Central Banks: Clear Tasks Instead of Outdated Formulas
The financial and economic crisis has shown that central banks need leeway for ad hoc interventions in the monetary and credit cycle. A clear separation between financial and monetary policy would be a first step towards long-term stability.
The radical measures that central banks have taken since the financial crisis may have prevented a deeper recession, perhaps even an economic depression. But they are also cause for discomfort. The primary concern relates to the balance sheets of many central banks, which have been inflated to historically unprecedented dimensions since the collapse of Lehman Brothers in the fall of 2008. This is also true for the Swiss National Bank (SNB), whose balance sheet has increased almost fivefold – first because of the measures taken to support UBS, and also mainly because of massive foreign exchange purchases during the euro crisis. At nearly 525 billion francs (as of the end of October 2014), SNB's balance sheet has now reached the level of 75 percent of gross domestic product. This is a record among OECD countries.
Although the economic data points to deflationary rather than inflationary trends, this development is fueling concerns that the situation could lead to uncontrollable inflation. It is also feared that interventions in the financial markets and the influencing of interest rates and other financial market prices distort not only savings and investment decisions in the private sector, but also the distribution of income. How should these risks be dealt with?
Mechanical Rules Have Failed
It seems clear to us that the (re)introduction of supposedly simple, mechanical rules for the behavior of central banks is not the answer. For example, the nostalgic sympathy for the gold standard as expressed in the rejected popular initiative "Save Our Swiss Gold" mistakenly considers that in times of crisis this limitation on the flexibility of central bank policy increases the instability of the economy rather than lessening it. The gold standard always had to be given up in times of crisis, and when it was temporarily reintroduced in the 1920s, it severely hampered the economic recovery. Central banks were equally ineffective in sticking to targets for quantities of money that were considered the recipe for success for several years after the inflationary period of the 1970s.
Finally, the Taylor rule postulated in 1992 by the US economist John Taylor also failed. It required, for the achievement of a stable inflation target, a relatively mechanical lifting and lowering of the key interest rate, which was based on the rate of capacity utilization and the current rate of inflation. Although inflation in the phase prior to the crisis was stable and at a low level and there were only minor setbacks in the economy and financial markets, severe economic imbalances were nevertheless building up during this phase.
Making the Financial System more Stable
Imbalances arose because financial institutions granted loans that no longer had any relation to the underlying capital or the growth potential of the economy. This resulted in leverage effects that led initially to a boom and then to a crash. In order to improve financial stability, the focus should therefore not be on the size of the balance sheets of central banks, but on the balance sheets of the entire financial system.
The "full money initiative" offers a solution that we consider misguided. Signatures for this initiative are currently being collected in Switzerland. This initiative intends to prevent commercial banks from creating money (liabilities side of the balance sheet) by expanding their lending (asset side), because under the initiative all assets would have to be financed by central bank money.
As a result of the fact that under a full money system only the central bank could create money, the benefits of decentralized information and risk transformation systems, as brought about by competition between financial companies, would be nullified. It also seems naive to expect that this kind of limitation on banking activities would preclude future crises. The plan fails to recognize that "shadow banks" would fill the profitable gaps, perform lending and thereby create "money."
The appropriate response to the risk associated with lending and money creation by the banks is not an artificial narrowing of business opportunities for banks or other financial institutions, but primarily the route that has been taken – that of strengthening their capital base and therefore their responsibility for themselves. As shown in the report published at the end of 2014 by the Federal Council's group of experts on the further development of financial market strategy, Switzerland has come a long way towards strengthening its financial stability. Such an approach is more useful than running the significant risk of full money reform with a very uncertain outcome.
From a regulatory standpoint too, the full money initiative is problematic. It is obvious that the SNB would be more subject to political pressure to adjust money creation to suit every economic mood or situation than if the stability of the marketdriven banking system were strengthened. Such strengthening could also help to clarify the boundaries between the monetary authority's and the financial regulator's areas of responsibility, which have become increasingly blurred since the crisis (keyword: macro-prudential measures).
Two Pillars of Stability
The concurrent blurring of boundaries between monetary and financial policy also increases the fear of inflation. If the central bank buys government bonds, it is de facto financing government deficits, while at the same time the depressed interest rates make it easier to refinance debt. And because, in addition to bond prices, the value of other assets is also rising, this policy could lead to the misallocation of capital (keyword: speculative bubbles); an additional effect that is exacerbating the debate.
In our opinion, the correct response by regulatory policy to this mixing is based on two pillars: firstly, the strengthening of the independence of the central bank from politics, and secondly, the obligation of fiscal policy to maintain long-term fiscal stability. A good approach is the debt ceiling built into the Swiss Constitution, which should be extended to other areas such as financing of social welfare. As well as strengthening financial stability, this would noticeably reduce the pressure on monetary policy to solve every problem that comes along. A realistic view of debt dynamics in many industrialized countries, however, leads us to fear that this pressure might increase even more over the next few years.