The perils of doing too much

Central banks have been recruited to stave off economic disaster but they may have been forced into overplaying their hand.

The global financial crisis has propelled central banks into prominent roles in fighting off recession while politicians have been slow to act.  Being the last remaining stalwart against economic disaster, central banks had to go further and do more than would have ever been previously conceivable due to their limited range of policies.  Even though the efforts of central banks have some effect in keeping the global economy afloat, the jury is still out with regard to the distortions left behind by the actions of central banks as well as their new roles as backstops for the global economy.

Most central banks have been given independence over the past few decades due to the notion that this will aid them in their central goal of reigning in inflation.  The theory behind this is that politicians would be tempted to use the tools of monetary policy – setting interest rates and the level of money supply – to boost economic growth and their re-election chances to the long term detriment of the economy.  So independent economists at central banks were given the reigns of monetary policy and a target for inflation of typically around 2% to ensure that a safe pair of hands would be in charge.  The typical cycle of monetary policy involved interest rates rising during periods of strong economic expansion to keep lending in check while a weaker economy prompted cuts to interest rates in order to make borrowing easier. 

The global financial crisis that struck in 2008 involved what could be deemed to be a perfect storm.  Politicians had got caught up in the bubbly state of the economy and government spending got out of hand backed by tax revenues that were later found to be just a temporary fill-up.  This was not just confined to a few countries but the Bush administration in the US, the Labour government in Britain, and many countries in Europe were running large budget deficits at a time when common sense would have suggested putting money away during the good times.  So when the banks got themselves into trouble and required help from tax payers, government finances were already stretched and there was nothing left in the coffers to bail out the economy. 

A crisis of confidence hit the global economy with spending by consumers and investment by companies being cut back due to the chronic uncertainty of whether the banking sector was going to collapse.  Your Neighbourhood Economist would argue, with a good dose of hindsight, that the typical Keynesian policies of an increase in government spending would have been the best response to the global slowdown with government making up for the shortfall in demand from elsewhere.  Government spending could have made up for the shortfall in demand, but the mismanagement of government finances meant that this option was not available.

Monetary policy was always going to be a struggle (a bit of hindsight coming in useful here too) as the activities of the central banks during recessions, such as boosting lending, are generally transmitted through the financial system.  Yet, banks everywhere were fighting for their own survival instead of being concerned about the tinkering of central banks in the background.  The weak translation of monetary policy into positive effects on the actual economy has resulted in the extent of the actions of the central banks having to be ramped up to have an effect.  The most obvious example of this is the recent announcement by the Japanese central bank that it plans to double the money supply in Japan which would be beyond belief even just a few years ago (for more, see All bets are ON). 

Even though the worst seems to be over, central banks are still in a difficult situation in terms of getting out of the role of being the guarantors of the economy.  The massive scale of their involvement in the economy will make an orderly retreat fiendishly difficult due to possible economic hiccups in the future and uncertainty over how the economy will respond.  Even if this Herculean task is pulled off with minimal problems, a new precedent has been set where central banks will now ride to the rescue if the economy goes bad. 

This situation is made worse by politicians who have shown themselves to only look short-term in their focus when dealing with such problems as the Eurozone crisis in Europe or the fiscal cliff in the US.  The expanding responsibilities of central banks may find them overextending themselves to the detriment of the good work they have achieved so far such as keeping a lid on inflation.  Central banks have overachieved during the global financial crisis considering their initial remit but should not have to be relied on to save the day.  Economists are not meant to be super heroes.