While the idea of the interventionist suppression of short-term ‘normal’ volatility leading to extreme volatility scenarios is not new, hearing it explained so transparently by a current (and practicing) central banker is still somewhat shocking. As Buba’s Jens Weidmann recent speech at Harvard attests, “The idea of monetary policy safeguarding stability on multiple fronts is alluring. But by giving in to that allure, we would likely end up in a world even less stable than before.”
Excerpts from Jens Weidmann – Europe’s Monetary Union
Harvard, 11/25/13 (Full speech here)
In the eyes of many politicians, economists, at least if they are central bankers, cannot have enough arms now – arms with which they are to pull all the levers to simultaneously deliver price stability, lower unemployment, supervise banks, deal with sovereign credit troubles, shape the yield curve, resolve balance sheet problems, and manage exchange rates.
It is probably safe to say that this change in attitude is not just due to a sudden surge in the popularity of economists and central bankers. Rather, it reflects the widespread view that central banking has come to be the only game in town. And quite a few economists seem to agree with this notion.
To some, the notion that the primary goal of central banks is to keep prices stable has become old-fashioned. Against the backdrop of the financial crisis, they argue that financial stability has become just as important, if not more so, than price stability.
By tearing down the walls between monetary, fiscal and financial policy, the freedom of central banks to achieve different ends will diminish rather than flourish. Put in economic terms: Monetary policy runs the risk of becoming subject to financial and fiscal dominance.
Let me explain these mechanisms a bit more in detail, starting with financial dominance.
The financial crisis has provided a vivid example of how financial instability can force the hand of monetary policy. When the burst of an asset bubble threatens a collapse of the financial system, the meltdown will in all likelihood have severe consequences for the real economy, with corresponding downside risks to price stability.
In that case, monetary policy is forced to mop up the damage after a bubble has burst. And, confronted with a financial system that is still in a fragile state, monetary policy might be reluctant to embrace policies that could aggravate financial instability.
Public debt and inflation are related on account of monetary policy’s power to accommodate high levels of public debt. Thus, the higher public debt becomes, the greater the pressure that might be applied to monetary policy to respond accordingly.
Suddenly it might be fiscal policy that calls the shots – monetary policy no longer follows the objective of price stability but rather the concerns of fiscal policy. A state of fiscal dominance has been reached.
Technically, fiscal dominance refers to a regime where monetary policy ensures the solvency of the government. Practically, this could take the form of central banks buying government debt or keeping interest rates low for a longer period of time than it would be necessary to ensure price stability. Then, traditional roles are reversed: monetary policy stabilises real government debt while inflation is determined by the needs of fiscal policy.
A lender-of-last-resort role would violate this principle of self-responsibility – in that same way as Eurobonds in this setting are at odds with it. Therefore, it would aggravate, rather than alleviate, the problems besetting the euro area.
The idea of monetary policy safeguarding stability on multiple fronts is alluring. But by giving in to that allure, we would likely end up in a world even less stable than before. This holds true especially for the euro area, where a Eurosystem acting as a lender-of-last-resort role for governments would upend the delicate institutional balance.
To disentangle the euro area’s fiscal and financial conundrums, we should practice the art of separation – especially with regard to the sovereign-bank doom loop. Or let me put it this way: Rather than for monetary policy to waltz with fiscal and financial policy, we need to erect walls between banks and sovereigns.
Of course, Taleb’s somewhat seminal piece on vol suppression remains a concerning glimpse of the inevitable.