Thursday, July 23, 2009

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.

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.


  1. Good point. Independence will enable central banks to make a more balanced decision based on rational data and sound judgment. Often, the political imperatives distort rational economic goals.

  2. Yeah, especially since rational economic decision-making sometimes involves doing something really unpopular, like raising interest rates. Or for that matter, electricity tariffs.

  3. hiya folks.....ape kabor semua?

    BNM is considering to change its law to make it more independent from MOF, their internal research team have been on the lookout to review other Central Banking Act since early last year.

    There's also the flipside of being independent and reporting to the ur post they're all dunggus....We also have another potential problem of BNM being the defacto "Debt Management Office"....pakcik makcik kat parliment will try to question ape pasal issue bond kat 3% kenapa tak tunggu besok boleh dapat 2.5%

  4. Glad to see you back satD!

    One thing I think the Austrian school of economics has right is that governments and politicians have no business getting involved with monetary management; there's too much incentive to keep liquidity up no matter what - more money to buy popularity in good times...and keep off unpopularity in bad times.

    Can you imagine BNM pulling a Paul Volcker if it had to report to Parliament?

  5. Hah if BNM ever goes to Parliment...gua budget they must do a crash course in Central Banking and Monetary Operations to all the pakcik makcik in the "committee"..if not buat malu aje...

    bro just saw the CDRC announcement by BNM .....presume its preemptive but hows the Credit Situation in KL?

  6. Defaults are up (slightly), but so are approvals. Interest rate margins are also solid.

    So far so good - nothing like 97-98.

  7. In a new world order where capital flows influence the trend of trade flows, it is important not only to have an independent central bank but one which is focused on preserving the purchasing value of the doemstic currency via pre-emptive anti-inflation measures.

    A good CB has also to work closely with the MOF to ensure that the economy does not fall into a balance sheet recession.

  8. Yes, more ECB and less Federal Reserve in terms of philosophy. Having said that, the anti-inflation record of both is remarkably similar.