Friday, August 31, 2012

The future of central banks

A WSJ Op-Ed. Here is a pdf for non subscribers:

Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks' main task is to guide the economy by setting interest rates. Central banks' main tools used to be "open-market" operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These "nontraditional" interventions are not going away anytime soon.

Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed's independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative "stress tests" for them to pass, and haggle over thousands of pages of regulation. When we think of the Fed 10 years from now, on current trends, we're likely to think of it as financial czar first, with monetary policy the boring backwater.

A revealing example of where we are going emerged last spring, admirably documented on the Fed's website. Using its bank-regulation authority, the Fed declared that the banks that had robo-signed foreclosure documents were guilty of "unsafe and unsound processes and practices"—though robo-signing has nothing to do with the banks taking too much risk.

The Fed then commanded that the banks provide $25 billion in "mortgage relief," a simple transfer from bank shareholders to mortgage borrowers—though none of these borrowers was a victim of robo-signing.

The Fed even commanded that the banks give money to "nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development." Why? Many at the Fed see mortgage write-downs as an effective tool to stimulate the economy. The Fed simply used its regulatory power to help meet that policy goal.

Even if you think it's a good idea (I don't), a forced transfer from shareholders to borrowers in pursuit of economic policy is the province of the executive branch and Congress, subject to reproof from angry voters if it's a bad idea.

The Fed said candidly that it was acting "in conjunction" with the state attorneys general and the Justice Department. So much for an apolitical, independent Fed.

True, $25 billion is couch change in today's Washington. But you can see where we are going: Hey, nice bank you've got there. It would be a shame if the Consumer Financial Protection Bureau decided your credit cards were "abusive," or if tomorrow's "stress test" didn't look so good for you. You know, we've really hoped you would lend more to support construction in the depressed parts of your home state.

Conversely, when the time comes to raise interest rates, how can the Fed not consider that doing so will hurt the profits of the too-big-to-fail banks now under its protection?

This is not a criticism of personalities. It is the inevitable result of investing vast discretionary power in a single institution, expecting it to guide the economy, determine the price level, regulate banks and direct the financial system. Of course it will use its regulatory power to advance policy goals. Of course, propping up the financial system will affect monetary policy. If we don't like this sort of outcome, we have to break up the Fed into smaller agencies with narrowly defined mandates.

The European Central Bank's political power is, paradoxically, even greater. The ECB was set up to do less—price stability is its only mandate, and it is not a financial regulator. But the ECB holds the key to the euro-zone's central fiscal-policy question. It has bought the debts of Greece, Italy, Spain and Portugal, and it is lending hundreds of billions of euros to banks, which in turn buy more of those sovereign debts.

Eventually, the ECB will have to suck up this volcano of euros, by selling back the bonds it has accumulated. If it can't—if the bonds have defaulted, or if selling them will drive up interest rates more than the ECB wishes to accept—then the ECB will need massive funds from German taxpayers to prevent a large euro inflation. It might ask for a gift of German bonds it can sell, as "recapitalization," or it might ask for a bond swap of salable German bonds for unsalable southern bonds. Either way, German taxes end up soaking up excess euros.

Our views of central banks have changed every generation or so for centuries. The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s. It's happening again, and it would be better to think clearly about what we want central banks to do ahead of time.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.


  1. The Fed is carrying 2.8T$ of assets on capital of 55G$, a Asset/Capital ratio of 50:1. If it were a regulated bank instead of the regulator, it would put itself into receivership.

  2. "The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s."

    But didn't you state in a previous discussion that the central bank doesn't control inflation/NGDP?

    Anyways, good post professor. This is why you should support a switch to NGDPLT. The proper role for a central bank is demand management. If AD is kept pumping then there would be no need for all the interventions we've seen in the past 5 years.

    1. Yes. And, Friedman's idea doesn't work anymore. I guess that needed to be clearer. I think the Fed's traditional (Friedman style) tools are next to powerless. So if the Fed wants to be powerful -- and if we want the fed to be powerful -- it needs more tools. Credit allocation, telling banks what to do, and fiscal policy (the ability to write checks to voters, aka helicopter drops) would give it more power. So, our question, do we want to imbue the fed with such power, or get used to an agency with a much smaller role in macroeconomic events? I favor the latter.

    2. '... fiscal policy (the ability to write checks to voters, aka helicopter drops)....'

      Isn't that monetary policy?

    3. No. The Fed on its own must always take something back -- usually treasury bills -- when it issues money. It can lend, it cannot give. It cannot drop money from helicopters. It cannot blithely write checks to voters. That's congress' job, executed by Treasury, that's fiscal policy. So far. (At best a helicopter drop is "coordinated fiscal and monetary policy." The Treasury borrows, writes stimulus checks to voters. The Fed buys the debt and issues money.)

    4. If the central bank announced open ended QE until they've hit a specified target then I think that would be enough. Since monetary policy is 99% expectations I would guess that because of this they would only need to purchase a small amount of bonds to reach their goal.

      So I don't really see why the FED needs anymore tools than it already has.

  3. Despite your last paragraph, I can't see much difference from the Fed's actions and the Walter Bagehot "lend freely against good collateral at a penalty rate" dictum. If we perceive a difference it's because we've not seen a banking crisis threaten a deflationary spiral since the 1930s. So the Fed is reading from a pre-1930s playbook.

  4. Professor Cochrane:

    8/22 - "The fact is, the Fed is basically powerless to create more inflation right now"

    8/31 - "The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s"

    It follows, then, that you disagree with Friedman's work in the 1960's?

    1. Yes. Friedman was brilliant for 1960. But not every idea lasts forever, or lasts into financial and economic changes 50 years outside what it considered.

    2. Pr Cochrane

      I see no contradiction here. Today, the facts may seem to contradict the view of Milton Friedman. Today, there is little inflation. But do not you think that with time, the Fed policy will eventually lead to hyperinflation? In other words, do not you think that the policy of the Fed increases the risk of inflation?

    3. Hyperinflation may come when/if money velocity returns. This over-indebted, retiring population cannot consume anymore. The domestic inflation is apparent in health costs, education, gasoline and houses- and now food. The tech, manufactured goods and textile imports from Asia show as deflationary items. The Fed seems to count the latter more heavily. Our currency is being systematically devalued to enhance our exports. Why we let them do this I don't know because they don't hire domestically anyway when demand goes up. Unless you count WMT and McD.

    4. Inflation is poorly defined and poorly measured. Normally, the price index expanded (including all assets) should have decreased significantly during the crisis if the government and the Fed had not intervened. But this decline was not seen because the Fed has pumped billions of dollars into the banking system and thus the inflation rate seems just low, as measured by CPI or PPI. It is a sham. In reality, inflation is very important. Naturally, the official inflation rate will jump once confidence is restored, investors and consumers seek to spend more. The fed sacrifices the long term for the short term! Bad times!

  5. Professor Cochrane
    Do you have any thoughts on the Austrian school of economics and ending the Fed altogether you could share?

    Kind regards
    Atle Willems

  6. Dr. Jeffrey Hummel at San Jose State University recently published a paper that concurs with much of what you wrote in this article. He specifically focuses on the differences between the approaches of Bernanke and Friedman to financial crises.

    "Ben Bernanke versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner"

  7. I read your WSJ op-ed with interest and very much agree with your concerns. At the beginning of the financial crisis, I was inundated with questions from students, friends, and family, about the effects of and policy responses to the financial crisis. My (short-hand) response was that I have great faith in Ben Bernanke as Fed chair. He seemed uniquely qualified for the times. Now I am concerned that my faith has been misplaced. I feel that the Fed under Mr. Bernanke has simply been an enabler of very bad fiscal policy moves that will leave us in even worse economic shape. This seems to contradict what (I thought) I knew about Mr. Bernanke from his academic work. Has Ben Bernanke as Fed chair been what you expected?

  8. Above, you write that "The Fed on its own must always take something back -- usually treasury bills -- when it issues money. It can lend, it cannot give."

    This seems inaccurate in at least two ways. First, if the Fed buys a bond that I've issued and then remits the coupon payments back to me, I'm sure we'd agree that the Fed is giving me something in the process. In practice, it is the Treasury rather than me that's on the receiving end but the giving is there just the same.

    Second, just because an open market transaction takes place this does not mean that there is no transfer bundled with the transaction. If the next highest bidder is willing to pay $99 for some security and the Fed pays $100 for that security, that looks like a $99 securities transaction coupled with a $1 gift.

    If open market activity is just exchanging like for like, then the Fed's open market desk would be running at exactly break even if we exclude all costs besides the actual cost of securities purchases. In this case, being on the other side of the trade would also be a break-even proposition. If open market activity consists of financial transactions bundled with gifts, then the open market desk would be running a loss and being on the other side of the trade would be profitable. We know that other market participants are willing to do business with the open market desk. Why should this be the case if the Fed is not running a regular loss?

    Anyway, what's your general view on the question of whether or not to have a central bank at all? I know it's possible to write down models where having a central bank is an improvement over not having one, so long as the central bank behaves according to the assumptions of the model. Do you think there is much evidence that central banks in this world constitute an improvement over alternatives such as commodity money or free banking?


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