Central Bank Exits, Now’s The Moment To Decide

In activist circles there is excitement that central bankers might rule the post-crisis economic world and exercise new powers with a bigger toolkit. What was temporary or tacit during the emergency would henceforth be ‘new normal’. Central banks will routinely make systemically-relevant loans and employ smart discretion in their purchase and disposal of gigantic combinations of assets. They will actively undertake new responsibilities for macroprudential and microprudential financial regulation. And they will target other goals, not just price stability or the inflation rate, but employment levels and … shiver … The Golden Fleece and El Dorado of economic goals - GDP growth itself.

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1. Fabulous and Frightening

The prospect of enormously expanded central bank functions looks fabulous to some, but frightening to others. The notion that in pursuit of growth and job creation monetary policy could substitute for real economy -- i.e. timeless policies and rules that stimulate competitive production and exchange of goods and services -- can appear deplorably fanciful and dangerous. A Chicago economist was noticed to have muttered into his 2012 PhD Class Reading List that “central banking really is the last refuge of central planners”. That’s true if one considers that in spite of what Keynesians and market monetarists want the public to think, there's been no fundamental change in the economic world to justify the radical experimentation with monetary activism. Not surprisingly, therefore, the old battle between central planning and market allocation still applies. The visions got dressed in fancy new clothes, but only the forms of economic life changed, not the substance. 

Since their extra tools and responsibilities overlap with regular government functions like fiscal and regulatory policy, the non-partisan hard-fought independence of central banks could appear under threat. Institutionally, in fact, it may not be an issue of central banks losing ground to politicians. Elected governments may be shedding integral state powers to unaccountable central banks. In the great oak tree of democratic society, why fret about State Snooping when present dangers are the Dangerously Drooping vital branches of your State.

The holistic implications of changes in the relationship of central banks with central governments are of such unusual proportions that ‘fabulous’ and ‘frightening’ scenarios do deserve serious attention. Yet, the slowly unfolding crisis which gave rise to bloated central bank balance sheets amply demonstrates that change is usually mundane and incremental. Any realistic debate about their near future is necessarily moderate and conservative. A reminder was the discussion which occupied moderately diverse economists, executives, and public officials at the recent 15th Geneva Conference on the World Economy

One of the organisers, Charles Wyplosz, describes their agenda: “Behind this unprecedented effort [of liquidity expansion] lies a seldom-discussed question: how do we revert to normality when it’s all over?” Which assets will central banks sell first? When interest rates rise which players will take the greatest losses? Etc. “A common theme … was that the exit strategy was bound to be highly political. Withdrawing policy support is always delicate, but the scope for capital losses and the impact on fiscal policy of large-scale bond sales stand to make exit highly controversial.”

2. Decision Time

Large-scale risk-relevant policy questions like ‘when and how do central banks exit’ escape the boundaries of economics. The ‘exit’ theme of the Geneva conference has a sociological ring. How can sociology contribute to understanding the timing of a modern political decision?

A characteristic of the modern state -- with its many overlapping hierarchies, and the multiple interest group demands constantly made upon every level of its apparatus -- is the remarkable ease with which it continually produces multi-level decisions whose consequences cannot reasonably be either controlled or predicted. The democratic political sphere, concerned as it is with creating and maintaining support, is also always offloading decisions, for example by shifting responsibility for an issue of socio-economic risk to the legal sphere or to the monetary policy sphere. However, there’s no disguising that the question remains ‘political’.

Another problem is that the dangers of these decisions in terms of gains and losses can rarely be quantified. Any judgement about potential risks of moving the variables around is subjective and informal. But there must be trust that an effort to calculate rationally is being made. Transparency in decision making helps foster the confidence. How a decision is made -- effectively and ethically -- matters for political perception. It is typical of politics to wait for precisely the right time to make a key decision. If a central bank waits for the ideal moment to exit a function -- such as ‘permanently’ ending its on-off strategy of quantitative easing -- then it can be accused of playing politics, which boils down to helping the government or the opposition.

The half-perfect solution to these conundrums is satisficing predictability.

The Geneva conference appears not to have been discussing the value of formal rules as a component of predictability in monetary policy. But one of the lead speakers -- Donald Kohn, moderate dove, ex-Federal Reserve -- stressed predictability and transparency. I paraphrase: Decide when it’s appropriate to exit, how to sequence the return to [new] normal functions, how to unwind assets. Tell people what’s going to happen and when, why it’s necessary, and the likely consequences. So nothing comes as a surprise. Then do it.

Open and transparent decision processes allow the decision makers to develop competence in areas where there is no existing precedent and new precedents are created. When moving from official secrecy to public communication, new public risks become apparent and new public expectations are created which the political sphere must necessarily deal with. But this is preferable to not knowing at all, i.e. uncertainty.

3. Predictability First

The real benefit of transparency and predictability is to decision receivers. Investors, enterprises, entrepreneurs, savers, and tax payers are reluctant to begin putting idle pools of money to work productively until they have reasonable certainty about future policy and rules. They are waiting. Bad news is better than no news. Central bank injection of liquidity, because it is now on such unusual scale and without predefined time or goal limits, is unpredictable. Expansionary policy may be extending rather than shortening the wait. Announcements on exit timing would go a small way toward meeting the requirements of a ‘real economy’ focus on limiting avoidable uncertainty. Predictability is the foundational principle for recovery strategy. One would hope for good general rules, but, in the absence of political will to create or enforce them, unequivocal commitment on timing for central bank exit would let people prepare to deal with the consequences. They should be told there will be nasty as well as beneficial consequences.

One final advantage of a public predictability-communication routine is that the message will be simplified, which over time can have a positive effect by actually simplifying the content, i.e. simplifying the economic rules and enforcement mechanisms.

If you study the logic and numeracy of the quantitative models and become convinced that quantitative easing and/or alternative central bank targets are the way to go, you should at least be prepared to set a time limit on these experiments in order not to magnify the scope for unintended consequences. If you study your 101 Econ, economic history, development economics, economic sociology, and institutional science, and then conclude that prolonged monetary activism is at best an unproven palliative or a distraction that delays the moment when structural problems are dealt with, or at worst something that prolongs and deepens the crisis, then you also would want a time limit. 1st of January 2014? Get ready.

Complementary Reading:

Allan H. Meltzer (6/6/13)
John B. Taylor (7/6/13)
John H. Cochrane (30/5/13)