Central Bank Power And Its Limit
The euro will not dissolve, and the U.S. Treasury can borrow as much money as it wants while paying practically no interest, all because a couple of central bankers say so. That’s real power.
But companies are not hiring, consumers are not spending, governments are sinking deeper into debt, and American workers are abandoning fruitless job searches in droves, despite years of effort by those same central bankers to make things better. That’s where central bank power meets its limit.
The European Central Bank and its U.S. counterpart, the Federal Reserve, can create money and put it into circulation by lending it out. This, combined with their ability to set target levels of interest rates – in effect controlling the price of money they create – is how central banks affect our daily lives. When money is too scarce and expensive, economic activity is choked off. When money is cheap and plentiful, consumers and businesses are supposed to be able to borrow and spend freely, stimulating demand and creating jobs. But too much money circulating too rapidly breeds inflation. Central bankers try to achieve a balance.
The system is not working very well right now.
On both sides of the Atlantic, governments have developed enormous appetites for low-cost money, which only the central banks, using their ability to create funds out of thin air and lend at whatever price they choose, can satisfy.
In normal times, governments that run budget deficits simply issue bonds that pay a fair rate of interest, and investors – ranging from private citizens to foreign central banks – buy the bonds, because they believe that a well-run government presiding over a healthy economy will be able to repay the money. When confidence in government creditworthiness falters, investors demand higher interest rates, or they take their money elsewhere.
This is what happened in Greece, Ireland and Portugal before they sought bailouts from their eurozone partners. It is what is still happening in Spain, which has so far asked for limited assistance for its banking sector, and in Italy, which has thus far not asked for assistance. Italy and Spain are the third- and fourth-largest euro economies, after Germany and France. Providing major assistance to them is beyond the resources of every existing institution except the ECB.
So it was big news when ECB President Mario Draghi declared that his bank is prepared to buy unlimited quantities of Spanish, Italian and other government bonds in order to keep government borrowing costs low. Draghi promised that the central bank would “sterilize” this massive intervention by withdrawing similar amounts of cash elsewhere in the financial system in order to prevent inflation. He also said that, in order to benefit from the artificially low rates the bank will produce, countries will have to request assistance from Europe’s financial rescue fund. The fund will have the power to impose budget austerity and demand economic reforms that national parliaments have been reluctant to produce on their own.
“We say that the euro is irreversible,” Draghi said. “So unfounded fears of reversibility are just that – unfounded fears.” (1)
But, as Bloomberg reported, Draghi also offered a realistic assessment of the central bank’s power in insisting that governments will have to undertake reforms to make the effort to save the euro work. “There is no intervention by the central bank, by any central bank, that is actually effective without concurrent policy actions by the government,” he said. (2)
It is not clear that Ben Bernanke and his colleagues at the Federal Reserve agree. In the wake of a dispiriting August jobs report, the bank’s policy-making Federal Open Market Committee is expected to announce additional steps to try to stimulate hiring. My guess is that these steps will involve the Fed purchasing longer-term Treasury bonds and possibly other instruments, such as mortgage-backed securities, in what would be the third round of major financial stimulus since the financial crash four years ago. Financial analysts have expected these steps, which they have already dubbed “QE3” (for “quantitative easing”) for months, and Bernanke signaled at a recent financial conference in Jackson Hole, Wyo., that he was preparing to act on further signs of hiring weakness. The jobs report was probably all he needed to pull the trigger.
Bernanke and his allies on the Fed seem to believe that they have to take action, despite the obvious signs that already ultra-low interest rates are not having the desired effect. Unfortunately, our problem is not that interest rates are too high, so the solution does not lie in reducing interest rates further.
Granted, record-low mortgage rates are helping the housing market find a bottom and even begin to recover in some cities. But the effect has been small, because so few people can actually get mortgages. Banks have heard the “no more bailouts” message loud and clear from politicians of both parties. Almost any loan officer in America will tell you that, public statements to the contrary, most financial institutions want to lend in only the most bulletproof situations, to borrowers who are the least likely to ever default. The banks probably have good reason to fear second-guessing by regulators if they loosen their standards, and they also have a lot of unhappy experience trying to foreclose on defaulted borrowers with imperfect paperwork.
The same is true for commercial loans to small businesses. Despite very low stated interest rates, many borrowers cannot get money. Businesses that need capital to expand can’t get it. Businesses that have capital in the form of big cash reserves don’t put it to use, because they have no confidence about future demand.
So most of the cheap credit the Federal Reserve is providing goes to the Treasury, where it funds our $16 trillion in accumulated debt at the lowest possible cost. Like the ECB, the Federal Reserve can use its power of money creation to ensure that our government never defaults on its debt, but it does not have the power – short of allowing a default – to force politicians to make good policy choices.
The situation reminds me of a leaky ship, with the central banks acting as pumps that get the water out of the bilges. The pumps buy time that can be used to make needed repairs. But if you don’t fix the leaks, they just get bigger. Eventually the ship goes down. No pump in the world has the power to prevent it.