What about accounting principles in Central Banks and Ministries of Finance?

Charles Goodhart of LSE in his speech at Norges Bank’s Celebrating 20 years of Inflation Targeting Conference puts some interesting thoughts on independence of central banking. He says that central banks intervening along with Ministries to ease financial crisis does not undermine independence of central bank. Infact, there is no alternative.

He adds what is instead needed is to have 2 seperate committees within the central banks- one for price stability and other for financial stability.

However, the issue which has become more interesting is viability of central banks:

But something of a spanner has recently been thrown into the workings of this separability theorem in the guise of the recent adoption of quantitative easing. This latter involves enormous fluctuations in the size of the Central Bank’s own balance sheet, and puts the Central Bank in a position where it can make either huge profits or massive losses. In short the Central Bank’s balance sheet has become risky, and Central Banks do not themselves have sufficient capital to absorb such risks. At a time when the private sector is being asked to mark-to-market all such assets that are not being held to maturity, there are some interesting questions to be asked about the accounting principles being employed in Central Banks and in Ministries of Finance. After all, if one of the virtues of quantitative easing is its relatively flexible reversability, we can hardly assume that all the assets being bought by Central Banks are to be held to maturity, can we?

One can hardly deny that quantitative easing, QE, drives a horse and cart through the thesis of the separation of fiscal and monetary policies. In a sense this has already been recognised in a pragmatic way in the UK; we British tend to pride ourselves on being pragmatic in contrast to theoretical or ideological. Anyhow the Governor has agreed with the Chancellor the main modalities of QE, that is the overall amount and the strategy of how and on what classes of assets the total funds may be spent, though the initiative has, I believe, come from the Governor and the MPC, and the Chancellor has effectively indemnified the Bank against the risk of loss, and he, and the Treasury, then leave the MPC to get on with the application. The government has to be involved in setting the strategy; leaving operational tactics for an independent Central Bank. How far does that diminish the effective operational independence of the Bank of England? In my own view, hardly at all.

But can such a division of duties work so smoothly elsewhere, for example in the USA where the separation of powers leaves Congress with control over fiscal policy, or in Europe where M. Trichet has no euro-fiscal counterpart? Does QE by the Fed represent, in part, a form of fiscal operation which has, for the time being at any rate, bypassed Congress. There are some in the USA who consider that QE raises some ticklish questions about the constitutional relationships between the Fed, the Treasury and Congress. For the moment this may be swept under the crisis carpet, but can it be so for long? The same is true in the Euro-zone. Could the Governing Council just decide off their own bat to, shall we say, treble the size of the ECB’s balance sheet? What would happen if the member state governments were unhappy with this decision, as Angela Merkel would undoubtedly be?

Hmm. We all think quantitative easing and credit easing to be a function of central banks under abnormal times like these. But has it been understood that if the risks turn out to be negative all would have to be borne by the government?

Goodhart asks whether Fed has bypassed Congress in taking these risks. One of the many proposed reforms in the recently announced Finance Fix plan is:

Amend the Federal Reserve’s Emergency Lending Authority:

Section 13(3) of the Federal Reserve Act provides that in “unusual and exigent circumstances” the Federal Reserve Board, upon a vote of five or more members, may authorize a Federal Reserve Bank to lend to any individual, partnership, or corporation. The only constraints on such lending are that any such loans must be guaranteed or secured to the satisfaction of the Reserve Bank and that the Reserve Bank must obtain evidence that the borrower is unable to obtain “adequate credit accommodations” from banks.

During the recent financial crisis, the Federal Reserve Board has used this authority on several occasions to protect the financial system and the economy. It has lent to individual financial institutions to avoid their disorderly failure (e.g. AIG). It has created liquidity facilities to bolster confidence and liquidity in numerous sectors (e.g., investment banks, MMFs, commercial paper issuers). Further, it has created liquidity facilities designed to revive the securitization markets and thereby restore lending to consumers and businesses whose access to credit was dependent on those markets. The Federal Reserve Board currently has authority to make such loans without the approval of the Secretary of the Treasury. In practice, in each instance during the crisis in which it has used its Section 13(3) authority it has sought and received the approval of the Secretary. Indeed, the liquidity facilities designed to revive the securitization markets have involved use of TARP funds to secure the 13(3) loans and the facilities were jointly designed by the Federal Reserve and Treasury.

The Federal Reserve’s Section 13(3) authority should be subject to prior written approval of the Secretary of Treasury for lending under Section 13(3) to provide appropriate accountability going forward.

In other words, US Govt already is acknowledging that Fed had bypassed it because of a legal loophole. Who said only private sector looks at loopholes in law? Now I actually understand why section 13 (3) was used and is so powerful. It allows Fed to take big decisions without Govt approval. But there is a silver lining as well- The crisis could be much deeper if  this law had been amended earlier.

The important lesson I get from reading these developments is monetary policy is not just about usual economic stuff. It has some very important legal and polictial implications as well. The text-books and research literature make it all look so simple. Reality is different.

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6 Responses to “What about accounting principles in Central Banks and Ministries of Finance?”

  1. What about accounting principles in Central…. Sorry, Folks, The CRA Really Did…. | Total Info Says:

    […] But something of a spanner has recently been thrown into the workings of this separability theorem in the guise of the recent adoption of quantitative easing. This latter involves enoRead more at https://mostlyeconomics.wordpress.com/2009/06/24/what-about-accounting-principles-in-central-banks-an… […]

  2. Samer Says:

    “During the recent financial crisis”
    I believe that the federal government, unfortunately, have not been able or even close to ending this crisis, which has destroyed a lot of people…!!!

  3. Audit Software Says:

    Exactly, what about the principles?

  4. What about accounting principles in Central Banks and Ministries … « Accounting Says:

    […] Se­e­ o­ri­gi­na­l­ he­re­: What abou­t ac­c­ou­nti­ng pri­nc­i­pl­es i­n C&#1… […]

  5. What about accounting principles in Central Banks and Ministries … Says:

    […] S­e­e­ the­ o­ri­gi­na­l p­o­s­t:  W­hat­ ab­o­­ut­ acco­­unt­i­ng pri­nci­… […]

  6. Margarito Mcbrady Says:

    What is an auditor? Someone who arrives after the battle and bayonets the wounded. hehe

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