Seeing Like a Central Bank

Tyler Cowen writes,

Eurogeddon is here, as a variety of countries have situations worse, in relative terms, than the Great Depression of the 1930s. It seems the bailout funds, especially the ESM, have given up on the notion of detaching sovereign and bank liabilities from each other. The so-called banking union is at best a common supervisor rather than real risk-sharing for deposit liabilities. The fact that we don’t have daily bond market crises, filling up my Twitter feed, is certainly welcome but constitutes a remarkable lowering of the bar for what success means.

What Tyler calls a “low bar” is in fact that same bar that central banks have always used. If the banks are not in crisis and the bond market is orderly, then everything is fine.

Recently, there were news stories in which AIG was considering joining a lawsuit against the government over loss of its value from the actions of the government during the financial crisis. Lawmakers talked AIG out of joining, but AIG may have had a case. The “AIG bailout” was arguably mis-named. In retrospect, it looks much more like a bailout of Goldman Sachs (and many other large banks, domestic and foreign), financed by the sale of some profitable AIG subsidiaries. From the vantage point of the central bank, that was good policy.

I would encourage economists to consider revising their model of central banks. The model in which the central bank is concerned primarily with inflation and/or unemployment is not necessarily the most predictive. What a central bank sees are banks and financial markets. When there are in turmoil, the central bank sees a need to act. When they are not in turmoil, the central bank is going to be in the mode of “It ain’t broke, don’t fix it.”

This model of central banking is what leads me to expect that, when push comes to shove, the Fed will tolerate much more inflation than most people think. Consider a scenario in which investors start to lose confidence in the ability of the U.S. government to get deficits under control. (This is the opposite of the crisis du jour, which is an artificial concern that Washington might stop living so far beyond its means.) Under such a scenario, bond interest rates soar. The Fed’s first priority will be to maintain an “orderly” bond market. They will do this by printing money to buy bonds. At that point, it will not matter whether inflation and nominal GDP are running above or below target. Inflation could already be high and rising, but if the bond market is in turmoil, seeing like a central bank will lead you to print more money.

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