The Changing Roles of Central Banks

Speaker: Prof. Charles Goodhart, LSE
Chair: David Vines, Balliol College, Oxford

Today there appears to be a cacophony of opinions about the future of central banks. To separate the signal from the noise, PEFM was privileged to host Prof. Goodhart. Taking a long-term view of the past and the future, he argued that the history of central banking has alternated between periods of consensus and uncertainty. Using this framework, he placed in context the many disparate debates taking place today in the world of central banking.

Prof. Goodhart began with the late Victorian consensus (1873-1914) focused on the gold standard and the real bill doctrine (the idea that the proper assets for commercial banks are bills of exchange focused on real activity). However, both of those broke down between 1914 and 1933 as they contributed to deflation and depression. Thus, a new consensus of fiscal dominance was born that lasted from 1934 to 1970. With the rise of Keynesianism and with central banks subject to financial ministries, the understanding emerged that financial instability is a result of excessive competition that squeezed profit margins and pushed banks towards riskier activities. However, between 1971 and 1990 the growth of technology and financial markets, stagflation and disputes about the appropriate anchor for monetary targets induced a period of uncertainty.
Another consensus emerged after 1990, focusing on price stability through inflation targeting and central bank independence due on the perceived time inconsistency problems of political principals. The resulting Great Moderation was an economic success, but the global financial crisis of 2008, followed by very sub-target inflation and low growth, brought an end to this consensus. This laid to rest some of the pre-2008 myths, in particular the belief that price stability and Basel capital requirements were enough to guarantee macroeconomic and financial stability. Instead, stability generated so much confidence that it induced increasing leverage that undermined solvency.

Notably, according to Prof. Goodhart large-scale crises lead to changes that are the outcome of a compromise between the status quo and radical proposals. For example, when the US banking system collapsed between 1929 and 1933, the Chicago Plan proposed backing up all demand deposits with cash reserves or public debt. Instead, Congress passed the Glass-Steagall act, dividing commercial and investment banking. In the 1970s, stagflation led to radical proposals of monetarism, but eventually a more pragmatic version was accepted. Today, the collapse of the banking system generated proposals for narrow banking, but the result was a compromise around ring-fencing.

This brings Prof. Goodhart to some of the contemporary debates around central banking. First, the constraint of the zero lower bound and limited success in restoring growth had led to suggestions inflation targets need to be raised, perhaps to 4%. Yet, this would not only ‘move the goalposts’ but will lead people to incorporate inflation into their expectations. Second, the BIS makes an argument for using monetary policy to lean against asset price bubbles. However, the increase in interest rates needed to deal for example with a housing price bubble is so high that it will destroy the real economy. This explains why central banks have focused on using macroprudential tools instead. Third, demands on banks to increase equity ratios, while desirable, have led banks to reduce assets. Under political pressure banks have deleveraged abroad, breaking the European single money market into pieces.

All this has combined to bring significant changes to central banks. Today they have a broader focus that includes financial stability, many instruments (including unconventional monetary policies, macroprudential tools and resolution tools), and find their independence at risk. However, they are criticized on four accounts. First, expansionary policies aimed to encourage borrowers to issue debt, but have resulted in large increases in debt ratios of both public and private actors. This has generated a debt trap as central banks hesitate to raise interest rates out of fear of causing a new recession, but keeping low interest rates increases debt ratios. Second, such expansionary policies have inflated asset prices, which are held by the wealthy, leading to significant and protracted distributional effects. Third, central bank interventions are also seen as affecting the shape of the yield curve, and as thus benefitting Spain and Italy at the potential expense of Germany. Finally, given the large quantity of public debt they hold, when QE unwinds, central banks will need to pay out large sums to commercial counterparts, leading to a collapse of seignorage.

In closing, Prof. Goodhart outlined some future trends that will affect central bank behavior. Demography is likely to worsen sharply, and given large increases in migration are unlikely to be politically sustainable, dependency ratios will rise. As a consequence, tax rates on a declining number of workers are likely to rise to pay for the associated health and pension obligations. This will lead to rising inflationary pressures, particularly as China also begins to age. To protect price stability, interest rates will need to rise back up if productivity per worker does not increase equally sharply. Yet, central banks will find themselves hobbled by their balance sheets, by the scale of debt ratios and by populist pressures for growth. As a result, central banks should expect a much more difficult future that likely includes more inflation and less independence.

Ivaylo Iaydjiev (St Antony's College, Oxford)