Judging from the growing number of official remarks, central banks – in a standalone capacity and jointly – have been discussing what to do in the event of major disruptions to the European payments and settlement system. The immediate focus is, of course, Sunday’s highly uncertain election in Greece. But the contributing factors go well beyond this as they are entwined in Europe’s increasingly messy debt and banking circumstances.
In welcoming such signs of responsible contingency planning, it is important to distinguish between what central banks can deliver and what they are incapable of doing. In the context of today’s complex crisis in Europe, these critical institutions have essentially been reduced to the role of fire brigades. They can try to reduce the risk of a fire and, should one occur, stand ready to fight it and contain damage. But, acting on their own, they are unable to alter materially the behaviour of those who place whole neighbourhoods at risk.
Through both emergency liquidity operations and the willingness to stand as a solid counterparty in dysfunctional markets, central banks can offset (but not eradicate) disruptions to the payments and settlement system. Most critically, they can reduce the devastating impact of market “sudden stops,” which are the equivalent of economic and financial heart attacks for capitalism.
Recent statements from a host of officials – including Mario Draghi, European Central Bank president, Mervyn King, Bank of England governor, and Timothy Geithner, US Treasury secretary – suggest this is indeed on the to-do list of major central banks. And the output, should it be necessary, would come in the form of both individual measures and globally co-ordinated ones.
But central banks are not the reason why Europe faces the tail risk of catastrophic disruptions. If anything, they have been working hard to prevent Europe from getting into the mess it finds itself in today. This, in turn, speaks to the critical policy distinction between willingness, ability and effectiveness.
While certainly willing and partially able, central banks have not been effective in severing the major “feedback loops” that erode on a daily basis the integrity of the eurozone, discourage private capital inflows and undermine the wellbeing of the global economy. Specifically, acting on their own, they do not have enough instruments to stop the bad interactions between weak banks and deteriorating sovereign creditworthiness. They have even fewer tools to stop individual country problems from contaminating what is an increasingly synchronised global slowdown. And they are powerless when it comes to breaking the adverse feedback loop between bad economics and bad politics.
Simply put, if they are not joined by more effective responses on the part of politicians and other government agencies, the best central banks can do is to slow marginally the steadily eroding impact of the west’s triple threat – of too little growth, too much debt and excessive political polarisation. And in pivoting from crisis prevention to crisis management, they can (and are) on alert to clean up the mess, but cannot counter all of the damage.
This reality is yet another indication of the extent to which the west has become hostage to a never-ending series of emergency tactical responses when what is critically needed is also a set of coherent strategic decisions. This leaves central banks in the role of a consistently scrambling fire brigade. And the longer they are in this role, the greater the erosion in their effectiveness to deal with an ever increasing number of fire threats.