Sunday, November 23, 2014

Central Banking’s New Club Class

NEW YORK – In the wake of the 2007-2008 financial crisis, the world’s central banks played a critical role in rescuing the global financial system. They stepped in when private markets froze, acting as lenders and dealers of last resort, and provided additional liquidity to grease the wheels of finance.

These central banks offered their services primarily to domestic actors, but they also extended their largess to foreign private entities. Indeed, even foreign states benefited after central banks entered into swap agreements, giving one another unlimited access to their respective currencies. This has created a worrying precedent.

Originally created as a temporary fix in 2007, the swap lines established at that time connecting the US Federal Reserve, the European Central Bank, and the Swiss National Bank have been extended each time a new crisis has unsettled the markets. More recently, however, six central banks announced that they had made their swap lines permanent.

But did these central banks have the legal authority to do so? And, even if they did, should they have used it?

The original swap lines might fairly be classified as emergency measures. But what may be permissible and justifiable in a financial emergency may not be appropriate as standard practice during normal times.

Central bankers might argue that we have entered a state of permanent market crisis analogous to the never-ending “war on terror.” But even this frightening analogy does not answer the question of whether central banks should assume positions of power in international relations.

Of course, a central bank’s mandate is price stability in the national economy that it serves, and price stability is influenced by exchange rates. So a case can be made that central banks should have the power to intervene in foreign-exchange markets, and that this power should – at least in times of crisis – include commitments to foreign central banks to provide unlimited liquidity in the domestic currency.

What is less clear, though, is whether the same justification can be used by central banks to create permanent swap lines with just a few other central banks of their choosing. This is akin to an announcement on a cruise ship approaching an iceberg that the crew will definitely rescue first-class passengers but not necessarily others.

Not every country’s central bank – not even every “friendly” country’s central bank – has been invited to join the swap-lines club. Membership is restricted to the United States Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, the Swiss National Bank, and the Bank of Canada.

There may be a legal rationale for this neo-imperial elitism. The so-called C-6 might argue that, given their price-stability mandate, only central banks of countries whose economic fate might destabilize domestic prices should receive privileged access to domestic currency.

But the choice of monetary partners is nonetheless a matter of judgment. For example, why Canada and not Mexico? Aren’t both members of NAFTA? Why Switzerland and not Brazil, one of the largest emerging markets?

Picking partners is an inherently political act. It bestows access to high-demand currencies on a select few, relatively strong, countries precisely when the weakest countries are at their most vulnerable. Having been left outside the club, these countries have no option but to self-insure by accumulating foreign-exchange reserves.

Indeed, empirical research suggests that countries without explicit or implicit access to liquidity tend to hold much higher reserves than the privileged few – only to be blamed by the same privileged few for contributing to global imbalances by hoarding excess reserves.

The C-6 swap club’s members may be correct in thinking that global finance requires more proactive central banking. But is it fair or right that they should be allowed to take matters into their own hands and determine a system of international monetary management designed to serve their own interests, with little regard for other, equally exposed, countries?

The joint announcement by the C-6 cements the great divide between first-class and coach economies. We are being asked to trust that these select central banks will do the right thing.

Trust is important. But when it comes to political decision-making, democratic control and accountability are essential.

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    1. CommentedJay Stephens

      Great piece. Agree with every word. To some extent I think there may also be a hidden driver here in the form of demand though - those C6 countries include all the markets pushing aggressive, risky products that should've been glass-steagalled away from institutions where their exposure can bring systemic risk (but aren't) so effectively those institutions are pooling their backstop, and extending that backstop to redefine "too big to fail" within a supranational context (i.e. the bailout for the next Lehman Brothers event might draw funds from the EU as well as the US under this model).

    2. CommentedJason Gower

      Excellent piece. So many of the "emergency" measures taken by central banks (above all the Fed) after the crisis have evolved into quasi-permanent structures. It is quite apparent that several of these measures were beneficial in reducing the potentially catastrophic impact of the crisis. However, and as the author adeptly points out, these remain unprecedented/experimental measures in many regards with highly uncertain long-term implications; economically, politically and ultimately socially. Unfortunately so much of what central banks do falls outside of the common knowledge of the general public but this discussion is needed on a global level.

    3. CommentedLee Adler

      Only 7 of the Fed's Primary Dealers are US banks. The rest are European, Canadian, and Japanese. The Fed has been pumping US dollars it creates into foreign financial systems for a long time and nobody seems to care.

    4. CommentedLee Adler

      The BoE formed a $33 billion swap agreement with the PBoC in June.