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Central Bank Governance and Oversight Reform
By John H. Cochrane, John B. Taylor
Hoover Institution PressCopyright © 2016 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
How Can Central Banks Deliver Credible Commitment and Be "Emergency Institutions"?
Central banks perform two apparently quite different functions. On the one hand, they are expected to operate monetary policy in a systematic manner in order to smooth fluctuations in economic activity without jeopardizing the economy's nominal anchor. On the other hand, in their role as the lender of last resort, they are expected to operate with the flexibility of the economy's equivalent of the US cavalry.
Both those propositions invite dissent and are unquestionably contested. On monetary policy, there are those, perhaps not here in Stanford, who will want to shout that monetary policy cannot be tied to rules but must be free to meet circumstances that are hard to fathom in advance. On lender-of-last-resort (LOLR) policy, meanwhile, there are those who stress with no less vehemence that a more rule-like regime is needed in order to keep central banks from straying too far into fiscal territory: liquidity support should be distinct from a solvency bailout.
Nevertheless, I suggest that the dominant views are as I initially expressed them, and not without reason.
Society gives the monetary reins to unelected technocrats in order to mitigate problems of credible commitment. A necessary precondition for delivering on that promise is that policy be systematic. Big picture, this is an institution designed for normal circumstances. Having, separately, allowed fractional-reserve banking, society also wants the monetary authority to provide liquidity re-insurance to banks in order to protect it from the social costs consequent upon the private banking system's liquidity-insurance services being abruptly withdrawn. That, by contrast with regular monetary policy, is an institution for economic and financial emergencies.
If a central bank succeeds in building a reputation for operating a systematic monetary policy, is that reputation jeopardized when it reveals its normally hidden innovative side during a crisis? Conversely, might a reputation for rule-like behavior in normal times sap confidence in its ability to ride to the rescue in a crisis? In other words, do central banks need to sustain a rich, multipurpose reputation that faces in two directions?
That is the subject of these remarks. Note that my title is not "Can central banks deliver credible commitment and be 'emergency institutions'?" It is "How can central banks [do so]?" In other words, I am positing that there is no choice other than to house these two functions, two missions, in a single institution and, further, one that is highly insulated from day-to-day politics: an independent central bank.
It is striking, therefore, that debates about the design of monetary-policy regimes and, when they have occurred at all, debates about the LOLR's role in crisis management have largely existed in parallel universes. The silos might be comfortable, but they hardly help society design and oversee the central banks into which they have placed so much trust.
Signs of this are apparent in current debates about the Federal Reserve and its advanced-economy peers. The "Audit the Fed" and "Taylor Rule" bills in Congress are framed as being about monetary policy, which of course they are. Quite separately, the Dodd-Frank Act materially changed the scope and autonomy of the Fed as a lender of last resort, and fresh proposals have recently been launched in the Senate. My point here is not on the merits or demerits of those or any other substantive provisions, nor is it that all reforms should come via a single piece of jumbo legislation. Rather, the point is that we might do better to think about central bank functions in the round, in terms of one joined-up regime for preserving monetary stability broadly defined.
If that is right, we need to step back a bit to think more carefully about what we are dealing with here. As I attempt to do so, we shall bump into some fairly deep questions about the distribution of power in democracies. We will also see the monetary policy/LOLR dichotomy dissolve, but only for it to be replaced by a deeper challenge for the design of robust, legitimate central banks: how to proceed when the fiscal constitution is not pinned down.
What do central banks do? Delegated managers of the consolidated state balance sheet
One way into this is to think of the central bank as conducting financial operations that change the liability structure and, potentially, the asset structure of the consolidated balance sheet of the state. If they buy (or lend against) only government paper, the consolidated balance sheet's liability structure is altered. If they purchase or lend against private-sector paper, the state's balance sheet is enlarged, its asset portfolio changed, and its risk exposures affected. Net losses flow to the central treasury in the form of reduced seigniorage income, entailing either higher taxes or lower spending in the longer run (and conversely for net profits).
The state's risks, taken in the round, might not necessarily increase with such operations. If purchasing private-sector assets helped to revive spending in the economy that might, in principle, reduce the probability of the state paying out larger aggregate welfare benefits and receiving lower taxes later. But the form of the risk would change and, because the driver was central bank operations, the decision-taker on the state's exposures would switch from elected fiscal policymakers to unelected central bankers.
Seen in that light, the question is what degrees of freedom central banks should be granted, and to what ends, to change the state's balance sheet.
A minimalist conception, advanced by Marvin Goodfriend, among others, would restrict the proper scope of central bank interventions to open market operations that exchange monetary liabilities for short-term Treasury bills (in order to steer the overnight money-market rate of interest). On this model, the LOLR function is conceived of as being to accommodate shocks to the aggregate demand for base money and plays no role in offsetting temporary problems in the distribution of reserves among banks.
Arguably, this would get close to abolishing the LOLR function as traditionally executed. As a governor of the Bank of England said of the 1820s crisis, when the function was first emerging, "we lent in modes that we had never adopted before ... by every possible means consistent with the safety of the Bank."
Perhaps more profoundly, at the zero lower bound the only instrument available to the central bank would be to talk down expectations of the future path of the policy rate ("forward guidance"). All other interventions to stimulate aggregate demand — for example, quantitative and credit easing — would fall to the "fiscal arm" of government. And that, not a judgment on the merits of the minimal conception, is my point: what is not within the realm of the central bank falls to elected policymakers, with the attendant problems of credible commitment and time-inconsistency.
At the other, maximalist end of the spectrum, the central bank would be given free rein to manage the consolidated balance sheet, even including writing state-contingent options with different groups of households and firms. That would get very close to being the fiscal authority, and cannot be squared with any mainstream ideas of central banking competencies in democracies.
So in one direction, the state's overall capabilities shrivel; and in the other, its functions are effectively seized by unelected central bankers.
We could try to resolve the question of boundaries through positive economics on the effectiveness of different instruments in responding to the shocks hitting a monetary economy. While that work is obviously essential, it is not the approach I take here, partly because answers are likely to be hedged about with uncertainty; but, more fundamentally, because that approach does not speak to which arm of the state should be delegated which tools. The problem appears to be that we don't know where the welfare advantages of credible commitment are outweighed by the disadvantages of the loss of majoritarian control, because that looks like a trade-off between incommensurable values.
I am going to approach the question of boundaries, therefore, by asking first what purposes a central bank serves and then what constraints are appropriate for independent agencies to have legitimacy in a democratic republic. As we proceed, the tension between commitment technologies and majoritarian legitimacy will resolve itself.
A money-credit constitution
Central banks are the fulcrum of the monetary system: the pivot, as Francis Baring put it two centuries ago when coining the term "dernier resort."
It is usual to think of their independence as being warranted by a problem of credible commitment. That is a necessary condition, but it is not a sufficient condition once wider issues than economic welfare are weighed, such as the loss of democratic control. The imperative of central bank independence is, I think, political, almost constitutional.
In order to maintain the separation of powers between the executive government and the legislature, the fiscal tool of the inflation tax cannot lie in the hands of an executive striving to stay in power. Otherwise it could avoid, or at least delay, requesting "supply" from the assembly by inflating away the burden of any outstanding state debt or, more generally, by printing money to finance its needs and increase seigniorage income. That society chooses to delegate to an agency rather than rely on tying itself to a commodity standard to meet this problem is, I believe, down to modern full-franchise democracies being unprepared to live with the volatility in jobs and output associated with the nineteenth-century gold standard.
On this view, in a fiat money system the independence of the monetary authority is a corollary of the higher-order, constitutional separation of powers. For the delegation actually to deliver credible commitment, the reputation of the central bank and its policymakers must be strapped to their success in maintaining price stability. That is one reason transparency is so important.
The setup unavoidably becomes richer, however, once we acknowledge that society has chosen, rightly or wrongly, to allow fractional-reserve banking, which brings the social benefits of liquidity insurance for households and firms bundled together with the risks from its inherent fragility and the social costs of systemic crises.
The LOLR function is called into existence to reduce both the probability and the impact of those risks crystallizing. That takes the central bank to the scene of almost any meaningful socially costly financial disaster, whether sourced in economic problems or operational malfunction, as when the Fed lent hugely to the Bank of New York to keep the payments system going in the mid-1980s. In consequence, central banks have a keen interest in the adequacy of regulatory and supervisory regimes, in order to contain the moral hazard costs entailed.
In other words, once private banking (in the economic sense) is permitted, central banks cannot avoid being de facto multiple-mission agencies intimately interested and involved in the functioning of the credit system, since most of the economy's money is the credit-money created by the banking system (broad rather than narrow money). As Paul Volcker said with tragic foresight in his 1989 valedictory Per Jacobsson lecture, "I insist that neither monetary policy nor the financial system will be well-served if a central bank loses interest in, or influence over, the financial system."
Since unelected power needs framing carefully in democracies, the de facto position I have outlined should be recognized de jure.
If that sounds ridiculously banal, remember that the Federal Reserve does not have an overall statutory objective to help preserve the stability of the financial system but only objectives tied to specific powers: for example, safety and soundness for the generality of banks and, since Dodd-Frank, stability for its powers over "systemically important financial institutions." In the United Kingdom, only since 2012 has the Bank of England had macroprudential and microregulatory functions framed in terms of an objective of stability.
The world I am describing requires not a "monetary constitution" of the kind advocated by James Buchanan but a money-credit constitution. By that I mean rules of the game for both banking and central banking designed to ensure broad monetary stability, understood as having two components: stability in the value of central bank money in terms of goods and services, and also stability of private-banking-system deposit money in terms of central bank money.
The idea would have been familiar to our nineteenth-century predecessors. Their money-credit constitution comprised the gold standard plus a reserves requirement for private banks (an indirect claim on the central bank's gold pool) plus the lender-of-last-resort function celebrated by Walter Bagehot. That package was deficient insofar as it did not cater explicitly for solvency — as opposed to liquidity — crises. Worse, as our economies moved to embrace fiat money during the twentieth century, policymakers fatally relaxed the connection between the nominal anchor and the binding constraint on bank balance sheets — to the point where, on the eve of the 2007 crisis, they were over-leveraged and horribly illiquid.
At a schematic level, a money-credit constitution for today might have five components: inflation targeting plus a reserves requirement that increased with a bank's leverage plus a liquidity-reinsurance regime plus a resolution regime for bankrupt banks plus constraints on how the central bank is free to pursue its mandate.
Compared with the nineteenth century, all five components of that schema would need fleshing out. Much of the past quarter century has been spent on the first — the nominal anchor — and even that work turns out to be incomplete. But other parts of the money-credit constitution are even more difficult to design. We have learned that regulatory arbitrage is endemic in finance, so that any regime for the economic activity of banking would need to cover "shadow banks" — not only de jure banks — and it would need to be richer and more adaptable than could be delivered solely by a leverage-driven reserves requirement. Nevertheless, that simple conception serves as a useful benchmark and a reminder that constraints on, and supervision of, banking soundness are integral to an economy's money-credit constitution.
To pursue the regulation of banking would be too big a detour from the parts of the money-credit constitution that most concern me here: what central banks must do (their mandate), what they may do, and the constraints on them.
Some of the necessary constraints on central banks are implicit in my earlier derivation of their independence from constitutional principles. Most obviously, rather than simply making the definitional statement that any independent agency must be in control of its instruments, it is specifically important that an independent central bank should be barred from lending to government on the government's direction. (Only the legislature should be able to sanction such lending, and through regular legislation, as with any tax.)
That provides one vitally important element of an answer to our question of where the line should be drawn around the capacity of the central bank to reshape the state's consolidated balance sheet. The outline of other components of the answer emerges from considering the legitimacy of central banks as very powerful, unelected institutions.
Excerpted from Central Bank Governance and Oversight Reform by John H. Cochrane, John B. Taylor. Copyright © 2016 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
Preface John H. Cochrane John B. Taylor vii
1 How Can Central Banks Deliver Credible Commitment and Be "Emergency Institutions"? Paul Tucker 1
Comments John H. Cochrane
General Discussion Michael D. Bordo John H. Cochrane Peter Fisher Robert Hodrick Charles I. Plosser George P. Shultz John B. Taylor Paul Tucker Kevin M. Warsh
2 Policy Rule Legislation in Practice David H. Papell Alex Nikolsko-Rzhevskyy Ruxandra Prodan 55
Comments Michael Dotsey
General Discussion John H. Cochrane Michael Dotsey Peter Fisher Andrew Levin David H. Papell Charle I. Plosser John B. Taylor Paul Tucker Carl E. Walsh John C. Williams
3 Goals versus Rules as Central Bank Performance Measures Carl E. Walsh 109
Comments Andrew Levin
General Discussion John H. Cochrane Michael Dotsey David H. Papell John B. Taylor Carl E. Walsh John C. Williams
4 Institutional Design: Deliberations, Decisions, and Committee Dynamics Kevin M. Warsh 173
Comments Peter Fisher
General Discussion Binyamin Appelbaum Michael D. Bordo John H. Cochrane Michael Dotsey Peter Fisher Andrew Levin Charles I. Plosser George P. Shultz Paul Tucker Kevin M. Warsh John C. Williams
5 Some Historical Reflections on the Governance of the Federal Reserve Michael D. Bordo 221
Comments Mary H. Karr
General Discussion Michael D. Bordo John H. Cochrane Peter Fisher Mary H. Karr Andrew Levin Charles I. Plosser George P. Shultz John B. Taylor Paul Tucker Kevin M. Warsh John C. Williams
6 Panel on Independence, Accountability, and Transparency in Central Bank Governance Charles I. Plosser George P. Shultz John C. Williams 255
General Discussion Michael J. Boskin John H. Cochrane Peter Fisher Robert Hodrick Andrew Levin David Papell Charles I. Plosser John B. Taylor Paul Tucker Kevin M. Warsh John C. Williams
Conference Agenda 297
About the Contributors 299
About the Hoover Institution's Working Group on Economic Policy 305