08/04/2011: Central bankers' job rotation

After national football coaches, central bankers must have the most second-guessed job in the world. Whatever they do — get more restrictive, expansive, or stay on the sidelines — there will always be a large number of people who criticize their actions, a number that grows as the wisdom of hindsight accumulates. Even attaining guru status, like Alan Greenspan during his near two-decade tenure as Chairman of the Federal Reserve, is no protection from becoming a vilified figure in the aftermath of a financial crisis.

Hence, it is almost banal that many criticize Jean-Claude Trichet, the European Central Bank President who just started hiking interest rates, as a super-hawk spooked by imaginary inflation threats, completely insensitive to fate of the depressed economies on the European periphery. Equally normal is that Ben Bernanke, the Chairman of the Federal Reserve who is sticking to his program of quantitative easing and shows no hurry to tighten, should feel the shotgun blasts of those who call him a mega-dove, a bird who is debasing the dollar and precipitating the US on an hyperinflationary path.

But what would happen if these two gentlemen exchanged jerseys and switched jobs? Having Ben Bernanke running the ECB and Jean-Claude Trichet the Fed might not require sending the uniforms to the tailor first. My best guess is: no more than a few stitches would be needed. It is not the person who defines the function, but the function which defines the person.

While the ECB’s single goal is to keep inflation under control, the Fed has a dual mandate; it focuses both on inflation and on economic activity/employment. Therefore it is natural that the ECB, perceiving mounting inflation expectations especially in Germany, the largest and strongest of the Eurozone economies, has started to hike. By the same token the Fed, confronted with a still extremely high unemployment rate in the US, elects to focus on stimulating the economy. This said, a deeper critique can be made of both central banks.

At the top of the macroeconomic policy game plan, the foremost objective of a central bank as lender of last resort should be to guarantee financial stability. With respect to this criterion, both central banks are currently walking with their policies on a tightrope.

The ECB, by hiking interest rates, is putting pressure on many households in the European periphery, people who have indebted themselves with adjustable-rate mortgages. Many such households could default on their debt, cascading pressure onto the banks which granted those mortgages. This in turn could deluge governments, which would need to step in if banks got into trouble.

With Portugal seeking the help of the EU after Greece and Ireland, all eyes are cast toward Spain. For the time being the public debt situation there seems under control. However, this could change radically if Spanish banks came under stress. If the ECB wants to avoid the next crisis of the euro, it will need to take this into account before hiking Eurozone interest rates too far.

The Fed does not have the problem of being the central bank of a currency area which is not optimal. However, in the US, extremely loose monetary policy has led to asset bubbles and busts already twice in the past decade, the second time bringing the global financial system to the verge of breakdown. There is no reason to believe that this time will be any different.

So both the ECB and the Fed have issues with monetary policy. However, in my view, the debate shouldn’t be about the macroeconomic goals, which are given by the institutional framework, but about the ultimate consequences of those policies on the financial stability in a still fragile environment.