"There can be little doubt that financial stability issues have risen to the top of the agenda for the major central banks."
That definitely is true today, but it was written in 1999 (in a book with the prophetic title of Debt & Delusion). If financial stability was at the top of the central banks' agenda by 1999, one can reasonably wonder what they were doing about it from 1999 to 2007.
"Independent central banks," the Transatlantic Law Forum accurately opined, "reflect an uneasy compromise between democratic principles and the need for [financial] stability."
True — but consider how much more uneasy it is if the central banks do not deliver financial stability, as they manifestly have not. Then consider what if, in the wake of the instability, they form a giant triangular alliance with the Treasury and government mortgage companies (of which more below).
The tension of central banks with democracy is fundamental, because an independent central bank is a Platonic idea. Most economists think it is a good idea — but it is inherently non-democratic. Ensconced in their independent central banks, safely protected from the vagaries and alleged inflationary bias of democratic politicians, these guardians with superior economic knowledge will guide the economic well-being of the people, keeping them safe from financial crises.
This is a Platonic claim to legitimacy based on knowledge. But what if the central bankers do not have any superior knowledge? There is certainly little or no evidence that they do. Among the many losses imposed by the 21st century bubble is a loss of credibility on the part of central banks and the economists who populate them.
How quaint and ironic it already seems that even as the housing bubble was developing its fatal inflation, central bankers convinced themselves that they had discovered how to create and sustain the so-called "Great Moderation." This is reminiscent of the equally quaint long-ago collapsed 1960s belief that economists had discovered how to "fine tune" economies.
Eight years after central banks put financial stability at the top of their agenda, what did they think they were observing? Well, at what we now know was the top of the bubble, they could count zero U.S. bank failures in both 2005 and 2006. As late as the second quarter of 2007, it seemed that bank profitability and capital were high and that the world had plenty, probably a surplus, of liquidity. As British banking expert Charles Goodhart so pointedly describes it:
"Never had the profitability and capital strength (over the last couple of decades) of the banking sector seemed higher, never had the appreciation of bank risk…seemed more sanguine than in the early summer of 2007."
Knowledge is made up of information and theories. What if the theories which guide the central banks' interpretation of information aren't right? Economics always provides a supply of mutually inconsistent theories.
The bigger your faith in what central banks are supposed to achieve, the bigger a problem this is for you. If you think they are supposed to "manage the economy," or even be the "maestro" of the whole economy, then it is a very large problem indeed.
The founding of the two historically most important central banks, the Bank of England and the Federal Reserve, display much more modest goals than those which were later added to what central banks were naively believed capable of.
The key point of the founding of the Bank of England in 1694 was straightforward: to make loans to the government. This is without doubt always a key role of central banks, especially in wartime (in the 1690s, King William was busy fighting wars for which he needed the Bank of England), but this is not usually mentioned in our contemporary, more grandiose notions of what central banks are supposed to be doing.
At the founding of the Federal Reserve in 1913, the key point was neither stable prices nor employment. It was rather to create what they called "an elastic currency." This is evident from the original title of the Federal Reserve Act:
"An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency…." (N.B.: This phrase begins a groundbreaking and foundational Act which is in total only 27 pages long.)
That means to print currency and expand credit when it is needed, especially in times of credit crises and panics. So we can see that in the 21st century financial crisis, the Federal Reserve did exactly what it was set up to do, as did the European central banks: they have excelled at creating and furnishing elastic currency, clearly demonstrating the Fed's original purpose, but pushed to fascinating lengths.
So the European Central Bank has become a huge holder of bonds of financially weak governments. And rushing in where its predecessors feared to tread, the Federal Reserve has become a huge holder of mortgage-related securities—it bought about $1 trillion of them, representing roughly 10% of all U.S. residential mortgage loans. This has created a tight relationship between the American central bank and other parts of the government, resulting in a remarkable triangle.
This government financial triangle is composed of: 1.) the Federal Reserve; 2.) the government mortgage companies, Fannie Mae and Freddie Mac; and 3. the U.S. Treasury Department. It works like this:
- The Federal Reserve buys $1 trillion of the debt and mortgage securities of Fannie and Freddie.
- But Fannie and Freddie are completely broke.
- So the Treasury buys $180 billion of Fannie and Freddie stock to support their obligations to the Fed and others.
- But the Federal Reserve is lending $1.7 trillion to the Treasury, which is running at a colossal deficit.
What are we to make of this triangle? It's certainly providing elastic currency with a vengeance, intertwined with real estate risk, and adding a new element—government mortgage companies—to Treasury and Federal Reserve interdependence. It does not appear that anybody can know how this will all turn out.
Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
