Central banks and illusions of independence
By Reuven Brenner
While much attention is now paid to personalities of incoming central bankers, far less attention is paid to debating central banks' mandates in light of the unusual fiscal and financial intermediary roles they have been fulfilling since 2008.
The crisis revealed institutional voids that the central banks filled quickly. Such ventures by central banks have been tolerated in the past too: there is nothing new about quantitative easing (QE). The Fed practiced it during the 1940-51 under the Treasury's explicit command, though the technique had no name then. The
Fed stopped the practice when it became officially independent again in 1951.
1940 fiscal parallels and the Fed's independence
Federal Reserve chairman Ben Bernanke acknowledges that he is replicating the monetary policies of the 1940-1951, though takes no note of the unusual circumstances then. Here is a quote from a 2008 speech:
... Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill.
The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills.
He fails to mention that during the 1940s, the Fed was carrying out fiscal policy under explicit Treasury orders. The low interest policy - inflation was in the double digits - helped pay for World War II and the accumulated debt.
The Fed could do this then both because there was domestic political support for the war effort, and later, as support after the war was weakened, the global conditions stayed such that capital had few places to flow: the US was in the immediate post-war period the safest place.
However, the world stabilized and capital started to flow to Western Europe too. At the same time, the US abolished the Office of Price Administration in 1947, and the official inflation rate this Office's policy kept artificially low until then hit double digits. Public debates then started about restoring the central bank's independence. This was done in 1951, president Harry Truman's pressure to continue with the "QE" policies to finance the Korean War too notwithstanding.
There are similarities and differences between that decade and the situation today.
The similarities are the monetary techniques used to achieve the low interest payments, allowing the Federal government to carry increased debts. There are similarities in the global situation too: during the 1940 decade as well as since 2007 when the present crisis started, grave problems notwithstanding, the US has been the safest place for capital to flow. Europe had big question marks hanging about its future then as now - though for different reasons. Russia, China, India and most of Latin America were not places where much capital could flow or be absorbed.
With much global savings flowing to the US, with domestic savings staying put, and with government policies elsewhere perceived unreliable, it was not surprising that the Fed could maintain low interest rates, the federal government can accumulate debts, and not default - then, as now.
The similarities are also in the fact that the Federal Reserve carried out explicit fiscal policy both during the 1940 decade and similarly during this crisis, although in this respect there is a significant difference between these two time periods.
Whereas during the decade of the 1940s the fiscal angle was acknowledged, namely that the low interest rate policy prevented the government from raising taxes explicitly and, instead, it "taxed" savers through both the lower interest and the inflation (much underestimated because of price controls during the 1940s) - today this fiscal angle is not acknowledged explicitly. Instead, the interventions are rationalized differently, but which at closer look do not hold up to scrutiny.
Central banks were right in injecting liquidity at the beginning of the crisis to correct for the accumulated mistakes in the banking system. But such a role has nothing to do with the roles the Fed undertook later in collaborating with the government and becoming the major financial intermediary for residential mortgages as well. And it does not have anything to do with keeping interest rates low - in fact the liquidity injections should have been done by charging the banks high rather than low rates.
Central banks' mandates
The policies have nothing to do with declared goals of balancing inflation and unemployment - as, at closer look, both these measures are fiction.
With labor force participation having dropped to historic lows during this crisis, and with tens of millions falling out of any official unemployment measures (appearing in un-targeted categories such as either "discouraged workers", or "disabled" (the latter rising from 2 million before the crisis to 11 million now, and who are supported by the federal government rather than state governments) - what do changes in the official unemployment rates even signal for central banks?
Former Fed chairman Paul Volcker summarized recently the answer in one sentence: The mandate of price stability and full employment has been "both operationally confusing and ultimately illusory".
As to inflation as a guideline: the apparent price level spike in mid-1947 in the US, when the Office of Price Administration was abolished, was a statistical illusion - not different from illusions 40-plus years later in post communist countries. The "inflation" had already happened in the black markets with the credit expansion: it just was not officially measured.
Today we are mis-measuring inflation for different reasons, failing to recognize the extent of the credit expansions taking place. The housing component - with which the Fed is now so heavily involved - is a major culprit for a number of reasons.
The Taxpayer Relief Act of 1997 exempted from taxation the profits on the sale of a personal residence of up to US$500,000 for married couples filing jointly and $250,000 for singles. The exemption applied to residences the taxpayer(s) lived in for at least two years over the last five. Taxpayers can only claim the exemption once every two years.
Before 1997, the rule was that only taxpayers age 55 or older could claim an exclusion, and even then the exclusion was limited to a once in a lifetime $125,000 limit. The 1997 Act changed all of that: you can buy and sell as much as you want during your lifetime (with some restrictions).
Such law would have implied to drastically change the weight of housing component in the Consumer Price Index, as housing became more of "an asset" and less of "consumption" than was before. That wasn't done. The demand for "housing" escalated, suppliers accommodated, and rents stayed low. As a result, in spite of the drastic rise in home prices, and their roughly stable 30% weight in the CPI, the latter showed little sign of inflation and did not signal undue credit expansion over 1997-2007 decade.
When home prices dropped severely, the index did not show drastic decreases either. Having lost their homes, and with millions of houses staying empty, homes ceased to be the unique "asset class" people expected, and they now rented more. Little wonder that indices mish-mashing "consumption" with items having wildly fluctuating characteristics "assets" or "investments" cannot offer central banks reliable signals of credit expansion - or retraction.
Perhaps we would have been far better of if, instead of referring to this asset class as "real estate", we would use the French term instead: "immobilier". This is the "real" feature of this class - its immobility, rather than being any more "real" than other asset classes. This term also suggests why politicians love to first subsidize this particular sector: they tend to "immobilize" voters. And once they are immobilized, this asset class become a wonderful subject to taxation: you can't take it away with you. (Indeed, one of the first things Francois Hollande did when elected president of France was to raise a variety of taxes on this immobile asset).
The present much ballyhooed recalculations of price indices to adjust for "quality" further weakens their reliability as indicators of pricing pressures. Whereas these adjustments were made in the name of recognizing the increased quality of technical devices, I did not read anywhere about the many goods and services whose quality has been going down the drain over the last few decades, such as public schooling, universities, health, infrastructure, be it roads or bridges.
If having mandates to pursue these indices could bring instability rather than promote stability, what mandate could central banks have?
Having a mandate for pursuing "price stability" rather than "illusions of precision" would be a step in the right direction - long advocated by Volcker. Pursuing monetary stability could be another, which would include designing the institutions to maintain them.
For example, the European Central Bank could have recommended well before the crisis establishing a European Financial Stability Fund, emphasizing that the euro is in fact a "fixed exchange rate" system, since there is no government or unified fiscal policy backing it (and it is not anchored in gold). As such, it needs a European version of an International Monetary Fund to deal with a balance of payment crisis, similar to the role of the IMF played while the Bretton Woods system lasted. Perhaps the stability fund created haphazardly during the crisis could have been in existence - if the central bank had such "supervising for stability" role.
Central banks could also be responsible for changes to consolidate accidental regulatory agencies, so as decisions could be taken faster and more accountably. Whether one agrees or not with Sheila Bair, former chair of the Federal Deposit Insurance Corporation, interpretation of events in her Bull by the Horns, the lack of accountability and the delays to which the uncertain boundaries between the Fed, the Securities and Exchange Commission, the FDIC and other agencies led highlight the lack of an institution under whose umbrella financial activities could be co-ordinated - accountably.
Perhaps the mandate should be explicit too about the conditions under which central banks pursue fiscal policy, and how does this transition of power happen. After all, the facts are that there have been virtually no wars when governments did not force central banks to inflate to pay for them by temporarily abandoning gold standards among others. Other times the Treasury dictated to the Federal Reserve the low interest policy to achieve similar goals - also without any formal transfer of powers.
Economists once speculated that the global bond market would not tolerate such inflationary policies and such lack of accountability. Indeed bond markets were severe on Asian countries during the crisis of the 1990s, as they have been on Southern European countries during this one. So why has the US been exempt from such pressures on Treasuries be in the 1940s or now?
As noted before, it was and is serendipity. There were no good alternatives to the US dollar then, and there have not been during this crisis. If there was an alternative to the dollar's reserve currency status, the low interest rates policies could not have been maintained.
With the imminent choice to be made for the role of Federal Reserve chairman, perhaps more attention should be paid to these questions and the mandates of central banks and less to their "personalities".
When mandates are clearer and enforceable, personalities matter less. That's one reason we hardly hear about Swiss politicians or central bankers: their unique direct democracy prevents them from pursuing drastic follies.
Reuven Brenner holds the Repap Chair at McGill's Desautels Faculty of Management, serves on the Board of its Pension Fund, and is also member of its investment committee. The article draws on his Force of Finance (2002), and Labyrinths of Prosperity (1994).