Wednesday, October 17, 2012

The end of central banking as we knew it

The European Central Bank and the US Federal Reserve have massively changed their balance sheet in recent years. The first step was an increase in size, the second is a change in the structure of the balance sheet, holding not only government bonds but also other securities. Some have called this last step "qualitative easing," and others have argued that it is inconsequential because the price of the securities internalize everything relevant, à la Modigliani-Miller (most prominently Michael Woodford, whose recent Jackson Hole paper is being treated like gospel).

A counter-argument comes from Roger Farmer. Qualitative easing is a quasi-fiscal policy, because it favors a particular sector through the purchase of its assets instead of the "neutral" government bonds. Also, it transfers risk form the seller to ultimately the tax payer. This is not only welfare-improving, as it allows to fine-tune the economy, it can even be Pareto-improving despite the fact that it implies redistribution. Indeed, the policy allows to smooth asset price fluctuations as if the yet to be born were capable of trading. It also removes unnecessary fluctuations in the stock market that are due to sunspots ("irrational exuberance").

The question, though, is why the central bank would be tasked with such operations. A central bank's role is to ensure the short-term health of the economy in general. Fiscal policy can redistribute across sectors and ensure a healthy long-term environment. The Fed and the ECB have resorted to such operations because of a general failure of fiscal policy. In the US, Congress is incapable of setting any sensible policy. In Europe, the EU cannot conduct fiscal policy because it has no taxation powers. Central banks are forced into a role they should not have, even if it looks optimal according to Farmer. But wait until lobbies, politicians and other rent-seekers try to influence qualitative easing.

1 comment:

Anonymous said...

EL, you make a lot of sense here. We have now central banks that appear to be in charge of labor market policy, and as there is more and more evidence of structural changes, even long-term labor market policy. This is not what the central banks are designed for. And the risk of corrupting central banks is real, especially in Europe where it is not industries but countries that push for the "right" policies. And this even though the ECB has a single mandate that is silent on the labor market.

In the US, the only agency that is free from politics and does its job is the Fed. Given the situation, it takes more responsibilities, but this is clearly not the best outcome. The Federal Reserve Act needs to be amended to focus on a single mandate, the price stability one, to force the government to actually do something about labor market policy in trying times.