DISCLAIMER: The person is speaking in a personal capacity and does not represent the institution that employs them.
RSummary:
– Thanks to their swift and bold action, central banks have managed to avert the worst.
– However, their support for the global economy is not without conditions. As Governor Trichet points out, « the Central Bank must be strong in its message to other partners, particularly with regard to executive powers. »
– To prevent the painkiller from turning into a sleeping pill, it is crucial to undertake the necessary institutional reforms, particularly in Europe, by completing economic and financial integration and strengthening the role of the central bank without undermining its credibility.
Jean-Claude Trichet, Honorary Governor of the Banque de France and former President of the European Central Bank, was the guest speaker at the 2014 Coface conference on country risk. As the US Federal Reserve begins to envisage a gradual exit from so-called unconventional monetary policies, some are wondering whether central banks will continue to support the global economy as they have done in the past. Here are a few points to fuel the debate.
« Few were in the cockpit at the time, and those who were saw the financial house of cards threatening to collapse. » For J-C. Trichet, central banks held steady during the storm and thus avoided a recession that promised to be worse than that of 1929. Without a rapid and coordinated response from global monetary authorities, we would be in a very different situation today. The end of the world that was predicted for September 15, 2008, did not happen. Or at least it has been postponed.
Nevertheless, the actions taken by central banks to support the economy were not without uncertainty. And, as a result, they were not without risk. On the one hand, the traditional role of central bankers was limited to controlling inflation, independently and without interfering with other policies. It was therefore necessary to « put in place measures that did not exist before the crisis, that were not recommended in the textbooks, and that therefore had to be invented. » Thus, in three days, economic thinking was able to break free from the orthodox monetarist legacy of the 1970s. Just enough time to assess the scale of the crisis. By making all the necessary liquidity available to financial intermediaries as part of a concerted effort by the world’s major central banks, central bankers succeeded in limiting contagion. Through very broad access to central bank refinancing in Europe, or through massive purchases of negotiable debt securities in the United States, they effectively replaced the failing markets, the interbank market in Europe and the money markets in the United States.
But why are central banks taking on so much responsibility for a crisis that they did not cause? In addition to the relatively rapid response capacity of monetary authorities and their proven expertise in macroeconomic analysis, J-C. Trichet puts forward a number of reasons which, with hindsight, could suggest a certain culpable passivity on the part of monetary and financial authorities in the pre-crisis period. On the one hand, the apparent calm during the period of Great Moderation and the belief that markets were efficient discredited the forward-thinking analyses of a few (rare) economists such as Minsky (1992: the Financial Instability Hypothesis). On the other hand, regulators underestimated the consequences of the extreme sophistication of financial products, which had become too complex to ensure better risk allocation. But these two effects mainly contributed unintentionally to strengthening the leverage of private and then public actors, which, having become excessive, proved to be the main driver of the crisis and its spread.
Are central banks the most relevant institutions to address the current challenges? In the case of the Eurozone crisis, the use of monetary policy, which by definition is common to the various member countries, may not appear to be the most appropriate tool in the face of divergent national trajectories, whether it be the departure of certain countries from the Stability and Growth Pact or the gradual erosion of the competitiveness of certain members. Similarly, the vulnerabilities of the Eurozone stem more from an institutional deficit: as J-C. Trichet points out, the common monetary policy has not been accompanied by common supervision of the financial system or a structure capable of ensuring a certain degree of solidarity in the event of a crisis affecting economic actors asymmetrically.
So, if the central banks, and in particular the ECB, are neither really responsible for the crisis nor really equipped to provide lasting solutions, why do they accept this unpleasant monetary arithmetic? In other words, in the words of Sargent and Wallace (1981), the de facto loss of independence of central banks in the management of their monetary policy: in the absence of a sufficient response from the political and fiscal authorities, which are better placed to address the root causes of the weaknesses, central banks find themselves forced to keep the patient alive by pumping in liquidity. As Governor Trichet points out, « the central bank must be strong in its message to other partners, particularly the executive authorities. » At best, liquidity injections can stabilize the patient and buy time, but the painkiller must not turn into a sleeping pill. The role of the central bank in the months and years to come will therefore be to preserve the incentive virtues of its remedy. This means being accommodating and bold in its use of monetary policy, as the crisis is not yet over, but above all remaining vigilant and vehement in ensuring that everyone takes responsibility to avoid a repeat of the problems of 2007/2010. The support provided by central banks to the global economy is not (and must not be) unconditional.
Nevertheless, if economics textbooks had to be rewritten in three days, it is also necessary to review the organization of economic actors, and in particular the scope of action of the Central Bank. This is now the major challenge facing the European Central Bank, while the question of exiting unconventional policies is not yet on the agenda in Europe. Although this aspect has been less developed by J.-C. Trichet, it remains an essential factor in determining the ECB’s ability to support the European and global economy.
So what should the mandate of central banks be? In fact, they have already taken on a role of financial stability (Ragot, 2012), which is gradually being institutionalized, for example through French banking law, which gives an explicit mandate to the Banque de France. The role of the European Central Bank has thus been strengthened through the establishment of macro- and micro-prudential authorities attached to the ECB (Lequillerier, 2013), to contain systemic risk (Duprey, 2013) and individual banking risk, respectively. Nevertheless, it is necessary to go further towards European integration in order to give more democratic legitimacy to this highly political process, without which the ECB risks seeing its credibility diluted: indeed, if it currently concentrates these different policies, it is more due to a lack of alternatives at the European level.
If the ECB implicitly transforms itself into a control or supervisory body, it will have to increase its transparency, a process that is already well underway. In order to strengthen their ability to sustainably support the global economy and encourage structural reforms, central banks have already significantly changed their communication strategy: « forward guidance » » ( see, for example, Thygesen, 2013, and Jurus, 2012)allows them to publish concrete information on the continuation of their monetary policy, the exit horizon for accommodative policies, and the conditions associated with their support for economies in difficulty. Bolstered by the credibility it has gained in the fight against inflation, the OMT (Outright Monetary Transactions) program announced in August 2012, which aims to provide unlimited support to a country in difficulty by buying back its debt on the secondary market, provided it complies with certain pre-established conditions, has had a significant effect… without it ever having been necessary (to date) to put it into practice.
Thanks to their swift and bold action, the central banks have managed to avoid the worst. While communication with the various political and economic players is now one of the best tools available to central banks, they must encourage concrete and more ambitious political change. As Governor Trichet points out, if we do not go further in addressing the root causes of the crisis, developed countries could find themselves in a situation similar to that of 2007. Alternatively, if unconventional policies become permanent, a certain dependence on liquidity could take hold in developed countries, but especially in developing countries, thus creating conditions conducive to the export of the crisis.
Thibaut Duprey
References
Duprey, T. (2013). In search of a definition of systemic risk, BSI Economics.
Jurus, A. (2012). Is forward guidance a credible strategy for ensuring greater transparency in US monetary policy, BSI Economics.
Lequillerier, V. (2013). And then the Single Supervisory Mechanism arrived…, BSI Economics.
Minsky, H. (1992). The Financial Instability Hypothesis, Levy Economics Institute Working Paper, No. 74.
Ragot, X. (2012). CentralCentral Banks in the Storm: Towards a New Mandate for Financial Stability, CEPREMAP Opuscules.
Sargent, T. and Wallace, N. (1981). Some Unpleasant Monetary Arithmetic, Federal Reserve Bank of Minneapolis Quarterly Review, Fall.
Thygesen, N. (2013). Forward guidance: hubris or common sense?Background for keynote address at the 50th anniversary SUERF/Banque de France conference.
