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Central Banking Deflowered

FLORENCE – After the European Central Bank announced on May 9 that it would buy the government bonds of Mediterranean countries experiencing severe fiscal strains, critics complained that the Bank had “lost its virginity.” The actions looked like a clear contravention of Article 21 of the ECB’s Statute, which forbids credit facilities to governments or to European Union institutions.

Similar comments were made about the US Federal Reserve in 2008, after it began large-scale purchases of non-conventional assets, including agency debt and mortgage-backed securities, in order to support the collapsing US housing market. Former Fed Chairman Paul Volcker, for example, complained that the institution was operating at the bounds of legality.

In both cases, the central bank looked as if it was doing something other than traditional monetary policy. In the past 30 years, a remarkable degree of consensus had been established that the primary, if not sole, responsibility of central banks was to ensure price stability. Increasingly, since the early 1990’s, it had become fashionable to define price stability more precisely through the use of inflation targets.

Keeping prices roughly constant was a very different mission from the historical role of central banks. In the original vision of central banking, price stability was not at all an obvious purpose, since the value of money was cast in terms of specific weights of precious metals.