Central Bankers Weren't Meant to Be Heroes

Heroic architecture.

Photographer: Andrew Harrer/Bloomberg

The U.S. recovery is starting to look halfway respectable. Europe's economies, meanwhile, face the risk of a third recession in seven years. There's a lesson in that contrast: Good economic policy means never having to ask your central bank to be a hero.

It's too soon to know how the story of the Great Recession will end. When the history is written, though, one theme will be paramount: It was the world's central bankers, not its elected politicians, who had to deal with the crisis -- a task for which they weren't adequately equipped (and still aren't). Some rose to the challenge; others didn't.

All the main central banks are implicated in the causes of the crisis, though the blame wasn't theirs alone. Finance ministries and regulatory agencies led the way. Later, when it came to damage control and then to shaping the recovery, central banks were no longer junior partners. Fiscal stimulus was too timid or too brief or both, and as the politicians flailed, central banks were thrust all alone to the front.

Those that promptly took an expansive view of their powers and responsibilities (the U.S. Federal Reserve and the Bank of England) got much better results than those that delayed too long (the Bank of  Japan) or refuse even now to step up (the European Central Bank). The most effective central banks stretched the limits of their mandate. Governments should never have made that necessary.

Why was any such stretching required? Because the crash was exceptionally severe, the fiscal response was puny, and interest rates can't be cut to less than zero. This so-called zero lower bound meant that central banks soon found they could no longer use the only policy fully under their control -- short-term interest rates -- to supply the stimulus their flattened economies needed. Instead, they had to resort to unconventional measures, especially quantitative easing.

Less Than Zero

The central banks had reason to hesitate over QE. The scale of asset purchases by the Fed and the Bank of England, and more recently the Bank of Japan, has been unprecedented. Unwinding this intervention won't be easy; the risk of unintended consequences from a flood of cheap money was, and is, great. But the evidence shows that QE worked -- by lowering long-term rates, by supporting asset prices and by bolstering confidence. It didn't trigger soaring recoveries, but without it there might have been no recoveries at all. If you doubt that, compare the U.S. and the U.K. on one side with the euro area on the other.

Questions over QE, though, aren't confined to the economic and financial risks. Modern central banks for the most part have operational independence, on the understanding that monetary policy is a relatively narrow and unpolitical endeavor.

But the line between monetary policy and fiscal policy is fuzzy to begin with, and large-scale QE blurs it further. When a central bank finances the government's deficit, that's as much a fiscal operation as a monetary one. QE, as implemented, has taken the form of secondary-market debt purchases -- government financing, you could say, one step removed.

Suppose instead that QE was linked explicitly to an increase in public borrowing, or even that the central bank simply decided to send every taxpayer a check. Such variants of QE would be more effective. But this "helicopter money" would be undeniably fiscal in character. Critics would say the contract under which independent central banks operate had been broken, and they'd have a point.

This makes it easier to understand the ECB's position. The euro area needs QE urgently -- but, unlike other central banks, Europe's is forbidden by law to finance governments. Europe's political leaders, if they had the wit and the nerve, would change this law. The fact remains that QE requires more bravery of the ECB's president, Mario Draghi, than it did of Ben Bernanke at the Fed or Mervyn King at the Bank of England.

Europe's QE Quandary

If QE remains part of the central banker's toolkit, thinking on central-bank independence may need to be revisited -- and if the unwinding of QE goes badly, you can count on that. But the dilemma is obvious: Bringing central banks under closer political control, so that they could more legitimately engage in quasi-fiscal operations, would likely paralyze them. Imagine, if you dare, Fed policy directed by congressional committee.

This makes it all the more important to avoid placing such a burden on monetary policy in the first place. During booms, governments should take more care to monitor and correct financial excesses, through macroprudential regulation and other means. Crashes will still happen -- and when they do, governments must have the fiscal capacity to respond with tax cuts and spending increases, sustained for as long as necessary. Greater fiscal restraint when economies are doing well means that bolder fiscal stimulus will be possible when they aren't. All this requires a much more forward-looking approach.

A tall order? You bet. Much as one might hope that next time things will be different, there's little sign these lessons have been learned. Sadly, for them and for everybody else, heroic central bankers are all too likely to remain in demand.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.