Central banks as lightning rods for crises

Written for session 39 – Central banks as lightning rods for crises

Central banks were born out of the need to guarantee the liquidity of banking systems, particularly during bank runs, which also gave them a duty of supervision. However, many of these banks were set up in response to budget shocks, generally linked to armed conflicts: this was the case, for example, with the Swedish Riksbank in 1688 and the Bank of England in 1694. But over the past 15 years, faced with a global financial crisis and then an pandemic, the central banks of advanced countries have been reduced to these historic missions.

Does this mean that, by temporarily abandoning their primary objective of macroeconomic regulation, they have taken on the role of “crisis lightning conductors”. The answer obviously depends on the meaning we give to the expression: does it mean that central banks have the power to neutralize crises, or simply the ability to redirect and transform their impact? This question suggests another: isn’t their role also, and above all, to help prevent crises as well as resolve them?

Neutralizing crises or deflecting their impact?

When the subprime crisis broke out, monetary authorities reacted swiftly, acting as lenders and market-makers of last resort to prevent financial institutions from becoming illiquid and freezing their exchanges. In this way, the collapse of the financial systems was avoided, and the consequences of the shock moderated. But this rescue did not prevent the onset of a “Great Recession”, which called for fiscal policy intervention and led to a sharp rise in public debt levels. The shock was therefore not neutralized, and in the years that followed it led to a slump in growth rates, a public debt crisis in the eurozone and a fall in inflation rates that limited the capacity of monetary policies to act.

As a result, when the health crisis hit, this limitation, combined with the fear of deflation, forced fiscal policy to predominate in a recomposed policy mix: central banks supported, if not encouraged, perhaps excessive fiscal laxity. This reaction, however, failed to absorb the cost of the health shock (compounded by that of the war in Ukraine). As in the previous crisis, its amplification by destabilizing expectations and behavior was avoided. But the increase in public debt indicates that payment of this cost has been postponed, while the return of inflation reflects the conflict that has arisen over its distribution among agents.

It remains to be seen whether, in both cases, better coordination between monetary and budgetary policies would have resulted in a more effective handling of the shocks.

Preventing shocks

While central banks can only partially neutralize crises, they also have the capacity to prevent them. In fact, as already mentioned, their role in supervising the banking system preceded their monetary regulation function, and the subprime crisis led them to step up their involvement in this area, while at the same time tightening the content of micro and macroprudential regulations. Recent events have shown that this evolution was very justified, and that it deserves to be completed. On a more general note, it has become clear that the pursuit of price stability is not enough to ensure financial stability.  This should prompt central banks to reconsider the conclusions of the debate on asset price bubble

control (Lean vs. Clean). They could also pay closer attention to the empirical work that has shown that keeping interest rates too low for too long carries financial risks. The recent past has provided fresh evidence of this.

But the risks that central banks are likely to prevent do not originate solely from internal dysfunctions in financial systems. For some time now, they have been concerned by the rise in environmental risks and have begun to take initiatives in response. This is a logical step and does not fall outside their sphere of responsibility since these risks can affect banking stability (through the devaluation of portfolio assets). Monetary policy, and even more so regulatory policies, can undoubtedly play a part in preventing them, by redirecting investments to make them more in line with ecological transition projects.

Beyond this, some have mentioned the need to consider the inequalities (of incomes and wealth) that monetary decisions are supposed to affect, and whose development presents a systemic risk. We could also add the risks generated by the excessive geographical spread of value chains, which call for relocations that preferential financing could accelerate.

Monetary policies could undoubtedly be effective in preventing these and many other risks, but their use comes up against several reservations:

• On the one hand, in some of the cases mentioned, prevention takes the form of a kind of selective credit policy, ignoring the principle of market neutrality that was a pillar of the dominant conception of “central banking”.
• On the other hand, it is hardly possible to set central banks too many objectives, given their limited range of instruments.
• Finally, we must avoid entrusting them with functions that interact too closely with the other components of economic policy, as this would entail coordination that could jeopardize their independence.

Whereas during the years of the “Great Moderation”, the missions of central banks were strictly limited, how far can we extend their scope today?