Opinion pieces and speeches by EPI staff and associates.
THIS PIECE WILL APPEAR IN THE SEPTEMBER 2002 ISSUE OF THE NEW ECONOMY PUBLISHED BY THE INSTITUTE FOR PUBLIC POLICY RESEARCH IN LONDON, UK.
Restructuring central banks
Creating a foundation for strong, stable and sustainable growth
On 1 January, 2002 another milestone in the process of European integration
was reached-the completion of the introduction of a single currency for 12 European Union countries. One of the tasks of the European Central Bank (ECB) had been accomplished.
On the other side of the Atlantic, the U.S. has been slowly recovering from a downturn that ended the longest U.S. economic expansion on record, a downturn that was partially caused by the actions of the Federal Reserve. To recover from the effects of allowing interest rates to rise too high, the Fed then had to lower interest rates gradually throughout the course of the subsequent recession.
In the U.S. as in Europe, the issue of creating the conditions for sustainable
growth is on the agenda for policymakers and the central banks. The objectives are similar and so have the strategies been so far-to prioritise price stability above all other policy goals. In some instances, both central banks have prioritised inflation fighting to the detriment of full employment and the maximisation of non-inflationary growth, even when there has been no real threat of inflation. At the same time, both central banks have attempted to influence public policy in areas well beyond their mandates and expertise.
To fulfil those mandates, both central banks need to be restructured. Important lessons can be learned from their operation to date. Restructuring will enable them to focus on all of their legitimate goals and prevent them from interfering with the achievement of goals in other areas.
Goals of central bank policy
Central banks are a key element of the macroeconomic policy mix. Their control over a country’s monetary system should be bound to the same
mix of policy goals as other policymakers involved in macroeconomic policy. These goals include low inflation, sustainable output growth, full employment and financial stability.
Only if macroeconomic policy can successfully strike a balance between these goals can it create an environment that is supportive of strong and stable economic growth. High inflation and also deflation constitute shocks to either financial assets or liabilities that disrupt the flow of lending and borrowing that is so crucial for growth. Financial instability, characterised by overly optimistic expansions of credit, which often accompany overvalued currencies, and subsequent increases in loan defaults, can make the financial sector a drag on the real economy, by disrupting consumption and investment. However, low inflation and stable finances will not necessarily lead to growth if people do not have jobs and spending power. Moreover, strong consumption growth, based on solid income growth resulting from high levels of employment, will also translate into higher levels of investment growth, as U.S. experience in the late 1990s showed (Weller 2002a). In other words, strong employment growth is an integral part of ensuring sufficient demand.
Both central banks are well situated to help strike the right macroeconomic policy balance. In particular, the importance of monetary policy has grown in terms of its influence on prices, employment and growth as the U.S. and Europe have opened their economies to more trade and capital flows. In addition, central banks have generally been entrusted with ensuring the smooth operations of payment systems. This positions them strategically to regulate financial market activities so as to ensure financial stability, which would entail stable asset price growth to ensure that credit of sufficient quality and quantity is available and keeping currency values in line with economic fundamentals. In fact, the Federal Reserve was created in 1913 exactly to ensure that the extreme financial booms and busts of the late 19th and early 20th century would come to an end. Currently, financial market regulations are still handled by national authorities in Europe. But as markets have become increasingly integrated across international borders regulation by a Europe-wide institution seems a logical next step.
Although central banks are in a strategic position to address the different policy goals, their mandates are currently more limited. One goal that is partially or entirely missing from the remit of both banks is financial stability. The Fed regulates some U.S. banks, but many important and possibly destabilising financial market trends, such as an unsustainable rise in the stock market, substantial credit expansions by non-bank lenders or an overvalued currency fall outside its purview. Similarly, the ECB is charged with ensuring the smooth operation of the payment system, but not with the larger goal of financial stability, which is also reflected in the fact that it does not have a role as lender-of-last-resort (Arestis and Sawyer 2002).
The other goals aside from financial stability are part of the mandate for the Fed, which is charged with finding a balance between inflation, full employment and growth. Similarly, sustainable and non-inflationary growth and high levels of employment are part of the mandate of the ECB, but they are explicitly subordinated to the goal of securing price stability.
The banks’ track record
The Federal Reserve
An analysis of Federal Reserve policy in the 1990s suggests that it had concerns about inflation, changes in output growth, high unemployment, and financial stability at different points in time (Weller 2002b) and did not always follow its own policies to the letter. For example, when consumer price inflation fell to three per cent or below the Fed shifted its priorities towards maintaining stable output growth, higher employment or financial stability. It did so largely by manipulating short-term interest rates rather than using other tools at its disposal and at the same time making its views known on fiscal and social policy.
The bank ‘s attention was on managing output and employment growth in the early 1990s. Inflation fell quickly below three per cent by the end of 1991, the exchange rate depreciated, and the stock market grew annually at eight per cent, leaving the tackling of high unemployment and slow growth as key policy targets. Between July 1990 and March 1991, the Federal Reserve lowered its target federal funds rate by 2.25 percentage points. And even after the economy showed signs of recovery the Fed continued its loose monetary stance by lowering the federal funds rate another ten times by the end of 1992.The loose
monetary stance was partially driven by the fact that the economy was in a recession, but also partially by the fact that the Fed was surprised by the sheer magnitude of the bank and thrift failures in the early 1990s.When the economy had regained some of its vigor and the unemployment rate rose to six per cent in 1994, it began raising rates again. When growth slowed again in 1995, it cut rates a further three times.
By contrast, the second half of the 1990s was marked by faster profit, employment, wage, output and stock market growth, alongside a rising exchange rate and growing trade deficits. Amidst this mix, the bank focused on
financial stability. After the Asian financial crisis, it lowered interest rates rapidly in 1998 to stabilise financial markets. In addition, it voiced its misgivings about the stock market bubble – most notably through Alan Greenspan ‘s famous ‘
irrational exuberance ‘ remark in December 1996 – rather than raising rates. When the bubble continued, it raised interest rates in 1999 to try to control the accelerated increase in stock prices (Weller, 2002b).
The Federal Reserve did not, however, focus exclusively on financial stability. Monetary tightening in 1999 was an attempt to limit further falls in unemployment and restrain economic growth, although it had already allowed unemployment rates to fall to 30 year lows and there were no signs of accelerated inflation. It also voiced opinions in other areas. Alan Greenspan supported the privatisation of Social Security in 1997 and large tax cuts proposed by President Bush in early 2001.
The European Central Bank
The European Central Bank’s track record, although much shorter, reflects its prime goal of price stability. Although unemployment in the Eurozone remained high and growth rates anaemic, the ECB raised rates in 1999 and 2000 fearing inflation might rise above two per cent with rising oil prices and a strong dollar. In the fall of 1999, the ECB began raising rates in tandem with the Federal
Reserve, although inflation was below two per cent and unemployment above nine per cent in the Eurozone at the time, largely out of fear that higher rates in the US would further weaken the Euro. Similarly, the ECB did not begin cutting interest rates until May 2001 – almost six months after the Fed had begun to lower rates and at least one quarter after growth had slowed in 2001.
Also similarly to the Fed, the ECB is no stranger to using its ‘voice’ as a policy tool. The primary focus of the ECB ‘s public interventions has been the need to reform the Eurozone’s labour market institutions. A noteworthy example was Wim Duisenberg’s speech at the Kansas City Federal Reserve Bank’s symposium in Jackson Hole, Wyoming, where he called for wage moderation and labour market flexibility and derided common social standards in the
European Union (Duisenberg 1999). Although social policy goes beyond the
ECB ‘s mandate, and despite a dearth of evidence supporting the claim that weaker labour market institutions would result in higher growth, ECB officials continue to use public forums to push for more flexible labour markets and lower labour standards (Barber 2002).
Looking at central bank policies on both sides of the Atlantic Ocean, several lessons become clear.
A broader and balanced mandate
Firstly, the mandates of the Federal Reserve and the European Central Bank need to be changed. In particular, they need to be broader: current mandates ignore financial stability as a central bank policy goal. The rise of stock markets in conjunction with currency overvaluation were important contributary factors in the U.S. recession and thus also to the global economic slowdown in 2001. A more proactive policy stance from the Fed, which was strategically situated to intervene, could have helped to deflate the stock market and exchange rate bubbles.
All four goals of central bank policy should be put on an equal footing. In particular, the ECB ‘s policy mandate needs to be changed to move full employment, sustainable non-inflationary growth and financial stability onto the
same footing as low inflation. Furthermore, the mandates of both central banks should not include fixed target values. One of the differences between the Fed and the ECB was that the Fed used some policy discretion in letting the unemployment rate fall below six per cent from 1995 to 1999. In contrast, the
ECB pursued a strict inflation target of two per cent, despite adverse effects on growth.
One corollary of a broader mandate for central banks is to allow the use of other macroeconomic policy tools, such as fiscal policy. This is of particular importance in the Eurozone where the Stability and Growth Pact sets specific limits on the annual budget deficits of member countries. The U.S. technically also has limits on budget expenditure growth on its books, but lawmakers have not adhered to them in recent years. Such strict annual limits on budget deficits should be avoided to allow flexible fiscal responses to changing economic conditions.
A choice of tools
Secondly, central banks need a choice of economic tools. Monetary policy alone cannot achieve all four goals, especially not through interest rates alone. Instead, both central banks should be given additional tools in line with their broader mandates. Both central banks particularly need mechanisms for sta-
bilising financial markets.
One option would be to allow central banks to regulate the amount of credit that households could use to purchase securities. The Federal Reserve already sets the maximum share of securities that can be purchased with broker credit. However, since borrowers have substituted other consumer credit for margin debt to purchase securities, the Fed’s regulation should be broadened to cover other forms of consumer debt (Weller 2002c). A similar regulation should be made available to the ECB – with due consideration of the different banking structures in Europe – as a tool to control asset price bubbles.
Another policy tool could be asset-based reserve requirements. Rather than banks being required to hold reserves based on their deposits, they could hold reserves based on their assets. Riskier asset classes would have higher reserve requirements. One advantage lies in the fact that regulators can con-
trol the composition of bank assets as well as their total value. Such requirements could also be applied beyond the traditional deposit taking institutions to new non-bank lenders (Palley 2000).Given that the banking sector has shrunk relative to non-bank lenders, the lack of regulation of those lenders has become a growing concern for financial stability. The ECB should also be given the role of acting as lender of last resort, in similar fashion to the Fed, if financial instability results in a contraction of credit and threatens the stability of the entire economy (Arestis and Sawyer 2002).
Thirdly, broader mandates and better central bank policy tools can only help to achieve the four central bank policy goals if central banks are held properly accountable. This should be done by increasing parliamentary oversight, making central bank decisions more transparent, and by increasing popular participation in central bank decisions. Greater accountability should ensure that central banks pursue all mandated goals with equal vigour and disregard objectives that are beyond their mandate. Central banks would not then be obstacles in the quest for the optimal macroeconomic policy mix.
Parliamentary oversight already exists in the U.S. and the EU in so far as the Federal Reserve is required to report to Congress and the ECB to the European Parliament. These regular reports should be maintained and broadened to include testimony from central bank officials other than the Chairman of the Federal Reserve and the ECB President (FMC 2001).
Central bank decisions need to become more transparent. Central bank meetings should be open to the public, with exceptions for regulatory discussions involving specific firms or individuals, and minutes of all meetings should be made available to the public at no charge (FMC 2001). The central banks should hold press conferences to explain their policy decisions after each meeting. And popular participation in central banks should also be increased. The Fed and some European national banks allow for only limited participation of labour and community representatives at the moment. The Fed and the ECB should be restructured to allow for more popular participation. Making the appointment of labour and community representatives to all decision-making bodies mandatory could achieve this.
Restructuring the Federal Reserve and the European Central Bank would promote strong, stable, and sustainable economic growth. With these proposed policy changes central banks would be more li
kely to work alongside other policymakers to ensure that the US and the EU attain strong growth and full employment. Moreover, successfully restructured central banks would also be less likely to wander into policy areas that are beyond their mandates and their expertise.
Arestis, P. and Sawyer, M. 2002. Monetary Policies in the Eurosystem and Alternatives for Full Employment, mimeo, South Bank University, London, and University of Leeds, Leeds, UK.
Barber, T. 2002. EU Member States Urged to Push on with Reforms, Financial Times, March 11, 2002.
Duisenberg, W. 1999. Economic and Monetary Union in Europe – The Challenges Ahead, luncheon address at the symposium “New Challenges Ahead for Monetary Policy” sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26-28, 1999.
Financial Markets Center (FMC). 2001. Six Ideas for Introducing the Fed to the 21st Century, FOMC Alert March 20, 2001, Philomont, VA: FMC.
Palley, T. 2000. Financial Stability in the OECD: The Missing Dimension in Public Policy, New Economy 7, No. 3.
Weller, C. 2002a. Lessons from the 1990s. The New Economy Vol. 9, No. 1: 57-61.
Weller, C. 2002b. What Drives the Fed to Act?, Journal of Post-Keynesian Economics Vol. 23, No.3: 391-416.
Weller, C. 2002c. Policy on the Margin: Evaluating the Impact of Margin Debt Requirements on Stock Valuations, Journal of Economics and Finance Vol. 26, No. 1.
Christian Weller is an economist at the Economic Policy Institute.
[ POSTED TO VIEWPOINTS ON SEPTEMBER 12, 2002 ]