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The Crises Of The Central Banker, Existential And Otherwise

There was a time when Central Bankers were just supposed to look out for rising inflation. The 2008 financial crisis and the ongoing European debt crisis is forcing them to search for a new identity.

Outgoing European Central Bank chief Jean-Claude Trichet
Outgoing European Central Bank chief Jean-Claude Trichet
Jean-Marc Vittori

PARIS - It doesn't take long before those unanswerable sorts of questions start popping up. Why are we here? What is the purpose of our existence? Is there a hereafter? Existential angst can strike without warning, and it may soon affect a very special group of economic actors: the central bankers of the world. In normal times, this category of people should not be vulnerable to this kind of doubt. They are chosen for their highly rational -- and rigid, some might say -- minds. The most eccentric of them all was a former journalist who became the deputy governor of the Bank of England, and who was shown the door for rolling around with someone else's wife right on the thick carpets of the "Old Lady" -- quite a fantasy indeed.

But today, the Central Banker has some radical soul-searching to do. He is accused of having provided the oxygen money that inflated the biggest speculative bubble in a century. Charles Goodhart, a venerable British economist who was a member of the Bank of England's Monetary Policy Committee, went as far as asking whether "a Central Bank that manages both liquidity and financial stability should also be given the task of setting interest rates."

What, then, is the real job of a Central Banker? What is his future? What exactly do people expect from him?

From a historical point of view, the answer to these questions is rather straightforward: Central Banks were invented to pay for war. The English founded theirs in 1694 to finance the reconstruction of the British fleet after it was destroyed by the French. Napoleon created the French equivalent, the Banque de France, in 1800, to which he immediately entrusted the mission to find money for his armies.

Over time, wars have mercifully become scarcer, but Central Banks continue to perform similar functions, because financial markets also need a tap from which rivers of money can flow in case of emergency. The awful liquidity crisis that affected the United States in 1907 led to the creation of the Federal Reserve six years later. For Charles Goodhart, "the essence of the Central Bank lies in its power to create liquidity."

In the 1930s, utterly unconscious Central Bankers refused to open the tap, with dire consequences on the Great Depression. Their short-sightedness brought them under the control of ministers. After the war, most economic affairs were administered in an almost ineffective but largely stable financial system. Bankers operated by the 3/6/3 rule (pay depositors 3% interest, lend money at 6%, and head for the golf course by 3 p.m.), while Central Banker supervised their actions and kept an eye on the then small financial markets.

But once capital markets became international, bankers started slipping out of the Central Bankers' control. At the beginning of the 1970s, massive financial flows contributed to making the international monetary system go bust. Then followed a massive creation of liquidity that eventually degenerated into inflation.

Starting in the 1980s, a consensus arose that the role of the "modern" central bank should be: preventing inflation, and "maintaining price stability," as stated in Article 127 of the Treaty on the functioning of the European Union. The rules of the game could not have been any easier. Central Bankers had one goal, and interest rates (or the price of what flows from the tap) were the instrument they would use to achieve that goal.

Central Bankers gradually forged the tools needed to organize their work -- "inflation targeting" and the "Taylor rule," which stipulates how interest rates should change depending on the rate of inflation. It was logical that Central Bankers also needed to became free of interference by governments, if they wanted to perform their activities unhindered. So Central Banks obtained their de facto independence (the United States in the early 1980s) and legal independence (New Zealand in 1989, France in 1993, the United Kingdom in 1997). The whole system thus seemed to work wonderfully: inflation had almost disappeared.

But it was nothing but an illusion. Completely obsessed by monetary matters, Central Bankers lost sight of finance -- which did what finance usually does when it is regulated solely by the market: it went bust. Bankers had to hurriedly open the tap and even take "unconventional" measures to direct cash where it was most needed. Today, most economists agree that Central Bankers will have to simultaneously decide when to open the money tap and how to set the price of what comes out of that tap, all the while trying to prevent anyone from drowning in the pool (liquidity, interest rates and financial stability are part of the now famous "macroprudential" strategy).

This raises a new series of problems. There is no completely satisfactory tool today for measuring financial stability. Central bankers will have to learn to handle new instruments, such as the level of reserves that banks are required to keep on deposit to protect themselves and avoid a credit boom. There is also the excruciatingly difficult question of knowing who should be in charge of monitoring all the ‘systemic" institutions that can cause the whole system to flounder along with them.

These debates are not only technical. Central Bankers will have to make tricky choices between different goals, such as price stability and the health of banks. In other words, they will have to do the work of politics even if no one elected them. Their independence will thus start to be questioned. There is no escaping the fact that their statutes shall have to be rewritten. Central Banks everywhere, and the European Central Bank in particular, must miss the good old days when controlling inflation was their only worry.

Read the original article in French

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