Central banks lose their allure

Central banks around the globe are starting to suffer at the pens of commentators as the world's debt problems persist. But monetary policy is just one tool among many for correcting economic woes.

The halcyon days when central banks could do no wrong are long gone, and criticism of them is getting sharper.

The harshest voice comes from The Economist ('The Twilight of the Central Banker'), taking to task the latest annual report of the central bankers' club, the Bank for International Settlements, which argues that central banks have done just about all they can. The doyen of economic journalists, Martin Wolf, is urging the Bank of England to do more. In the US, Paul Krugman has been critical of Fed Chairman Bernanke, on the grounds that he too should have done more.

How justified is this criticism?

First, it has to be acknowledged that the BIS has a reputation for taking an uncompromisingly tough stance
. It talks tougher than its member banks, especially in its phobia of government debt. And of course central banks have made mistakes. The largest errors, however, were before the global financial crisis: US interest rates were kept too low for too long after the 2001 'tech wreck'. Prudential regulators did a poor job, not just in the US but in the UK and Europe as well.

The current criticism, however, is focused on the post-GFC period. But once the crisis started to unfold, the actions of central banks are harder to fault. Just about everywhere, they moved interest rates quickly to a near-zero setting and kept them there. If policy-rate setting can be faulted, it's that the rhetoric of the BoE and the European Central Bank threatened to tighten too soon.

In the US, Bernanke got this one right: he not only lowered interest rates but committed to keeping them low, and this is what matters if you want to encourage longer-term borrowing. He also implemented 'Operation Twist' to lower longer-term interest rates.

With interest rates close to zero and monetary policy in the classic 'liquidity trap', central banks in the US, UK and Europe explored the new territory of quantitative easing. This had been tried a decade earlier in Japan in an attempt to break out of the 'lost decade' of the 1990s, with little or no effect. Bernanke was prepared to go further in 2009, buying up private-sector debt to revive this paralysed market.

Whether the subsequent QE exercise had much effect on interest rates is debatable, but there is no doubt that financial markets liked this demonstration that the central bank cared. They responded by strengthening equity prices. Late last year the ECB carried out huge QE-style operations in response to the parlous state of the bond markets of the southern Europeans.

Given these policy initiatives, the absence of a strong recovery is being taken by some as evidence of policy failure. But the better conclusion is that the instruments are not capable of fixing the problems. This is the main thrust of the BIS defence.

It would be absurd to expect monetary policy to fix the problems of the debt-ridden southern Europeans. The ECB has already loaded its balance sheet with worthless Greek paper; the inevitable write-offs will leave the ECB in need of recapitalisation. In the UK the BoE has bought up 30 per cent of the total stock of government debt in an attempt to stimulate the economy. Nevertheless, total bank credit has fallen for the past two years, and lending to business is lower than three years ago. The response to increased base money has not been to expand lending, but to repay debt. The BoE is now looking for more direct ways to encourage lending, but this takes it onto tricky political territory.

In the US, QE seems to be losing its power; it is, after all, largely a psychological instrument. What is needed is a credible fiscal policy, with short-term stimulus combined with medium-term consolidation. Just because the political system is incapable of providing this doesn't mean monetary policy can be a substitute.

Perhaps the greatest problem with the critical commentary is the ignorance it demonstrates of how monetary policy actually works. The Economist, Wolf and Krugman all carry the legacy of Milton Friedman's misleading message in which monetary policy works by increasing base money, expanded by the banking system through a credit multiplier. But extra base money doesn't encourage banks to expand their lending; they are already lending to all the bankable customers who want to borrow at the going interest rate. The extra base money just accumulates in the banks' balance sheets in the form of deposits with the central bank, with little or no effect.

Perhaps the most curious lesson The Economist draws is that central bankers need more democratic oversight (i.e. less independence). A glance at its own readers' correspondence would demonstrate that the monetary policy debate contains a good share of nutters and cranks, as well as those who, like themselves, just don't understand how it works.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.


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