Authored by Harold James, originally posted at Project Syndicate,
The US Federal Reserve’s recent surprise announcement that it would maintain the current pace of its monetary stimulus reflects the ongoing debate about the desirability of cooperation among central banks. While the Fed’s decision to continue its massive purchases of long-term assets (so-called quantitative easing) was motivated largely by domestic economic uncertainty, fears that an exit would trigger interest-rate spikes in emerging economies – especially Brazil, India, Indonesia, South Africa, and Turkey – added significant pressure. But should central banks’ decision-making account for monetary policy’s spillover effects?
Discussion of central-bank cooperation has often centered on a single historical case, in which cooperation initially seemed promising, but turned out to be catastrophic. Like most of our modern cautionary tales, it comes from the Great Depression.
In the latter half of the 1920’s, there was almost constant transatlantic tension, as US monetary policy drove up borrowing costs and weakened GDP growth in Europe. In 1927, at a secret meeting on New York’s Long Island, Europe’s leading central banks convinced the Fed to cut its discount rate. Although the move helped to stabilize European credit conditions in the short term, it also fueled the speculative bubble that would collapse in 1929.
Cooperation in the 1920’s was both novel and fragile, based as it was on the friendship between Bank of England Governor Montagu Norman and Benjamin Strong, Governor of the Federal Reserve Bank of New York, and, to a lesser degree, their ties with the president of Germany’s Reichsbank, Hjalmar Schacht.
The oddly intimate and affectionate relationship between Strong and Norman included regular visits, telephone conversations (a novelty at the time), and an extensive and bizarre correspondence, in which they discussed personal matters as much as monetary issues. Strong once wrote, “You are a dear queer old duck, and one of my duties seems to be to lecture you now and then.”
By the late 1920’s, though, Strong was dying of tuberculosis and Norman was experiencing successive nervous breakdowns. Their legacy of cooperation would soon crumble, too, with most observers concluding after the Great Depression that central banks should be subject to strict national controls to block future efforts at collaboration.
Central-bank cooperation in the aftermath of the 2008 financial crisis has unfolded in a remarkably similar manner. Initially, increased cooperation seemed to be just what the doctor ordered, with six major advanced-country central banks lowering their policy rates dramatically on October 8, 2008 – three weeks after the collapse of US investment bank Lehman Brothers – in a coordinated effort to stabilize plunging asset markets. They subsequently pumped huge amounts of liquidity into the banking system, thereby averting a total collapse.
Now, as the Fed contemplates its next move, emerging-market central bankers are becoming increasingly concerned about the destabilizing effects of monetary tightening on their economies. At September’s G-20 summit in Saint Petersburg, between discussions of the security challenge posed by Syria, world leaders attempted to tackle the issue by creating a formula for international monetary cooperation. But their limited efforts resulted in a fundamentally meaningless appeal.
The modern view is that the Fed’s mandate requires it to act according to inflation and employment outcomes in the US, leaving it up to other countries to combat any spillover effects. This means that other countries must devise appropriate tools to limit capital inflows when US interest rates are low and to block outflows when the Fed tightens monetary policy. But emerging economies missed their chance to limit inflows, and impeding outflows at this point would require draconian measures that would contradict the principles of an integrated global economy.
Moreover, unanticipated shifts in market expectations make it extremely difficult to anticipate the need for such tools. In this sense, the recent G-20 injunction that advanced-country central banks “carefully calibrate and clearly communicate” monetary-policy changes is unhelpful. Given how difficult it is to communicate coming policy changes accurately, markets tend to be skeptical about long-term forward guidance.
This highlights a fundamental difference between central-bank cooperation in the 1920’s and today. Back then, monetary policy was viewed as an “art” practiced by a “brotherhood” of central banks. Modern central bankers, recognizing the limits of such personal ties, often attempt to formulate official rules and procedures.
But adhering to rules can be difficult when policymakers are confronted with the conflicting goals of preserving stable employment and GDP growth at home and ensuring that international capital movements are sustainable. When things go wrong (as they almost inevitably do), there is a political backlash against central bankers who failed to follow the rules – and against the cooperative strategies in which they engaged.
We are thus left with a paradox: While crises increase demand for central-bank cooperation to deliver the global public good of financial stability, they also dramatically increase the costs of cooperation, especially the fiscal costs associated with stability-enhancing interventions. As a result, in the wake of a crisis, the world often becomes disenchanted with the role of central banks – and central-bank cooperation is, yet again, associated with disaster.