Can Central Bankers Cope With the Crisis?

Recently, markets have focused most of their attention on Europe. Even though continental Europe possesses a centralized monetary authority, it lacks a centralized fiscal authority.

As a result of this, in making lending arrangements, monetary authorities failed to recognize rather stark differences in the creditworthiness of eurozone member nations. That, in turn, led to some European countries borrowing well beyond prudent limits.

The undeniable fact is that the European Central Bank — the ultimate guardian of the euro and of the institutions operating within the euro framework — failed to pursue policies to rein in the excessive growth of debt. That is why we now have this extraordinary conflict between debtors and creditors within Europe.

There is no easy way out. If the European currency is reconstituted with mainly strong countries as members, the costs will be incalculable. And if the discipline imposed by the creditor nations prevails, Europe’s economic recovery will likely be tepid at best.

Conversely, if creditors accept major debt reductions, leading financial institutions — especially those in Europe — will be forced to absorb losses on a scale that will severely limit their capacity to finance economic growth.

Europe’s financial conundrum insures that the U.S. dollar will remain the world’s key reserve currency for some time to come. Japan will not — and cannot — assume that role. Along with trying to extricate itself from a decade-long economic slump, its sovereign debt is very high and its currency does not float freely.

None of the leading emerging economies yet possess the kinds of legal, financial and political institutions that would enable their currencies to displace the U.S. dollar. To be sure, U.S. sovereign debt is a serious matter. But it is currently less of an intractable problem than in other leading nations.

Monetary no-man’s land

The much more pressing challenge for the developed world going forward is whether or not the monetary approach to restoring economic growth will succeed. The major central banks in Japan and the West have embarked on new tactics — and, in some cases, very aggressive measures — compared with previous periods of monetary accommodation.

We have ventured into a monetary no man’s land. While the previous record of monetary policy was checkered, the new approach is decidedly untested.

This is not to say that previous monetary tactics remained constant over the years. In the early post-World War II years, the principal approach in the United States confined open market operations to U.S. Treasury bills. It was generally unobtrusive, rather than interventionist.

In the early 1960s, the Fed influenced the yield curve in order to defend the U.S. dollar’s international role, while also encouraging economic recovery. After that, monetarism was popular for a while, but failed because financial innovation blurred the definition of money.

All the while, the Fed tried to encourage price stability, shorten the duration of recessions and ward off financial mishaps. Its record on inflation and recession has been generally positive, with the notable exception of the 1970s. Its record on restraining the overexpansion of debt — the central cause of most financial crises — has been poor.

Now, as is the case with their colleagues in Europe, America’s central bankers have embarked on an aggressive monetary strategy. Considering the enormity of the financial and economic problems that the United States faced in 2008, the Fed’s actions have accomplished a great deal.

They have slowed the fall in housing prices, narrowed the yield differential between low and high credit quality bonds, lifted stock prices, and improved the balance sheets of financial institutions. So far, so good.

Nevertheless, these monetary tactics present some vexing issues and underlying uncertainties. The basic approach is analogous to dosing a patient with steroids. Financial markets have come to depend on these doses.

Going forward, whenever a financial or economic crisis arises (however minor it may seem in hindsight), investors will expect another dose of central bank accommodation or other monetary stimulation. After years of monetary dependency, it will be no easy matter for financial markets to return to normal conditions.

The efficacy of the Fed’s embrace of inflation targeting also is worth questioning. The Fed’s inflation targeting aims at the core index for personal expenditures, excluding the cost of energy and food.

This approach — which is dubious at best — dates back to the 1970s, when then-Fed Chairman Arthur Burns excluded energy and food prices in order to minimize public perception of an outbreak of inflation. Even if these prices are more volatile than other cost indices, it is risky and misleading to exclude them. Prices of these essentials clearly affect household spending.

Moreover, by excluding the price of energy — especially oil — the Fed’s monetary policy ultimately serves to support the pricing practices of the international oil cartel. How so, you wonder? By always supplying sufficient bank reserves to justify those prices, that’s how.

What matters even more is that the Fed’s actions to encourage or even allow inflation could seriously undermine public trust in the central bank. Americans are forced to accept a substantial depreciation in the purchasing power of their currency.

It is worth remembering that “only” a 2% annual depreciation (read: inflation) equals a compound loss of 22% of purchasing power over ten years, or a 33% loss if the inflation rate is 3%.

So we are confronted with a dilemma. The current monetary accommodation is clearly aimed at encouraging economic expansion. At the same time, it is encouraging all of us to become even greater risk takers — as if we hadn’t taken more than enough risks before.

The Fed’s role in this is tricky, to put it mildly. On the one hand, it is very actively engaged in promoting risk-taking. On the other hand, it does not underwrite the maturity and credit quality risks that stem from that increased risk-taking.

Getting back to a more normal economic and financial life will not be an easy task. Too many abuses still have to be rectified. Hopefully, the economic and financial follies of recent decades will be sufficient reminders to limit future excesses.

Editor’s note: This article was adapted from the author’s remarks at the 21st Annual Hyman P. Minsky Conference in New York City, on April 11, 2012. The conference was organized by the Levy Economics Institute of Bard College with support from the Ford Foundation.