Burton G. Malkiel
This article addresses three topics. First, it describes what economists mean when they use the term “bubble,” and contrasts the behavioral finance view of asset pricing with the efficient market paradigm in an attempt to understand why bubbles might persist and why they may not be arbitraged away. Second, it reviews some major historical examples of asset-price bubbles as well as the (minority) view that they may not have been bubbles at all. It also examines the corresponding changes in real economic activity that have followed the bursting of such bubbles. Finally, it examines the most hotly debated aspect of any discussion of asset-price bubbles: what, if anything, should policy makers do about them? Should they react to sharp increases in asset prices that they deem to be unrelated to “fundamentals?” Should they take the view that they know more than the market does? Should they recognize that asset-price bubbles are a periodic flaw of capitalism and conduct their policies so as to temper any developing excesses? Or should they focus solely on their primary targets of inflation and real economic activity? The discussion pays particular attention to bubbles that are associated with sharp increases in credit and leverage.
Central banks affect the resources available to fiscal authorities through the impact of their policies on the public debt, as well as through their income, their mix of assets, their liabilities, and their own solvency. This chapter inspects the ability of the central bank to alleviate the fiscal burden by influencing different terms in the government resource constraint. It discusses five channels: (i) how inflation can (and cannot) lower the real burden of the public debt, (ii) how seigniorage is generated and subject to what constraints, (iii) whether central bank liabilities should count as public debt, (iv) how central bank assets create income risk and whether or not this threatens its solvency, and (v) how the central bank balance sheet can be used for fiscal redistributions. Overall, it concludes that the scope for the central bank to lower the fiscal burden is limited.
Mark J. Roe
This article outlines the main weaknesses in the interaction between political institutions and capitalism in both developed and developing nations, illustrates this interplay with historical capital markets examples, and shows how the interaction between capital markets and politics has been seen in the academic literature. It focuses not on the standard and important channel of how institutions affect preferences and outcomes, but on how and when immediate preferences can trump, restructure, and even displace established institutions. The article is organized as follows. First, it describes the concepts of how capital markets depend on political institutions and preferences. The second part shows how political divisions can lead to differing capital markets outcomes in the developed world, describing conflicts between haves and have-nots and fissures among the haves. The third part develops these concepts for the developing world, looking at elites' interests, nonelites' interests, political stability, and the impact of economic inequality. The fourth part examines several contemporary and historical examples in the developed world, including the power of labor in Europe, managers in modern America, populists in American history, and the forces for codetermination in mid-twentieth-century Germany. The fifth part extends and deepens the argument, showing the impact of left-to-right shifts over time and how these can be better analyzed in the academic literature. The sixth part describes overall limits to a political economy approach, while the final section concludes.
Jakob de Haan and Jan-Egbert Sturm
Many central banks in the world nowadays regard their external communication as an important tool to achieve their goals. This chapter provides an overview of the different ways in which central banks inform the public about the future direction of monetary policy and how successful they have been in recent years. Forward guidance is either part of a monetary policy strategy in which an explicit inflation target is targeted or is part of a strategy that attempts to circumvent the effective lower bound regarding the nominal interest rate. In both cases, forward guidance attempts to influence longer-term interest rates and inflation expectations through the expected future short-term interest rates.
J. Scott Davis and Mark A. Wynne
Over the past twenty-five years, central bank communications have undergone a major revolution. Central banks that previously shrouded themselves in mystery now embrace social media to get their message out to the widest audience. The volume of information about monetary policy that the Federal Open Market Committee (FOMC) now releases dwarfs what it was releasing a quarter century ago. This chapter focuses on just one channel of FOMC communications, the postmeeting statement. It documents how this has become more detailed over time. Then daily financial-market data are used to estimate a daily time series of US monetary policy shocks. These shocks on Fed statement release days have gotten larger as the statement has gotten longer and more detailed, and the chapter shows that the length and complexity of the statement have a direct effect on the size of the monetary policy shock following a Fed decision.
This chapter analyzes the evolution and effects of central bank crisis management since the mid-1980s based on a Hayek-Mises-Wicksell overinvestment framework. It is shown that given that the traditional transmission mechanism between monetary policy and consumer price inflation has collapsed, asymmetric monetary policy crisis management implies a convergence of interest rates toward zero and a gradual expansion of central bank balance sheets. From a Wicksell-Hayek-Mises perspective, asymmetric central bank crisis management has contributed to financial market bubbles, decreasing marginal efficiency of investment, increasing income inequality, and declining growth dynamics. The economic policy implication is a slow but decisive exit from ultra-expansionary monetary policies.
The financial deregulation in major Western economies in the 1970s and 1980s freed banks from many preexisting constraints, facilitating competition and greater risk-taking and eventually leading to prudential regulation and supervision as a specific, well-defined area of regulatory activity. It was codified in the Basel Accord, which allowed banks considerable discretion in how they met broadly specified regulatory requirements and was focused primarily on individual bank safety. The financial crisis of 2007–2008 highlighted numerous weaknesses in the design and application of this approach. The previous micro-orientation has been complemented by a macroprudential focus, suggesting a strengthened case for central bank involvement in prudential regulation. Microprudential regulation has been strengthened, with changes reflecting less confidence in the previous market-oriented approach and more reliance on direct controls. The wheel has turned such that prederegulation approaches and attitudes have been incorporated into the postcrisis design and approach of prudential regulation.
David G. Mayes, Pierre L. Siklos, and Jan-Egbert Sturm
This chapter covers central bank topics including governance, independence, balance-sheet and crisis management, and challenges in macroeconomic modeling. It is intended as a summary of current and potential challenges faced by central banks in monetary policy and maintenance of financial system stability. The chapter covers a variety of views about past and present behavior and performance of central banks around the world, providing a state-of-the-art perspective on likely future challenges to be faced by this critical institution. The chapter points out gaps where future research is likely to be fruitful and the questions and issues that remain unanswered. One motivation for the book is the financial crisis of 2007–2009. Nevertheless, several themes covered and analyzed predate the crisis. The aftermath of the crisis also raised new questions about the scope, influence, and response of central banks in a changing macroeconomic landscape. The chapter also touches on fintech and digital currencies.
David T. Llewellyn
The most serious global banking crisis in living memory has given rise to one of the most substantial changes in the regulatory regime of banks. While not all central banks have responsibility for regulation, because they are almost universally responsible for systemic stability, they have an interest in bank regulation. Two core objectives of regulation are discussed: lowering the probability of bank failures and minimizing the social costs of failures that do occur. The underlying culture of banking creates business standards and employee attitudes and behavior. There are limits to what regulation can achieve if the underlying cultures of regulated firms are hazardous. There are limits to what can be achieved through detailed, prescriptive, and complex rules, and when, because of what is termed the endogeneity problem, rules escalation raises issues of proportionality, a case is made for banking culture to become a supervisory issue.
Michael W. Taylor, Douglas W. Arner, and Evan C. Gibson
The traditional central bank consensus is designed around two mandates: monetary and financial stability. Following the Great Stagflation of the 1970s, central banks’ policy objective became biased toward maintaining a low and stable rate of inflation or monetary stability. This was based on the presumption that a stable price level would achieve both monetary and financial system stability. The deemphasis on financial stability remained until the global financial crisis, when the prevailing consensus was exposed for being thoroughly inadequate. A new consensus has emerged that broadens central banks’ financial stability mandate to include macroprudential supervision. This chapter analyzes the new central bank consensus, how this has resulted in institutional redesign, and the effectiveness of discharging postcrisis financial and monetary stability mandates.
David G. Mayes
This chapter explores how the handling of bank failures in the global financial crisis led to dramatic changes in provisions for crisis avoidance and crisis management at the national and international levels. These provisions have led to an increase in the role of the central bank. The intention has been to end the idea of “too big to fail” by giving the largest banks capital and liquidity buffers that make failure unlikely and also to introduce bailing in as a substitute for bailing out. This aggregation of powers in the central bank raises problems of potential conflict of interest and politicizes the role of the central bank in a way that may compromise its independence. Central banks may thus be at the apex of their power and find that functions are taken away from them in the future when the nature of the problems is exposed.
Forrest Capie and Geoffrey Wood
Governance is a topic whose discussion has been confined to private-sector organizations. To an extent, this is not surprising, for the greater part of the public sector in most countries does not take the form of a corporation. But some parts do. The Bank of England is a prominent, but certainly not the only, example. This chapter maintains that corporate governance is perhaps better not viewed as a separated subject embracing matters not just economic but also ethical, but rather as a subdivision of an analytical framework that certainly dates back to Adam Smith. This chapter shows how that framework can both embrace corporate governance and be extended to public- as well as private-sector organizations. The chapter argues that the study of the governance of central banks is certainly illuminating and may be useful for the conduct of policy.
This chapter describes the impacts of the global financial crisis on monetary policy and institutions. It argues that during the crisis, financial stability took precedence over traditional inflation targeting and discusses the emergence of unconventional policy instruments such as quantitative easing (QE), forex market interventions, negative interest rates, and forward guidance. It describes the interaction between the zero lower bound (ZLB) and QE, and proposals, such as raising the inflation target, to alleviate the ZLB constraint. The chapter discusses the consequences of the relative passivity of fiscal policies, “helicopter money,” and 100 percent reserve requirement. The crisis triggered regulatory reforms in which central banks’ objectives were expanded to encompass macroprudential regulation. The chapter evaluates recent regulatory reforms in the United States, the euro area, and the United Kingdom. It presents data on new net credit formation during the crisis and discusses implications for exit policies.
Leonardo Gambacorta and Paul Mizen
Central bank policy operates first through financial markets and then through banks as they adjust their interest rates. This chapter discusses the transmission of policy in this first step of the monetary transmission mechanism, known as interest-rate pass-through. Historically, the focus of attention has been the interest-rate channel. We show the origins of this channel via a microfounded model of interest-rate setting by deposit-taking institutions that are Cournot oligopolists facing adjustment costs. We then examine other channels such as the bank lending channel and the bank capital channel and the role of central bank communications, signaling, and forward guidance over future interest rates. Each is shown to influence the setting of current short-term interest rates. The chapter closes with some issues for the future of pass-through in the transmission process.
This article examines the relationship between electoral politics and credit default swaps (CDS) pricing. It presents research indicating that financial markets react to elections in Latin America, raising the cost of CDS, even when controlling for standard sovereign credit risk variables. Even for countries with sound public finances, financial markets can still swing rapidly when concerned by political events. Furthermore, supporting the suspicions of politicians that much of the volatility is driven by short-term investors, a distinct divergence emerges between long- and short-term instruments. While elections have a minimal, short-term, and frequently insignificant impact on the prices of ten-year CDS prices, they have a large, longer lasting, and statistically significant impact on the prices of one-year CDS. In other words, the existence of an election increases the basis point cost of a CDS and the perceived credit risk of that election. The perceived credit risk of Latin American governments is higher at an election, even after controlling for a range of economic and political variables. Finally, contagion effects in Latin America are economically and statistically significant.
Liquidity Swaps between Central Banks, the IMF, and the Evolution of the International Financial Architecture
Pauline Bourgeon and Jérôme Sgard
The 9/11 terrorist attacks in New York, then the 2008 crisis and the euro crisis have seen a major monetary innovation in the form of large-scale exchanges of liquidity swaps between core central banks. For instance, the US Federal Reserve and the European Central Bank exchanged for a few days or weeks equivalent amounts of their respective currencies, so that the ECB could lend dollars to eurozone commercial banks, and vice versa. At maturity, the swaps were either extended over time or reimbursed. This utterly simple operation thus allows central banks to act collectively as a Fed-led, network-based international lender of last resort. A significant corollary is that the action of the IMF, which used to be the main international crisis manager, now extends only to the developing countries and the (smaller) emerging countries. Conditionality, with its strongly asymmetric dimension, is limited to this latter group, while unconditional swaps are now the key liquidity channel for supporting the rich and powerful countries.
Charles Goodhart, Nikolaos Romanidis, Dimitrios P. Tsomocos, and Martin Shubik
Mainstream macromodels have assumed away financial frictions, in particular default. The minimum addition in order to introduce financial intermediaries, money, and liquidity into such models is the possibility of default. This, in turn, requires that institutions and price formation mechanisms become a modeled part of the process, or a “playable game.” Financial systems are not static, nor are they necessarily reverting to an unchanging equilibrium, but they are evolving processes, subject to institutional control mechanisms, which themselves are subject to sociopolitical development. Process-oriented models of strategic market games can be translated into consistent stochastic models incorporating default and boundary constraints.
Gerald P. Dwyer
Regulation of financial institutions to avoid the worst effects of financial crises has become a major topic of research and a focus of regulators’ efforts. Policies designed to reduce crises’ effects on real GDP and employment are called macroprudential. Moral hazard has been introduced by deposit insurance and bailouts of banks and large financial institutions. Too little is known to premise macroprudential regulation on externalities. That said, higher capital at banks and other institutions counteracts one effect of deposit insurance and would make the financial system more resilient. Living wills are likely not to be time-consistent. Regulators will not have an incentive to use them in a financial crisis. Instead, they will bail out firms to avoid adverse effects on the economy. Institutions determining regulators’ choices in a crisis need to be designed to make it equilibrium behavior for regulators to let financial firms fail.
Patrick Honohan, Domenico Lombardi, and Samantha St. Amand
Central banks have a mandate—either explicit or implicit—to guard against systemic financial crises and manage them if and when they occur. Given the need to make urgent decisions in the face of rapidly evolving circumstances, the central bank in a crisis faces challenges of economic analysis, market judgment, and political legitimacy. Lacking a simple criterion such as the rate of inflation, crisis-management decisions are inevitably contested in terms of both technical success and democratic legitimacy. Focusing on the mandates and the toolkit of central banks, this chapter illustrates how shortcomings can arise in responding to macrofinancial crises and then highlights directions for improvement. A selection of case studies identifies how political economy dynamics had an impact on historic episodes, for better or worse.
Michael Binder, Philipp Lieberknecht, Jorge Quintana, and Volker Wieland
For many years, structural macroeconomic models used at central banks for policy evaluation have exhibited New Keynesian features such as nominal rigidities and forward-looking decision-making. More recently, new contributions have added more detailed characterizations of the financial sector. This chapter employs a comparative approach to investigate the characteristics of this new generation of macro-financial models and documents increased model uncertainty. Policy transmission is highly heterogeneous across types of financial frictions and monetary policy has larger effects, on average. A simple policy rule optimized to perform well over several models with financial frictions involves a weaker response to inflation and the output gap than in earlier models. Including a response to financial variables such as credit growth does not improve performance very much, yet a response to output growth does. Models with financial frictions produce somewhat better forecasts. Overall, model-averaging yields a more robust framework for designing monetary policy.