By Patrick Bolton, Stephen Cecchetti, Jean-Pierre Danthine & Xavier Vives
BARCELONA – The global financial crisis that erupted in 2008 transformed the role of central bankers and the scale and scope of their policy toolkit. Today, financial stability is once again at the core of central banks’ missions, and interest rates in a number of rich countries are likely to remain at or even below zero for some time. This means that central bankers’ actions will be more visible and politically sensitive than they were even a decade ago. And that poses a growing threat to one of the great institutional innovations of the late twentieth century: central-bank independence.
Some observers say central banks can best guard against political interference by retreating to the narrow price-stability mandate that served them so well prior to the crisis. This advice is misguided. There can be no avoiding the imperative for central banks to revive their original role as guardians of financial stability.
After all, price stability is not an end in itself. It is merely one pillar supporting the macroeconomic stability that society needs. Financial stability is a second part of this foundation, as the recent crisis amply demonstrated.
In this broader context, central bankers will inevitably find themselves in discussions with politicians, regulators, and financial supervisors about their role in society. That is as it should be: such engagement is essential to sustaining central-bank independence.
Our recent report, Sound At Last? Assessing a Decade of Financial Regulation, highlights three important ways in which the 2008 crisis changed our collective view of central banking. First, when interest rates hit the zero lower bound (ZLB), further monetary-policy actions resemble, and often simply substitute for, measures normally taken by others. Second, the scale of central-bank lending has increased dramatically. Third, today’s policymakers are rightly focusing on lowering systemic risk to reduce the frequency and severity of financial crises.
Revisiting the status of central banks is prudent, given the very real possibility that rates will be at or near the ZLB in the future. Specifically, we call for the formal establishment of a special regime, triggered by the ZLB, whereby the executive branches of government and the central bank contribute their views and jointly agree on the entire range of available policy options.
When policy rates reach zero, the various players should meet at regular intervals under transparent rules. Following each meeting, a joint public statement would provide an assessment of current economic conditions, available policy options, and the chosen course of action. In case of disagreements, democratically elected government officials would inevitably have the final say, although they would be required to explain fully the various arguments and the rationale for the decision. This special ZLB regime would help to protect the central bank’s independence by providing a political endorsement of unconventional policies.
The unprecedented scale and scope of central banks’ actions as lenders of last resort (LOLRs) since the outset of the crisis continue to attract substantial attention. It is essential that such activities remain legitimate in the eyes of the public. Central banks must therefore clarify both the purpose and the operational structure of their LOLR activities, and end the increasingly untenable doctrine of constructive ambiguity, whereby policymakers were intentionally vague about to whom and under what conditions they were willing to lend. Here, as in many other economic-policy arenas, ensuring democratic legitimacy requires transparency and commitment.
In addition, the emphasis on systemic risk and “macroprudential” policies makes it necessary to amend central banks’ mandate. Although there is no agreement on how best to organize the various components of financial and monetary policy, we favor the “one-roof” model, in which the central bank has the dual objective of price stability and financial stability. Meeting these goals requires central banks to be both a transparent LOLR and a macroprudential authority with appropriate tools.
Institutional constraints will lead to variations in this model across countries. In some (possibly many) cases, several authorities will share responsibility for financial stability, making coordination and full accountability essential. The agencies involved should acknowledge the inherent operational difficulties when multiple authorities with diverse objectives have a common responsibility, and the authorities should confront head-on the risk that fragmentation and a lack of coordination lead to inaction.
As with monetary and fiscal policy coordination at the ZLB, public statements should accompany deliberations concerning financial stability, with disagreements made a part of the public record. In short, the common standards of communication for monetary-policy decisions should also apply to the decisions of a financial-stability committee.
Protecting central-bank independence requires adaptation. In the post-crisis world, governments and citizens will continue to delegate increasingly broad policymaking powers to an unelected independent institution. Central banks must therefore become increasingly accountable in order to maintain their legitimacy. We need a public debate to forge agreement on a framework for central banks’ objectives, tools, and communication mechanisms. Failure to have such a discussion would pose a risk not only to central-bank independence, but also to financial stability and overall social welfare.
Patrick Bolton is a professor at Columbia Business School. Stephen Cecchetti is a professor at the Brandeis International Business School. Jean-Pierre Danthine, a former vice chairman of the Swiss National Bank, is Professor and Co-Director of the College of Management at the École Polytechnique Fédérale de Lausanne and Associate Member and President of the Paris School of Economics. Xavier Vives is Professor of Economics and Finance at IESE Business School.