Journal of Financial Economics

REF 113 Central Banks

The crisis has exposed central banks all over the world to play a special – and partly new – role in advanced economies. This poses a series of challenges to the institutional framework underlying monetary and other policies. The first is the need to adapt the mandate, especially to ensure financial stability. The other is the impact of monetary policy on other policies, in particular fiscal, and on the overall institutional framework. The paper focuses on the European monetary union, which was mainly designed for good times. Since crises do occur, however, monetary policy needs to ensure that they do not end up into catastrophes. But monetary policy cannot be the only game in town and substitute for other policy actors. This is a difficult balancing act, which only an independent central bank can play. However, central bank independence is being put at risk throughout the world.

The crisis has exposed the balancing act lying at the heart of monetary policy. On the one hand, central banks are key participants in addressing short-term challenges that the economy faces. On the other hand, their crisis-fighting efforts have to be designed and made public in full consistence with their long-run price stability mandates. To successfully manage this balancing act, a clear distinction must be made between the monetary policy objective and the conduct of policy. The ECB’s strategic framework and the aim of maintaining inflation rates “below, but close to, 2% over the medium term” contain the necessary elements to achieve this balance. First, there is scope for inflation to vary within the range along the way to convergence with the medium-term policy aim of 2%, and many path configurations are possible. Second, the “medium term” itself is not a pre-set time span, but is dependent on the underlying shocks. This has enabled the ECB to react flexibly to the crisis, while remaining within the stable framework of its monetary policy strategy.

The perception that the government bond buying program (OMT) announced by the ECB may lead to future tax burdens on countries, in particular on Germany, is based on an erroneous application of solvency principles that apply to private agents, but not to central banks. We argue that the creditor nations’ taxpayers, in particular the German taxpayers, will receive tax revenue from the implementation of the OMT. We also measure the size of the bond-buying program that is compatible with price stability. It turns out that this estimate critically depends on whether the Eurozone stays in a liquidity trap situation or not. Today, as the Eurozone is still in a liquidity trap there is no limit to the amount of government bonds the ECB can buy without triggering inflation.

The ECB reacted swiftly and efficiently when the financial crisis burst in 2007 but it then experienced difficulties to cope with the euro sovereign debt crisis. Up till July 2012 the ECB refused to act as lender of last resort thus aggravating the crisis. Then the new ECB took a courageous bend and launched the OMT program, even as it has not yet been challenged by financial markets. The difference of reactivity between the two ECB may have two different reasons. On the one hand, the old ECB may have realized too late the seriousness of the crisis or may have tried to resist to an unavoidable contagion. On the other hand, it may have been paralyzed by political constraints. But the quick adoption of the OMT program highlights that such constraints can be put aside when required.

The monetary policies in response to the financial crisis demonstrated that changes in central bank balance sheets have major macroeconomic consequences. The New Classical Macroeconomics, which gained increasing sway from the late 1980 and which led to an exclusive focus on the policy rate that was not warranted, had simply assumed away such effects (Ricardian equivalence). Getting their balance sheets back to normal levels is important in order to preserve policy flexibility for the future and will present central banks with some formidable challenges. This task will require cooperation with Treasuries without surrendering monetary policy independence. While central banks must be entirely pragmatic in their monitoring of market resilience, they must beware of the “financial dominance” trap.

Monetary policy in Israel during the global crisis used unconventional measures alongside aggressive cuts in the interest rate. The measures included the purchase of foreign currency, the purchase of government bonds in the secondary market, and additional measures. As the economy began to recover, the Bank of Israel gradually reduced the scale of monetary expansion, rolling back the unconventional measures first. However, foreign currency purchases have continued in various schemes up to date, reflecting the importance of exports to the economy and the enduring challenge posed by an appreciated currency. Several lessons arise regarding unconventional measures: they should be considered an integral part of monetary policy at a near-zero interest rate; they enhance the intensity of the monetary policy response, which is crucial at a time of crisis when the risks of underreacting are acute; the variety of these measures allows the pursuit of several goals apart from monetary expansion.

Before the crisis emerging countries experienced substantial economic growth and their central banks made considerable progress in adopting modern and theoretically sound frameworks, which further reinforced the benign environment. That period of global growth now appears to have given way to a period where incremental growth looks more like a zero-sum game. As a result, later vintages of the capital stock in the emerging market export sector are likely to generate very low returns. We thus consider that their growth model is broken and that resource misallocation must be stopped. As highlighted during the last post crisis period, monetary policy is ill-equipped to reallocate resources to new sectors and regions. A better tool would be a modern industrial policy that must become the cornerstone of emerging countries policies.

Since the international financial crisis, a new central banking is prepared, and therefore a redefinition of monetary policies pursued by central banks and instruments to ensure financial stability. The analysis in this article focuses on the relationship between the new central banking and the globalization of credit, especially in light of the recent experience of emerging countries. There is a plea for an extension of macroprudential policies to foreign sources of credit boom.

This paper analyses Banque de France’s independence during the 20th century. The contribution highlights a tradition of government intervention to drive monetary policy in order to finance government spending. During the 1980s, it was particularly difficult to reform the Banque de France Act implemented in January 1973. Only a hard foreign constraint (international capital mobility and European integration) push to adopt a new law in 1993 (August 4) with an important degree of independence.

In the course of the 1970s and 80s, central banks became focused on price stability as a prime objective, and they were given more independence to assure such a mandate. Both developments grew out of practical experience combined with a new perspective on macroeconomic theory. The design of the ECB is a prime example; steps were taken to explicitly exclude objectives and/or instruments that might have distracted the ECB. After 2008 central banks in the US, the UK and Japan embarked on unconventional policies – massive purchases of securities and guidance to markets about future policy actions – in order to get around their inability to lower the short-term policy rate further; this brought them closer to governments, though as yet without any formal change in their independence. The ECB has not followed suit; the heterogeneity of the participants in the Euro area has made unconventional policies less useful or outright impossible.

Both the central bank strategic framework and doctrine have been challenged by the recent financial crisis. Their focus on price stability was too narrowly defined and insufficient considerations were given to financial stability. When key interest rates reached their zero lower bound, central banks had to resort to non-conventional measures, leading them to err far away from their legal mandate. Paradoxically, this strategic framework has not been questioned so far. The central bank mandate has even been extended to factor in macro-prudential policy and, in some cases, micro-prudential responsibilities. The main challenge raised by the centralization of all these regulatory powers is the extent to which central banks will be able to carry out all their duties in full independence. However, independence is key for the success and the implementation of central bank core missions : price stability and lender of last resort.

The recent crisis will undoubtedly change central bank behaviour for a long time. Before the crisis, they managed short-term interest rates and looked after being credible in case of inflation shock. With the crisis, they implemented nonconventional policies and are now led to find solutions to problems that did not exist prior to the crisis. We see five new challenges ahead for central banks: the exit of ultra-expansionary monetary policies, the trap of irreversibility of monetary policies, the design of a deflation fighting kit, the identification of the assets whose prices they must watch and the risk of interest conflicts between monetary policy and banks supervision.

Innovative monetary policies have been triggered by the 2008-2010 crises. Withdrawing these unconventional policies brings in challenges but central banks should think about the new boundaries of their activities that go well beyond the narrow field of monetary policy.

This paper underlines the difficulty to reconcile three objectives: accompanying the economic recovery when it is feeble, normalising the liquidity situation in money markets, and setting incentives right to encourage the cleaning-up of bank assets. The articles argues in favour of longer-term open market operations as a new central tool for the implementation of monetary policy, while it underlines the limits of strategies based on negative interest rates or on forward guidance.

In the case of the euro area, the ECB will also face another host of longer term challenges. These include financial disintegration, the political economy of its OMT programme, the institutional dynamics of Banking Union, and its new “three-pronged” prerogatives (financial stability, supervision and monetary policy). Its mandate will likely need to be redefined.

Inflation targeting was the only objective of monetary policy up to the financial crisis. Its rationale rests on a strong efficient market hypothesis that the systemic crisis has invalidated. Monetary policy must be overhauled to encompass financial stability under radical uncertainty, while money is endogenous and monetary policy has multiple objectives. Therefore it must use multiple instruments and allocate them to the objectives according to their relative performances. The responsibility for financial stability involves new macro prudential tools to manage financial vulnerabilities, some of which pertaining to monetary policy. Furthermore monetary and fiscal policies interact, which leads to reconsider the nature of central bank independence.

This article aims at explaining how Switzerland succeeded in building a major competitive advantage in the financial sector. From a historical perspective, we show that the period 1914-1936 was decisive in Swiss monetary history, Switzerland moving from a status of minor international financial centre to a major place, with the development of very powerful actors like banks. Hence we highlight that if the banking and financial industry played an important role in this process, such a competitive advantage solidified durably only thanks to a national coalition around the conservation of the value of the Swiss franc. In particular, the industry of goods was at the core of such a coalition. The fetishism of the Swiss franc during this period appears to have been a decisive factor for the financial specialisation of Switzerland.

Now that it is no longer a taboo to consider the exit of a country from the euro area, it may be appropriate to revisit the different stages that led to the introduction of the single currency. Before the commitment made to that effect in the late 1980s, a common currency had begun to be used, albeit modestly, by the countries participating in the European Monetary System, as well as by a few other countries. This private ecu, as it was called, could have become the common currency for the Community to be used for transactions between two countries, without replacing the national currencies. This set-up would have been along the lines described by Keynes at the international level at the end of WW2.

This paper reviews the operational aspects of the private ecu system and compares this Community currency with the concept of the “parallel currency”, which was often invoked.