Recently former Indian central bank chief spoke about how he was not the uber-confident alpha male liked by markets. He was obviously reflecting on the few such central bankers whose over the top statements continue to be given big likes by markets. The markets ironically love this central figure who with his loud statements and display of bravado like that of yesteryear (and even today) dictators.
The earlier dictators swung mood of the general public in their favor and today’s central bankers try and seing the mood of markets in their favor. Nothing else actually matters. What is actually just comical stuff is appreciated by one and all. But then as it is true with all dictators happens to central bankers as well. Seeing nothing much happening other than image management, people soon figure the folly of their beliefs and we have a crisis before things come back to normal.
This research by Prof Stefano Ugolini of University of Toulouse shows how Mario Draghi statement of “whatever it takes” was just that. He also draws lessons from Bank of England during Gold Standard phase before World War I. The Bank was expected to lead the world but faltered. This was minus all the bravado from BoE chief as we didn’t need central bankers then to show off. We had quite a few dictators doing the job:
Economists generally agree that Mario Draghi’s London speech on 26 July 2012 was crucial in stopping the self-fulfilling Eurozone crisis (Rebooting Consensus Authors 2015). While markets were awed by the ECB President’s pledge to do “whatever it takes” to preserve the euro, only a few observers paid attention to the limitations attached to this vow—“within our mandate”.
As always, the devil is in the details. In 2012, markets apparently chose not to test the limits of the ECB’s new commitment. No doubt, it would have been difficult to contend that the Eurosystem did not possess enough firepower to make its pledge credible. However, even in case the economic sustainability of a given monetary policy is unquestionable, its political sustainability is not necessarily so. Central bankers’ actions are embedded into a specific institutional context, and such a context is crucial in determining to what extent the pursuit of monetary targets is going to be effective.
- Textbooks assume that the right to issue cash allows the central bank to expand liabilities at will, thus subtracting it from the basic constraints to which all other banks are subjected. The strength of such an organisation (i.e. the sustainability of its monetary policy) is theoretically infinite.
- But real-world central banks are not merely money-issuing agencies – they are complex organisations endowed with a bundle of different (and possibly conflicting) tasks (Ugolini 2011). As a result, their strength depends on the combination of their rights and obligations. The strength of real-world central banks (i.e. the sustainability of their policies) is then decidedly finite, and its extent is a fundamental determinant of their ability to pursue their targets effectively (Stella 1997, Bindseil et al. 2004, Archer and Moser-Boehm 2013).
- The existence of a correlation between central bank strength and policy effectiveness is confirmed by a number of empirical studies (e.g. Klüh and Stella 2008, Adler et al. 2012, Perera et al. 2013). All enquiries, however, only cover recent periods, and one might wonder whether their conclusions are tied to the peculiarities of today’s international monetary system – especially in the case of peripheral countries, whose short-dated adoption of ‘sound’ monetary targets might be at the root of poor policy effectiveness.
- As a result, it is interesting to ask whether also core countries with a consolidated record of policy target stability may be vulnerable to the same kind of problem.
During Gold standard:
In a recent paper, I argue that the Bank of England (BoE) during the final era of the classical gold standard (1889-1914) provides a relevant case to test whether the correlation between central bank strength and policy effectiveness also applies to core central banks with a long-standing commitment to ‘sound’ monetary policy (Ugolini 2016).
- The BoE stood at the very centre of the global monetary system – the pound sterling was by far the leading international currency of the time, and the ‘Old Lady of Threadneedle Street’ was seen as “the conductor of the international orchestra” (Keynes 1930).
- The BoE’s staunch attachment to conservative monetary policy was universally acknowledged – in spite of the occurrence of a series of violent financial crises, the pound’s convertibility into gold had never been discontinued since 1821, and official gold reserves had never fallen below legal limits since 1866.
Despite this remarkably successful record, however, the BoE suffered from a fundamental weakness due to the mutual inconsistency of the package of rights and obligations assigned to it:
- On the one hand, the BoE was expected not only to preserve gold convertibility, but also to perform balance sheet policy aggressively in case of crisis (viz. unlimited lending of last resort through its non-stigmatised standing facilities).
- On the other hand, the Bank lacked adequate financial resources for performing balance sheet policy on a satisfactory scale without jeopardising convertibility. Political factors prevented the BoE from securing additional ways to expand its liabilities – shareholders opposed additional capital calls; Parliament opposed an increase of banknote circulation; and bankers’ lobbies opposed the introduction of reserve requirements.