Fed has a problem buying private sector assets and ECB has a problem buying govt. assets….

Economists differ greatly on what a central bank can do and not do. Adam Posen is in the camp

In this oldish speech released recently, he reflects on recent ECB measures. He says somehow the bad ideas that central banks cannot stimulate economies keeps coming back:

Let me say very sincerely that I am grateful to Peter Praet, Benoît Cœure, and all our colleagues at the European Central Bank (ECB) for including me on the program for the first ECB Forum on Central Banking. It is a great honor. In particular, it is very nice to be seated next to my friend and role model Otmar Issing, because I think he embodies what many of the people in this room (including our ECB colleagues) are trying to do, which is to build a unified Europe through economic means without sowing division between member countries. At this time and juncture, from outside the euro area, let me say that I admire the ECB for the continued pursuit in Otmar’s spirit. So thank you.

Let me also begin my remarks exactly where Peter asked us to, which is how we get from some of the discussions we have had so far to practical policy. Peter placed the discussion in the context of the recurring debate between the liquidationist view and the balance sheet view. I would like to think that if the 1930s in Europe were not enough to settle the debate, then the 1990s in Japan would have killed the liquidationist view forever.1 Unfortunately, it has not. Sometimes, as Agustín Carstens pointed out a moment ago, it is not just that bad ideas get recycled; they simply will not die. Some of us were writing back in 1998 about Japanese economic policy turning recovery into prolonged recession and having self-fulfilling monetary policy restraint because of backward-looking output gap measures, and so on. And yet, here we are in the euro area today.

The point that is worth taking away is that we already had a very strong theoretical literature by people like Caballero and Hammour or Greenwald and Stiglitz that Japan bears out: When you get these kinds of credit booms followed by a recession, the recession does not punish, let alone cleanse, the right firms. Simply having a recession is too blunt an instrument. Simply tightening monetary conditions is still too blunt an instrument. To be very pointed about this, when we look around the euro area right now, it is very difficult for anyone to argue credibly that the incidence of the current credit crunch across borders, differentiated according to the country risk within the unified monetary zone and with differentials according to the size of firms, is in any way less than arbitrary. Of course, we can rationalize why it is occurring this way, but the facts do not support a liquidationist interpretation that the right businesses are being rationed out of credit, and the better investments are the ones being pursued right now. We can debate that in religious terms, but I would hope that those who are empirically minded would let us move on.

Monetary policy needs to discuss differentiated asset classes:

The point that we got fundamentally wrong in the early 2000s was that we did not include in our analyses the fact that asset classes and financial markets are highly differentiated, particularly in times of strain. This relates to an earlier discussion of the costs of the Lehman Brothers’ failure—the impact of a true crisis is a switch in the overall economic environment, not just the direct impact of the shock. The euro area’s macroeconomic challenge is not just that we are in a low and declining inflation state. It certainly should not be defined as just trying to calibrate monetary policy in terms of how much liquidation versus how much moral hazard we will induce. It is that we have moved from one state of blissful ignorance, moral hazard and credit boom in combination, to an already protracted state of huge risk aversion and dysfunctional financial markets. This new other state that we are in cannot be summarized by monitoring the degree of balance sheet adjustment, even though that is an important aspect. I think monetary policymakers have to take the analysis at least one step further.

Think about the way that we try to understand the Great Depression. First there was the Friedman-Schwartz argument about monetary aggregates. Then we had research by Frederic Mishkin and others who looked at household balance sheets instead of the disembodied aggregates. We found the big explanation when Ben Bernanke led the effort to deepen the analysis with the nonmonetary transmission of the shock through the destruction of information in the banking system. That remains the core cause, and in spirit it still applies today, specifically very well to southern Europe’s current downturn. Now, all of you in this room know this in principle, but nonetheless our policy discussion often disengages from that reality. Yet, if any insight should have clearly emerged from the policy experience of the last five or six years, it is the fact that there is no single representative interest rate that the central bank controls that affects all assets in the economy (at least in the current state of the world). That has been our overwhelming policy constraint—the zero lower bound is reached because of that situation; it does not cause the situation.


He then points how Fed and ECB have this basic problem of which assets to buy.

If we are going to have central banks move forward in the world—and this includes the Federal Reserve, the People’s Bank of China, and the Bank of Mexico, not just the ECB—they have to meet their mandated public goals of financial and price stability. To do so, we have to recognize that in today’s world financial markets are segmented. Borrowers and lenders are both differentiated. Central banks will only be able to meet their goals by engaging in intervention that is not neutral across assets or groups of asset holders. To the extent that this becomes fiscal policy, it is well within precedent and has operational trade-offs—it is not a religious matter.

Again, to draw attention to something that I have pointed out before but which is critical: In the United States it is unimaginable to some that the Federal Reserve would engage in buying private sector assets, as defined by Congress, because that would be considered fiscal policy. In the euro area, it is unimaginable to some that the ECB should buy public bonds outside the very specific conditional market program because that would be considered fiscal policy. So the issue of what can be considered an acceptable intervention does not have a universal truth. It is a matter of context and reasonableness, as is the case for any other instrument of policy. Therefore, the real issue is what if the central banks were to lose some money in dealing in nongovernmental assets. And the answer to that is you set in place a rule for recapitalizing your central bank ahead of time so that does not arise as a problem.

Interesting bit..

Despite central banks being broadly similar, the political economy finally dictates the specifics..

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