Friday, November 20, 2009

We Used to Take Central Banking More Seriously

A long time ago in a galaxy far, far away Jedi Masters of money & banking would teach their disciples that, in order to achieve long-term financial stability, a monetary system needs to be based on sound principles such as:
The Fed does not want the credit risk that comes with uncollateralized lending.
Paying interest on [bank] reserves would reduce the income the Fed returns to the U.S. Treasury, shrinking the U.S. government's revenue.
The government's too-big-to-fail policy limits the extent of the market discipline depositors can impose on banks ... encouraging large banks to engage in extremely risky behavior (and putting small banks at a competitive disadvantage).
During periods when the growth rate of potential GDP is changing, central bankers face challenges that are even more daunting than usual. Failing to react to a decline in potential output growth, as policymakers at the Fed did in the 1970s, can result in an extended episode of undesirably high inflation, which can be costly to eliminate. But tightening policy in the face of an increase in potential growth can prevent growth from occurring.
These statements are in reality extracts from Cecchetti's textbook Money, Banking and Financial Markets, 2nd edition of 2008, a book written before the financial crisis. I've been teaching these lessons for many years now. Explaining to my students why it is that these sound principles, among many others, have been abandoned or are not being given enough attention since the beginning of the crisis, when in reality we should be paying heed to them now more than ever, has been a bizarre and unique experience in my career.

Have the guardians of our currency joined the dark side of the Force?

The abandonment of sensible central banking is probably more disturbing to me than to the average American economist due to my work experience with central banks in Brazil, Bolivia, and Angola during hyperinflation. In the Central Bank of Brazil I was part of the (usually minority) group that continuously fought for those textbook principles, that insisted on the notion that sticking to them was a necessary condition to fix a financial system that had become cursed by monetary mismanagement.

It's painful to watch the deterioration of the foundations of the American monetary system. It's only happening, in my opinion, because we've been allowing our representatives to ignore harsh fiscal, monetary and corporate bankruptcy realities that will have to be dealt with anyway, sooner or later. In other words, we've chosen to temporarily bailout our present at the permanent cost of our future. All that I'm left with is a new hope:

The Jedi Masters of money & banking have gone into Exile, but the tide will turn. When that happens, may the Force be with them.

No comments: