Central banks

Mario Draghi

Mario Draghi, December 8, 2011. Image by Getty.

Will the European Central Bank save the eurozone? This is an extremely controversial question. What is clear, however, is that the central bank is the only entity with the capacity and the calling to do so. Without the euro, the ECB ceases to exist. That is true of no other eurozone institution. It gives it the incentive to act. It is also acting on a large scale.

The resistance to funding governments by purchasing bonds on a large scale, even in secondary markets, remains strong, as Mario Draghi, the new president of the ECB made plain in his interview with the FT on December 18.

Nevertheless, he argued, the ECB took important action the week before:

“We cut the main interest rate by 25 basis points. We announced two long-term refinancing operations, which for the first time will last three years. We halved the minimum reserve ratio from 2 per cent to 1 per cent. We broadened collateral eligibility rules. Finally, the ECB governing council agreed that the ECB would act as an agent for the European Financial Stability Facility (EFSF).”

Thus the ECB is determined to fund banks freely, at low rates of interest, thereby subsidising them directly and the governments they lend to, indirectly. Read more

During any period of monetary disorder – the 1970s, for example, or today – a host of people calls for a return to the gold standard. This is not the only free-market response to the current system of fiat (or government-made) money. Other proposals are for privatising the creation of money altogether. (See, on this, Leland Yeager, professor emeritus at the University of Virginia and Auburn University, in the latest issue of the Cato Journal.) But the gold standard is the classic alternative to fiat money. Read more

People with a free-market orientation believe that the economy has a strong tendency towards equilibrium. Over the long term money is “neutral”: a rise in the money supply merely raises the price level. In the short term, however, monetary policy may have a big impact on the economy. A big question, however, is over how to measure the impact of monetary policy in an environment such as the present one, when short-term interest rates are close to zero and the credit system is damaged.

The difficulty arises because of the huge divergence between what is happening to the monetary base (the monetary liabilities of the government, including the central bank) and what is happening to broader measures of money (principally the liabilities of the banking system). The former has exploded. But the growth rate of the latter is extremely low. (Look at the chart that accompanied my column, “Why it is right for central banks to keep printing”)

People worried that governments are “printing money” point to the balance sheets of central banks with horror and insist this is bound to be inflationary. Inside the eurozone, Germans are particularly concerned about the willingness of the European Central Bank to buy the debt of governments. Yet the growth of broad money (M3) in the eurozone over the past twelve months has been close to zero. That would suggest there is no inflationary pressure whatsoever.

So which measure is relevant? My responses would be as follows: Read more

The conventional wisdom in both Japan itself and the west is that the country has an unmanageable public debt problem. I find this quite unpersuasive. All the country needs to do is generate, say, expectations of 3 per cent inflation and the public debt problem should melt away like snow. But the longer it waits the bigger the ultimate adjustment will need to be.

In 2010, according to the Organisation for Economic Co-operation and Development, Japan will pay net interest of 1.1 per cent of gross domestic product on net financial liabilities of 105 per cent of GDP. Since 2000, Japan’s average rate of deflation (on the GDP deflator, the widest measure of inflation) was 1.2 per cent. So let’s treat the expected real rate of interest on Japanese government borrowing at 2 per cent. Read more

First comes financial crisis; then comes sovereign debt crisis; then comes financial repression. This is the view of Carmen Reinhart, co-author of This Time is Different, the masterly study of financial crises through the ages. I recently had a fascinating conversation on this topic with her, here in New York, where I have been living since the beginning of April.

So the question for the exchange is: how likely is financial repression? What forms might it take? Might this even be the end of the era of globalised finance? Read more