Modern central banks are the lifeguards of our financial system. When our financial system is drowning and the economy is sinking beneath the waves, it is the central banks that must come to the rescue. But what happens when the people tasked with saving the system are out of effective options? Who will save the lifeguards when they’re drowning?
Only twenty years ago, the notion that the lifeguard of the financial system might run out of options and not be able to rescue the economy was unthinkable. The Federal Reserve, and the other major global central banks, could always cut interest rates. With interest rates in the mid or even high single digits, central banks could “slash” interest rates, thereby providing a massive boost to economic activity.
If this drastic action failed, then the central banks could use the “last resort option”: printing money. Everyone believed that printing money would have an immediate and positive effect on stabilizing financial markets and promoting full employment. In a way, they were right: QE has certainly promoted “stability”, or what others might call “speculation”, in financial markets.
However, the very real question that confronts us now is what happens in the next crisis? What tools do the central banks have left at their disposal to deal with the next crisis? And will these tools be effective at saving the markets and the economy? And if the central banks fail, then who will step up and save the economy?
At this point in time, confidence in the economic future of the United States is high. Very few of the investors that I met with recently in New York believe that any sort of serious economic disruption is coming in the immediate future (next 12-18 months). But what if it does? After all, the current environment of economic optimism is very similar to that which preceded both of the previous recessions.
What if 2015 turns out to be a year of deep recession, or worse, a year in which the global banking crisis returns? What strong, bold actions can the Fed take from here? What can the Bank of Japan do that it has not already done? What aggressive steps can any of the central banks take without risking their credibility, destroying the value of their respective currencies and driving up the price level?
The central banks have a problem. In their rush to be all things to all people, they have forgotten to prepare for their most important role. In order for the central banks to act as the lifeguard of the financial system, they must keep something in reserve. This they haven’t done.
We can think of this by way of simple analogy. When someone is drowning, a lifeguard must race out into the water, swim through the waves, get that person on their board and bring them back ashore. This is the glamorous part of being a lifeguard that we see on television reality shows.
However, the part we don’t see is just as important. The lifeguard must rest and recuperate between rescues. The lifeguard must sit and watch the developing rips and keep an eye out for those that are getting into trouble. Most importantly, the lifeguard must remember that she is a lifeguard. She can’t be down at the beach just “having a good time”.
Moreover, the lifeguard can’t be in the water with all the other swimmers when trouble comes. If the lifeguard is suddenly caught in a rip, then maybe the lifeguard can save herself, but how will she see all the other swimmers that are in trouble and be in a position to rescue them?
The problem for the major central banks is that they have spent too much time in the water (a sea of excess monetary liquidity) and are not ready for the next rescue. Despite the fact that their efforts are well intentioned, the central banks are in a very poor position to react when the next rip develops and starts to drag the weaker swimmers under.
A major part of the problem is the somewhat ridiculous multi-point mandates that the central banks have imposed upon themselves.
Officially, the Fed has three key objectives for monetary policy imposed upon it by Congress: maximum employment, stable prices, and moderate long-term interest rates. From this comes the “dual mandate” of the Fed: maximum employment and price stability.
This dual mandate has already been widely criticized, not just by those on the outside, but by those on the inside. One of the greatest central bankers of the 21st century, Paul Volcker, in his May 2013 speech to The Economic Club of New York titled “Central Banking at a Crossroad”, argued that the dual mandate of the Federal Reserve is “both operationally confusing and ultimately illusory”.
However, the responsibilities of the Federal Reserve extend far beyond this “confusing and illusory” dual mandate. In addition to maximum employment and price stability, the Fed is also tasked with supervising the banks and ensuring the stability of the financial system.
It is this last point that is perhaps the most important role of the Fed. The Fed’s role in ensuring the stability of the financial system is something that is largely taken for granted by the markets. But in its attempts to fulfill its other goals, most notably “maximum employment”, the Fed has embarked on a highly aggressive policy path that will significantly impair its ability to fulfil its most important role just at the time when it is needed most.
If the Fed was not tasked with maintaining “maximum employment”, then the Fed could have unwound QE by now and could have begun the process of normalising interest rates. If a crisis hit today, the Fed could cut rates and re-engage in unconventional policy measures such as quantitative easing. But this is not where we are. Nearly seven years since the last crisis, the Fed has not even begun the process of reducing the monetary base or raising interest rates.
So, what are our options if another crisis hits today?
Frankly, they’re not good.
The major central banks can’t cut interest rates: they’re already at zero. They could print more money. However, it’s far from clear whether the beneficial effects of this action would offset the potentially negative effects of this action. Clearly, it depends somewhat upon the nature of the crisis. If the crisis was related to some part of the private credit markets (student or auto loan defaults), then the Fed might be able to dampen the effects of the crisis by buying up these loans and the impact on inflationary expectations may be small.
However, if the crisis involved a loss of faith in the long-term economic outlook of the United States, then any actions by the central bank may be counterproductive. Ramping up the monetary base from unprecedented levels to even more unprecedented levels may not be the best solution for restoring confidence. Rather, it may be the straw that breaks the camel’s back: an act that triggers a loss of faith in fiat currency, which in turn ignites a wave of global inflation that wreaks further havoc in the global financial markets.
If the central banks can’t solve the next crisis, then who can?
Clearly, fiscal policy makers could always revert to the first (and only) recommendation in the Keynesian playbook: spend more money.
Again, this is a fine idea in the right circumstances. A country with relatively low levels of government debt to GDP can, and should, issue debt to support the economy in a time of crisis. But we don’t live in that world today. Government debt to GDP is now at levels that have only been seen in a time of war.
Once debt levels reach a certain point, taking on further debt to support the economy becomes counterproductive. Maybe we are not at that point yet. Maybe we are. The problem is that we should never be in the position where we are even contemplating crossing that line in the sand.
So the question remains. What happens in the next crisis? Who will save the lifeguard when the lifeguard is about to drown?