9

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.