TILBURG, Netherlands — The current economic crisis highlights the need for major changes at central banks. It is time for a return to some form of moderate monetarism — but in a 21st-century mold.
The current crisis has made central bankers’ jobs far more complicated. Over the past 30 years or so, many central bankers supposed that all they needed to do was keep their sights fixed on price stability. Every instrument at their disposal was to be used for that goal. From now on, however, central bankers will have to aim for financial stability as well.
Implicitly, central banks will also have to try to ensure that a new recession does not occur. But the current institutional setup of today’s central banks is highly inadequate for meeting these challenges. Central banks will have to get additional tools for their new tasks. And that is where things get very complicated.
The reason is simple: According to Tinbergen’s Rule — named for Nobel laureate Dutch economist Jan Tinbergen — central banks must have one independent instrument for each task they perform, such as ensuring price stability. If they have more than one task, they will need an equal number of instruments.
The complicating factor here is that these policy instruments must be independent of each other. Consider interest rates. That instrument cannot be used for both price stability and financial stability, as the outlook for price stability could warrant higher interest rates, while ensuring financial stability might require a lower interest rate.
For example, if a central bank, in times of economic distress in the banking sector, floods the banks with additional, cheap liquidity, that will increase the supply of money on financial markets and push market interest rates down. If the inflation rate is set to increase in the near future, that will collide with the task of price stability. Central banks are constantly confronted with tradeoffs between price and financial stability.
Finding new instruments that are effective, easy to use and independent of the interest-rate instrument seems to be an impossible task. And yet there is a solution. Central banks should give the growth of (broad) money supply more prominence in their monetary policy strategies.
The European Central Bank, with its often criticized monetary pillar, may have a head start. Many economists agree that the current financial and economic crisis is attributable, at least partly, to the fact that important central banks, such as the Bank of England and the U.S. Federal Reserve, kept their key interest rates too low for too long. That led to a long period of double-digit growth in money supply.
The ECB was more cautious. To be sure, the fall of the risk premium on financial markets, the development of all kinds of exotic derivatives, and these derivatives’ subsequent misuse sowed the seeds for this crisis, but those factors could not have caused the crisis without the plentiful rainfall that allowed those seeds to grow. That precipitation was the abundant growth in money supply in the United States, the United Kingdom, and the larger emerging economies.
Of course, targeting the money supply is not without its drawbacks. Financial innovation has weakened the link between money growth and inflation, for example. But the relationship has not disappeared entirely. As the current crisis clearly shows, sooner or later too much money will lead to excesses, if not in consumer price inflation, then in asset price inflation and the disappearance of the risk premium.
Wherever too much money growth occurs, the consequences for price stability, financial stability and even economic stability will be severe, as the current crisis shows.
Preventing such outcomes requires central bankers to be able to juggle more than one ball — and giving (broad) money supply far greater weight in monetary-policy strategies than is now the case would help keep central banks from dropping them all.
Sylvester Eijffinger is professor of financial economics at Tilburg University and a member of the Monetary Experts Panel of the European Parliament. Edin Mujagic is a monetary economist at Tilburg University and economics editor at the Dutch weekly magazine FEM Business & Finance. © 2009 Project Syndicate (www.project-syndicate.org)
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