The credit crisis that hit the world economy in August teaches us many lessons about the workings of integrated financial markets. It also teaches us something about the responsibilities of central banks.
Until the crisis, the consensus view was that central banks should target inflation and that is pretty much all they should do. In this view, central banks should not target (or try to influence) asset prices either, as was stressed by the former Federal Reserve chairman Alan Greenspan, because central banks cannot recognise bubbles ex ante. Or, if they can, the macroeconomic consequences of bubbles and crashes are limited as long as central banks keep inflation on track. Inflation targeting, we were told, is the new best practice for central bankers that makes it unnecessary for them to try to influence asset prices.
The credit crisis has unveiled the fallacy of this hands-off view. If the banking system were insulated from the asset markets, the view that monetary policies should not be influenced by what happens in asset markets would make sense. Asset bubbles and crashes would affect only the non-banking sector and a central bank is not in the business of insuring private portfolios.
The problem that we have seen in the recent crisis is that the banking sectors were not insulated from movements in the asset markets. Banks were heavily implicated both in the development of the bubble in the housing markets and its subsequent crash. Since the banking system was implicated, the central banks were also heavily involved owing to the fact that they provide insurance to the banks as lender of last resort. Some may wish that central banks would abstain from supplying this insurance. However, central banks are forced to provide liquidity during a crisis because they are the only institutions capable of doing so. Thus, when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that is when the balance sheet of the central bank will be affected.
There is a second reason that the hands-off approach has been shown to be wanting. During the past few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long and, as a result, have created credit and liquidity on a massive scale. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no supervision, just as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.
So, what should central banks do besides target inflation? First, central banks should recognise that asset bubbles are a source of concern and that they should act on the emergence of such a bubble. The argument that a bubble can never be recognised ex ante is a very weak one. One had to be blind not to see the bubble in the US housing market, or the internet bubble. This is the case for most asset bubbles in history.
It has been argued that even if central banks can detect bubbles, they are pretty much powerless to stop them. This argument is unconvincing. It is not inherently more difficult to stop asset bubbles than it is to stop inflation. Central banks have been highly successful at stopping inflation.
Second, central banks should be involved in the supervision and regulation of all institutions that create credit and liquidity. The UK approach of dissociating monetary policy from banking supervision has not worked. Central banks are the only insurers against liquidity risks. Therefore they are the ones who should control those who create credit and liquidity. Failure to do so will continue to induce agents to create excessive amounts of liquidity, endangering the financial system.
The fashionable inflation-targeting view is a minimalist view of the responsibilities of a central bank. The central bank cannot avoid taking more responsibilities beyond inflation targeting. These include the prevention of bubbles and the supervision of all institutions that are in the business of creating credit and liquidity.
Until the crisis, the consensus view was that central banks should target inflation and that is pretty much all they should do. In this view, central banks should not target (or try to influence) asset prices either, as was stressed by the former Federal Reserve chairman Alan Greenspan, because central banks cannot recognise bubbles ex ante. Or, if they can, the macroeconomic consequences of bubbles and crashes are limited as long as central banks keep inflation on track. Inflation targeting, we were told, is the new best practice for central bankers that makes it unnecessary for them to try to influence asset prices.
The credit crisis has unveiled the fallacy of this hands-off view. If the banking system were insulated from the asset markets, the view that monetary policies should not be influenced by what happens in asset markets would make sense. Asset bubbles and crashes would affect only the non-banking sector and a central bank is not in the business of insuring private portfolios.
The problem that we have seen in the recent crisis is that the banking sectors were not insulated from movements in the asset markets. Banks were heavily implicated both in the development of the bubble in the housing markets and its subsequent crash. Since the banking system was implicated, the central banks were also heavily involved owing to the fact that they provide insurance to the banks as lender of last resort. Some may wish that central banks would abstain from supplying this insurance. However, central banks are forced to provide liquidity during a crisis because they are the only institutions capable of doing so. Thus, when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that is when the balance sheet of the central bank will be affected.
There is a second reason that the hands-off approach has been shown to be wanting. During the past few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long and, as a result, have created credit and liquidity on a massive scale. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no supervision, just as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.
So, what should central banks do besides target inflation? First, central banks should recognise that asset bubbles are a source of concern and that they should act on the emergence of such a bubble. The argument that a bubble can never be recognised ex ante is a very weak one. One had to be blind not to see the bubble in the US housing market, or the internet bubble. This is the case for most asset bubbles in history.
It has been argued that even if central banks can detect bubbles, they are pretty much powerless to stop them. This argument is unconvincing. It is not inherently more difficult to stop asset bubbles than it is to stop inflation. Central banks have been highly successful at stopping inflation.
Second, central banks should be involved in the supervision and regulation of all institutions that create credit and liquidity. The UK approach of dissociating monetary policy from banking supervision has not worked. Central banks are the only insurers against liquidity risks. Therefore they are the ones who should control those who create credit and liquidity. Failure to do so will continue to induce agents to create excessive amounts of liquidity, endangering the financial system.
The fashionable inflation-targeting view is a minimalist view of the responsibilities of a central bank. The central bank cannot avoid taking more responsibilities beyond inflation targeting. These include the prevention of bubbles and the supervision of all institutions that are in the business of creating credit and liquidity.
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