Monday, April 21, 2014
Exit from comment view mode. Click to hide this space

The Only Game in Town

TOKYO – What should central banks do when politicians seem incapable of acting? Thus far, they have been willing to step into the breach, finding new and increasingly unconventional ways to try to influence the direction of troubled economies. But how can we determine when central banks overstep their limits? When does boldness turn to foolhardiness?

Central banks can play an important role in a cyclical downturn. Interest-rate cuts can boost borrowing – and thus spending on investment and consumption. Central banks can also play a role when financial markets freeze up. By offering to lend freely against collateral, they “liquify” assets and prevent banks from being forced to unload loans or securities at fire-sale prices. Anticipating such liquidity insurance, banks can make illiquid long-term loans or hold other illiquid financial assets.

To the extent that unconventional monetary policy – including various forms of quantitative easing, as well as pronouncements about prolonging low interest rates – serves these roles, it might be justified.

For example, the US Federal Reserve’s first round of so-called quantitative easing (QE1), implemented in the midst of the crisis, was doubly effective: By purchasing mortgage-backed securities, the Fed brought down interest rates in that important market (in part, probably, by signaling its confidence in those securities), and restored it to vitality. Similarly, with its outright monetary transaction (OMT) program, the European Central Bank has offered to buy peripheral eurozone countries’ sovereign bonds in the secondary market – provided that they sign up to agreed reforms.

The logic is that conditionality will ensure that countries are solvent, while OMTs will restore trust to a market that has broken down because investors fear that the countries concerned will exit the eurozone. Again, its effect, thus far, has been significant.

Other unconventional policies, however, have been undertaken to stimulate the economy, rather than to deal with broken markets. The benefits have been commensurately smaller. QE2, in which the Fed bought long-term government bonds, did not have a discernible effect on long-term government interest rates. Indeed, with its recent decision to pursue QE3, the Fed is focusing once again on the mortgage-backed securities market; but, given that the market is much healthier now, it is unclear how much good this will do.

Recently, the Fed expressed its intent to keep policy rates low for a long time – until employment picks up strongly. The hope is that if investors consider this announcement credible, long-term interest rates will come down further, encouraging spending. But the immediate effect on long-term bond rates has not been encouraging.

As central banks venture farther into uncharted territory, advocates argue that at worst they will do no harm. In fact, no one really knows.

For example, sustained low interest rates hurt savers who traditionally prefer safe short-term investments. Pensioners and those near retirement, facing low income from interest, may cut back further on consumption, weakening the economy. Bolder pensioners, desperate to generate higher returns, may take undue risks – for example, investing in junk bonds – that could jeopardize their nest eggs. And, unfortunately, such financial risk-taking may have little impact in terms of spurring corporations to assume more risk by investing.

Similarly, a potential downside to quantitative easing is that low interest rates send capital to higher-growth, high-interest-rate countries. In theory, as capital floods in, these countries’ exchange rates will appreciate rapidly, making them look unattractive and automatically stemming the flow. In practice though, as investors make money on their trades, they bring in yet more money, forcing further currency appreciation. All too often, the process does not end smoothly but in a crash. No wonder recipient countries resist inflows of hot capital.

We also know little about how smooth the exit from quantitative easing will be. In theory, as the economy picks up and interest rates begin to climb, central banks will simply pay higher interest rates on their reserves, so that they can finance their holdings of long-term securities and shrink them slowly. But higher interest rates also imply large capital losses for central banks’ asset holdings.

Even if some of these losses are offset for the government as a whole (as the central bank loses on its holdings of government debt, the treasury gains in equal measure, because the debt it owes is worth less), the losses on long-term private debt holdings are real. Moreover, the argument that losses are offset is not easy to explain to the public. Will opinion be sympathetic to the Fed when politicians like Ron Paul excoriate it for losing tens of billions of dollars monthly on its asset holdings? Will bond markets fall sharply (and interest rates rise) as markets fear that the Fed will be pushed to sell its enormous holdings in short order?

A last defense offered by advocates of continuing on the path of adventurous monetary policy, even when the perceived benefits are small, is that, because politicians refuse to settle their differences and act, monetary policy is “the only game in town.” In democracies, when there are no other alternatives, politicians often eventually do the right thing. By creating the impression that something beneficial is being done, unconventional monetary policy relieves pressure on politicians. So, when central bankers argue that they are the only game in town, they are ensuring that outcome.

Central bankers nowadays enjoy the popularity of rock stars, and deservedly so: their response to the difficult and uncertain environment during and after the financial crisis has been largely impeccable. But they must be able to admit when they are out of bullets. After all, the transformation from hero to zero can be swift.

Read more from our "New Model Central Banking" Focal Point.

Exit from comment view mode. Click to hide this space
Hide Comments Hide Comments Read Comments (9)

Please login or register to post a comment

  1. Commentedroberto martorana : This is my page about a new theory macroeconomic conception monetary system , axiom: money printed and put into circulation can not be less than the money asked in return ; i wrote about this on "riodialogues":I suppose a new rule for central bank: when one of the central bank have a new emission of money whith each rate the same bank print corrispective quantity of money of the rate ,out of balance,and give this quantity to compense the monetary mass at a pubblic commission that use for pubblic necessity etc etc...we resolve three problem :pubblic necessity,pubblic balance,and market crisis,;for example : the B.C. have a emission of hundred billion unit and fix a rate of 3% and give this money to commercial bank,at the same moment print 3 billion and give these to pubblic commission that spend for pubblic problem....

  2. CommentedJoshua Ioji Konov

    What the Central bankers are doing is pouring more liquidity into an economic system that underperforms in creating better paid employment and fiscal stability by relying on financials instead of removing the structural reasons for the entire system's inadequateness. The world of globalization and high productivity has been putting some new priorities not apprehended by the economics and unless it happens no any long term success could be achieved: the internal for the developed economies approaches i.d. Detroit or the international such i.d. the majority of the world deepening into poverty would only bring inequality, economic slowdowns, and most damaging Earth's environmental deterioration.

  3. Commentedkiers sohn

    why do ALL economists hide from the Econ 101 "truth": ie. When rates start rising, the Fed will TAKE LOSSES on it's porfolio of ultra long bonds and other securities and paper.

    The Fed is a "bad bank" of last resort. Is it capitalism? Is it fair? Is it in public interest? If the Fed owns a majority of long bonds, then "market" reaction to anticipated rate rises will not be the "MARKET" talking? it's absurd.

  4. CommentedZsolt Hermann

    Unfortunately the whole situation is upside down.
    The central banks, or any bank in fact should not play any role in what is happening.
    The banks simply got into their prominent positions as a result of the excessive, constant growth economy forcing everybody into overspending, relying more and more on credit.
    But these financial institutions, with their inflated and imminently bursting bubbles have no real bullets at all, they have absolutely no capacity to solve the crisis, it is the opposite, with this meddling, pouring virtual money into the tanks of the broken system, "providing false liquidity" they delay the "revelation of the evil", the recognition of the true problem which is the basic economic model and its serving cast.
    The banks should gradually withdraw from the arena leaving leaders and public to examine and understand how a global, interdependent human network works in a closed and finite natural system, and what new socio-economic model is suitable to provide a predictable and sustainable future.

  5. CommentedFrank O'Callaghan

    We must recognize where the problem began. The quest for widening inequality has created instability. Huge personal remuneration in the financial sector coupled with the refusal to honestly account the zero sum game of paper shuffling built up unacknowledged deficits that were hidden by less and less credible rouses until the fall of Lehman Bros.

    The crisis of confidence has caused doubt in the values of many asset classes. The ocean of liquidity poured by central banks has been taken by the very criminals who caused the problem rather than being used to prime the pump of international trade in the real economy.

    So, what is our solution? Clearly the bill must be paid by those who caused it. The great wealth of the beneficiaries of the crisis should be immediately forfeit. Inequality must be narrowed or eliminated. Power, work, resources and responsibilities must be more broadly shared. Unemployment must be brought down to an acceptable 2-4% of the workforce and special attention paid to the long-term unemployed.

    Our world has great challenges ahead, not least in environmental and demographic terms. We have tools to hand that are much more powerful than the merely economic. We must begin to use them.

  6. CommentedProcyon Mukherjee

    Raghuram is once again back at his best!

    Unfortunately the game is not only the only one, it could well be the everlasting one (QE infinity); one would find the argument perfectly ludicrous that firstly the money would ensure that asset prices would inflate and then it would make ‘some’ wealthy and then this incremental ‘wealth effect’ would make people spend more thus creating jobs!

    Those markets that shadow future expectations like stocks and commodities have met with a mixed reaction; after the initial euphoria the markets would have better sense prevailing that such high PE multiples with such low fixed asset investment is untenable, while the corporate sector would keep importing jobs.

    It leaves a sobering thought that with fiscal cliff-hanger in play and the quality of public investments deteriorating over time and with a looming bubble of debt which is growing with such ferocity, what does it leave FED, when the interest rates eventually harden and unwinding actions knock on the door? Or are we assuming that interest rates have no other way to go, which if true defeats the very purpose of the stimulus as then we are projecting a continuation of low job growth environment and perpetual low inflation?

    Procyon Mukherjee

  7. Commentedcaptainjohann Samuhanand

    The politicians of India have been clamoring for a loosening of its tight monetary policy which the Indian Central bank is following.They have milked the Indian public sector banks like State bank etc to give loan to unscrupulous Indian big fat cats like Mallaya who sits on real estate worth crores but takes loans to pay CEOs who donot pay his pilots and staff.Same with some of the other Indian big fat cats who milk the Indian savings through corrupt politicians and now NPA(non performing assets) of Indian public sector banks is worrying.

  8. Commentedsrinivasan gopalan

    With his characteristic clarity, the distinguished professor has done a nice job in highlighting the risks embedded in pursuing unconventional monetary policy, particularly in the United States. The deliberate attempt to keep the interest rate at flat or zero with a view to reviving consumption and stoke the demands for funds by the stakeholders by the Federal Reserve cannot be replicated in other countries which have their own peculiar problems. For instance, Dr Rajan, who is currently the Chief Economic Advisor in the Finance Ministry of India, cannot get around the country's apex bank, the Reserve Bank of India, to experiment with unconventional monetary policy. Even otherwise, calls from the authorities quite often signal indirect message to the RBI to change gear for a cut in policy rates. Though trade and industry in India have been demanding policy rate cuts to help them generate growth impulses and to stay invested in downturn times like this, the RBI is not flinching from its fixed goal of taming inflation which is relentlessly going up. It would be a travesty of policy for the central bank in India if it is to follow the example of the Federal Reserve to flood the money market through a cheap money policy. It is nice to know that Dr Rajan is not even overly enthusiastic about countenancing such a policy in the US, though it had not caused major damage to its economy so far. But in an uncertain milieu like this, it would be imprudent to break from convention and resort to magic bullet lest the results should come home to roost before long, much to the dismay of the stakeholders of the real sectors of the economy. G.Srinivasan, Journalist, New Delhi (India)