One Good Reason Why Central Banks Should Be Independent: Politicians Don't Understand Monetary Policy

This article on Bloomberg caught my eye yesterday. The relevant passage is:

"Representative Alan Grayson, a Florida Democrat, questioned what authority the Fed used to lend hundreds of billions of dollars through currency swaps to central banks around the world.

'One of the arrangements is $9 billion for New Zealand -- that works out to $3,000 for every single person who lives in New Zealand,' Grayson said. 'Wouldn’t it have been better to extend that kind of credit to Americans rather than New Zealanders?'"

Here's Bernanke's reply:

"Bernanke countered that 'we are lending to all U.S. financial institutions in exactly the same way' and that 'we have a longstanding legal authority to do swaps with other central banks.'"

...which is a nice way of saying Rep. Grayson doesn't have a clue of what he was talking about.

What happens when central banks do a swap? Using the NZ example, the Fed loaned the RBNZ US$9b. Can the RBNZ use this to increase credit in the NZ economy? How so when the USD is not legal tender in New Zealand? Getting that USD into the NZ banking system in NZD form implies a contraction of the domestic portion of the money supply, not an expansion, unless it's fully sterilised. So why do the swap?

Because NZ, just like everybody else in the aftermath of the Lehman collapse, faced a flight to safety of foreign investment and domestic capital which caused a spike in USD demand. There was a currency mismatch between the foreign currency assets and liabilities of the banking system. If the central bank's international USD reserves were also insufficient, then NZ banks would have failed to meet their international obligations. This would have an impact not only on NZ's credit standing, but also on the counterparties on the other side of the transactions.

Not so bad if you're domestic: all that happens is that your capital can't leave. But what about foreign creditors? And all those hedge funds and banks who played the forex carry trade (remember NZ's high deposit rates? Was it only last year?)? The swap lines the Fed engineered allowed US firms to call back their foreign-based capital and bolster both cash and capital reserves right when they needed it most.

Failure to meet USD obligations would have greatly exacerbated the liquidity and credit crunch of late-2008. The NZ swap line of US$9b was relatively small - the ECB got US$200b.

The net actual effect is that the Fed and participating central banks transformed private sector USD liabilities into official sector USD liabilities, with the corresponding increase in credit worthiness. It also meant that any USD the Fed actually lent out through the swap lines came right back to the US.

Having Congress overlooking the Fed's shoulders gives me the willies. If Rep. Grayson is any example of the average level of economic competence there, politicians and monetary policy shouldn't mix - and that goes double for BNM and Parliament.

Update
Mark Thoma at Economist's View has a video and a nice discussion going on about the same subject of Bernanke's testimony. Plus a correction: RBNZ's swap line was $15b (of which none was actually utilised!), and the ECB got $300b not $200b.