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”.
Conclusion
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.
References
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.