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In the kingdom of the blind

28 January 2014 By Edward Hadas

Of the world’s three most important central banks, which one is doing the best job? Of course, it’s too early to tell – the distinguished economist Alan Blinder may now regret describing Alan Greenspan as “the greatest central banker who ever lived” in 2005. But there’s a good case that the European Central Bank under Mario Draghi deserves the prize.

The conventional wisdom holds otherwise. Like the U.S. Federal Reserve and the Bank of Japan, the ECB has been using low interest rates and targeted support of troubled financial markets to stimulate depressed economies. But the euro zone central bank is widely criticised for having been too slow to respond and being insufficiently aggressive in its policies. In particular, it has avoided quantitative easing (QE), the injection of newly created money into the financial system.

In contrast, while the Fed under Greenspan’s successor Ben Bernanke is unpopular in some circles, economists often praise it for having understood the challenges of financial crisis, very low inflation and quite moderate growth. Even the Bank of Japan, long considered a policy laggard, seems to be better at easing than the euro zone’s monetary authority.

The conventional case for the Fed and against the ECB has two parts, monetary and economic. They are both subject to serious doubt.

The monetary argument is over the effectiveness of QE. The thinkers at the Fed, the Bank of Japan and the Bank of England – as well as most economists at investment banks – have few doubts. They say that central banks have reduced long term interest rates and improved market liquidity by using zero-maturity cash to purchase long-term securities. As a result, say the QE-ists, GDP growth is stronger.

It is impossible to tell if that is what has happened. Bernanke’s joking comment – “The problem with QE is it works in practice but it doesn’t work in theory” – is only half right: the theory is indeed weak. It takes several leaps of faith to believe that temporary central bank manipulation of the bond market has increased investment or consumption in a sustainable way.

But the practical claim is also at best controversial. Even if part of the improvement in the U.S. economy could be clearly traced to monetary policy, which it cannot, there are other serious issues. QE seems to have pumped up some financial markets, perhaps to unhealthy levels. Also, this is an unprecedented experiment. There could be severe problems when monetary policy returns to what used to be considered normal. For now, QE offers nothing better than doubtful rewards and high risks.

The ECB may have avoided QE mostly for political reasons – it might violate its mandate. And the central bank could yet succumb to the near-equivalent of bond buying, perhaps by purchasing bank loans. However, if it stays the course, discretion could well prove economically wise in the long run.

The economic argument for the Fed’s approach is crude but apparently compelling. Its defenders say the U.S. central bank must be doing better because the United States, the home of the 2008 financial crisis, is doing better than either Europe or Japan.

The growth numbers support that assertion, but Fed fans put too much weight on monetary policy. Differences in bank reorganisations, not to mention labour markets, industrial structures, fiscal policies and natural resource production, had more effect on the economic trajectory than differences in rates and QE.

Meanwhile, the ECB has taken a more active role in economic policy than either the Fed or the BOJ. The bankers of Frankfurt have used their power and prestige to encourage – even force – the bureaucrats of Brussels and the governments of weaker euro zone members to change their ways. If unified banks, more competitive wages and reformed labour markets lead to a stronger euro zone a decade from now, the ECB will deserve some of the credit.

The ECB has not dealt well with every problem. In particular, its unwillingness or inability to spawn inflation sits poorly with its reluctance to countenance writing down the value of excessive sovereign debts. Even now, it much prefers to support debtor nations than to help them with the tricky task of restructuring their obligations without disrupting the financial system. Still, within these limits the ECB has tried to find euro zone solutions for the problems of overly indebted members.

Even if the American and Japanese central banks escape unscathed from QE, they are not far ahead of the ECB in dealing with sovereign debt overloads. Inflation, which erodes the value of these debts, is still uncomfortably low in both countries. Radical solutions such as monetisation or write-downs are not under consideration. If the ECB can find a low-pain way to clean up the residue of past government excesses, then its standing at the top of the pack will be indisputable.


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