Six of the worst
Central bankers have many new tools. It is far from clear that they can use them well enough to build and maintain a solid financial system.
Before the 2008 financial crisis, the world’s monetary authorities focussed intensely on one tool: their power to set the overnight risk-free interest rate. Their theory told them this number controlled everything else that might interest a central bank. The right policy rate would keep financial markets healthy, restrain inflation (deflation was not a worry then) and discipline profligate governments. It would stimulate the right amount of economic activity, neither too much nor too little.
Better still from the perspective of the high priests of money, the theory said that the correct use of the interest rate tool did not have direct political implications but required tremendous technical expertise. The implication was that politicians should leave central bankers alone and everyone else should stand back in awe.
The crisis demonstrated the theory’s inadequacy. Since then, the toolkit has been expanded. The additional equipment is a mix of old stuff taken out of storage and some more experimental devices. Janet Yellen of the U.S. Federal Reserve, Mario Draghi of the European Central Bank and their peers around the world now have no less than six sorts of tools. Sadly, none of them really seems up to the job.
Interest rates have not been abandoned, but the policy rate has been effectively zero for six years in every major economy. Not low enough, say some economists. There are experiments with negative rates, down to -1.25 percent in Switzerland. However, even the most adventurous central banker is wary of seriously negative rates. These would provoke outrage from savers forcibly turned into dis-savers and the technicalities could cripple the financial system. The traditional tool is effectively done.
Guidance was favoured by central bankers who liked the idea that their mere words could reshape reality. It was always wishful thinking, since commitments are always tentative. Unexpected disinflation has in fact undermined the British and American quasi-promises to raise rates as soon as unemployment rates fell to something like normal. Last week, the Swiss overturned their firm guidance on the durability of the currency ceiling, with dramatic results. Central bankers have lost credibility and their guidance tool has been deeply devalued.
Pegs of currency values were once fairly common, but they were totally out of favour in the pre-crisis era. The September 2011 Swiss partial peg against the euro looked like a promising, low-risk revival. The Swiss National Bank collected foreign currency in exchange for newly printed francs. The gains for the domestic economy were substantial and the costs, mostly higher property prices, minor. But the Swiss lost their nerve on Jan. 15. The peg tool looks discredited.
Quantitative easing has become highly fashionable. In the United States, the UK, Japan and now the euro zone, the creation of money, used to buy low-risk bonds in the market, has become standard practice. Central bankers hope to influence interest rates and encourage productive lending. They definitely inflate asset prices, but the effect on the rest of the economy is unclear. The QE tool is, at best, doubtful.
Macroprudential regulation is a new name for the old idea that central banks should supervise and guide the entire financial system. That was hard enough in the old epoch. With the expansion of non-bank finance, the growth of a host of derivative financial instruments and the increase in corporate and household leverage, even the wisest regulators are perplexed. It does not help that they have almost no experience with interventionist regulation. This tool is promising, but for now it is mostly daunting.
Fiscal coordination was taboo in the pre-crisis dispensation. Central bank independence was prized, despite the obvious and unavoidable interdependence of fiscal and monetary policies. After rescuing banks and indirectly financing government spending, it should be clear that central banks are actually an integral part of the government. As yet, though, central bankers mostly cling to the old myth. Draghi does help out the hapless politicians of the euro zone, but even he would not want to work publically on unified fiscal, monetary and regulatory policies. The fiscal tool is largely denied.
So the central banks’ tools are done, devalued, discredited, doubtful, daunting and denied. For those who have grown used to central bankers doing politicians’ dirty work, it’s deeply discouraging.