey, governance was fundamentally changed from the central bank being subordinate to the Finance Ministry to being independent from the Finance Ministry. In Zimbabwe, public or private, the central bank printed an amount of money necessary to finance the government's budget deficit. The central bank had no discretion or independence.
On DiranM's point, crony capitalism is a severe problem that has been highlighted recently by Luigi Zingales in his book, A Capitalism for the people. There is ample evidence that government agencies have been "captured" by the business firms and labor unions they are intended to regulate. Using the central bank to pick winners is a way of extending regulatory capture to national central banks.
The worry that central banks are moving from monetary policy into fiscal policy is a real one. There is also another aspect of expansion of central banks duties that this post does not emphasize, namely, the supervisory function. The ECB has mostly stayed out of supervision, but it is now being urged to become the main supervisory body. The Fed has been more active in the area, although duties are split among several agencies. During the Dodd-Frank debates, some advocated centralizing all supervision in the Fed, although that point of view did not prevail in the final legislation.
I tend to be sympathetic, in theory, with the idea that monetary policy and the supervisory function should be separated (as Latvia did, by the way, after a banking crisis in the early 1990s that was caused partly by weak supervision). However, when I have discussed this idea with supervisory staff at the Fed, they object that they do the job better than any of their rival agencies. There is something to that claim, so as far as the U.S. is concerned, practical advantages of keeping a supervisory role for the Fed may will outweigh theoretical arguments to the contrary.
Good point. The Dodd-Frank bill gave the Fed some new supervisory duties that some Fed employees were not anxious to have. Who wants to name the Systemically Important Financial Institutions and specify what special regulations they will face?
The article points to very right points.
1. The Fed almost tripled the monetary base since 2008, http://m5.paperblog.com/i/19/192724/the-changing-…
2. Most of the additional liquidity is deposited in the excess reserves in the Fed so until now it did not cause major change in the economic activity. http://m5.paperblog.com/i/19/192724/the-changing-…
3. If the Fed will start to purchase other than the Treasury securities, it directly interferes in the federal budget policy, without any need for legal approval.
I remember similar situation, when the Israeli Government, using guaranties increased its expenses without legal budget approval. it was in the seventies i wrote you about some time ago.
3. All this function of Fed to trade with government securities, is necessary only because the Government is not a institution to be trusted as to budget obedience.
4. Because of the huge excess reserves hold by the commercial banks in the Fed, I believe, when the pendulum will turn and the banks will start to withdraw their excess money, the Fed will have to change the minimum reserve ratio, and it will become a major monetary tool, and not only a tool to secure stability of the commercial banks. And if so Why not to finance the government deficit directly by printing money? To make it work, all is needed is to make disobedience to budget discipline an offense of treason.