What Can Central Banks Do?

August 29, 2012

This summer, the U.S. Federal Reserve Bank (Fed) and the European Central Bank (ECB) claimed they would strive to address fundamental structural problems in the U.S. and European economies. Yet neither central bank has rolled out concrete measures to achieve these goals. While some have perceived this as a failure, it is more accurately characterized as a situation in which both central banks have largely run out of policy options, says John H. Makin, a resident scholar at the American Enterprise Institute.

This is first true of the Fed, which faces serious challenges to its credibility due to public condemnation for the current economic climate. Nevertheless, the Fed has remained largely passive in discussions of how to proceed into the near future, despite bleak projections for economic growth in 2012.

  • The Fed's passiveness is almost certainly due to the fact that the bank has little firepower left with which to induce faster growth.
  • Interest rates have been cut virtually to zero, and longer-term rates have dropped to historic lows as the economy has slowed and risk-averse investors have sought out the safety of government bonds.
  • Moreover, the use of these tools earlier during the recession yielded disappointing results, suggesting that even if their ammo had not bottomed out, the Fed's playbook would remain exhausted.

The persistent inability of the Fed to stimulate aggregate demand makes it difficult to escape the reality that the U.S. economy is stuck in a liquidity trap.

Unfortunately, the economic issues facing the ECB are equally daunting. Before its August 2 meeting, ECB president Mario Draghi had signaled to markets that the ECB was prepared to do "whatever was necessary" to preserve the euro currency system. However, its policy options are also limited.

  • The debt situations of peripheral EU members such as Greece, Italy and Spain are of such significance that drastic emergency lending and interest rate controls would be necessary to help them balance their budgets.
  • However, the maneuvers necessary to accomplish this end are politically unviable, as the ECB cannot be viewed by stronger members of the EU (such as Germany) as financing the excessive debts of these nations.
  • Thus, the ECB finds itself as a referee charged with adjudicating a solution between parties that are fundamentally at odds.

Source: John H. Makin, "What Can Central Banks Do?" American Enterprise Institute, August 16, 2012.

 

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