Three single points of failure
2003 looks like it's going to become an interesting year for the world's major central banks. First up is the change at the helm of the Bank of Japan, where governor Hayami will be replaced in March. The process by which his successor is being chosen is appropriately arcane and Japanese. There are informal rules that the governorship alternates between appointees from the Bank of Japan internally and bureaucrats from the Ministry of Finance. It's now the MoF's turn to appoint a governor, but the final decision will have to be made by prime minister Koizumi. Hayami is often blamed for the delfation that has gripped Japan for the last ten years and he's often described as an inflation hawk. His refusal to print money to lift Japan out of deflation has meant that Japan is now in deep trouble, the critics argue. On the other hand, Hayami has argued that the problems lie elsewhere, in the rigid economic structures and the unwillingness of the politicians to push through economic reforms. The betting now is that the new governor of the Bank of Japan will be someone who's more in tune with the government's policies and will be more likely to the politicians' bidding. Whoever the new governor is, he's not going to be able wave a magic wand and restore the Japanese economy to health. The politicians aren't helping much either, as proposals have been floated recently to double the sales tax. This will hardly help Japan emerge from its slump.
The next big change will be at the European Central Bank, where Dim Wim Duisenberg will be riding off into the sunset. His term as governor is not yet up, but he premature departure is a result of an informal deal at the time of the ECB's creation. The French desperately wanted the governorship after the Germans had succeeded in moving the ECB's headquarters to Frankfurt. In the horse-trading that followed, Duisenberg emerged as the preferred candidate as he was seen to reconcile German central banking prowess with a concern for the smaller countries of the Eurozone. The French only accepted the deal because Dim Wim promised to step down halfway through his term, and that's going to happen this summer. His successor is very likely to be French, although the front-runner, Jean-Claude Trichet, has been caught up in a corruption scandal which could endanger his chances.
The entire process of selecting the ECB governor has thus been a perfect example of what's wrong with the structures of the EU. The gap between the level of institutional unification and the real level of convergence on the ground is huge. Putting your own countries' people in charge of EU institutions is seen as a goal in itself with the purpose being of imprinting whatever desired characteristics on the other countries. Despite the many affirmations of the European Ideal, the member countries still primarily look out for themselves. The French are obviously the best example of this. But this is only to be expected. It would not be so bad if the EU's structures were built to reflect this reality. Instead, the structures are built on the assumptions of currently unattainable unity of purpose.
It's hard to guess what changes there will be to the ECB's policy once Dim Wim is gone. It can hardly get worse, one would assume, yet the ECB's hands are tied to some extent. Its primary goal is to achieve price stability in the Eurozone, and that means a targeted inflation rate of 2% for the Eurozone as a whole. With the economies of the Eurozone diverging it faces the unenviable task of trying to contort the square peg of reality to fit the round hole of the European Ideal. The reins of monetary policy will likely be loosened a bit. Given the relatively sad state of the world economy, that's not likely to become a problem for the Eurozone. The stronger euro is keeping import prices down. With Germany stagnant, there is no great danger that the inflation rate of the entire Eurozone will spin out of control anytime soon.
The most intriguing possibility is the possiblity that Alan Greenspan will retire. He's now 77 years old and may feel he's done his bit for the keeping the US and world economies afloat. Having been first appointed by Ronald Reagan in 1987 just a few months before the equity market crash, he's now serving under his fourth President. His reign at the Federal Reserve has been marked by low macroeconomic volatility and deft intervention in times of crisis. His first big test was the crash of 1987, and he responded by expanding the money supply to avert any systemic risk from developing. This has been his tried and true method over the years, which was repeated during the Asian crisis, the Russian default, the failure of LTCM and the aftermath of September 11th. His critics argue he's just been postponing the inevitable final reckoning by inflating the economy, which led to the internet bubble and is now feeding a housing bubble. I don't think the US housing market has reached bubble proportions yet (in contrast to the UK housing market).
However, Alan Greenspan has become an iconic figure in international finance. Filling his shoes is not going to be easy with the kind of reputation he built up. And his job is the most important of the big three. So why would he resign this year? His age is certainly a factor, and at 77 he may just want to relax for the remaining years of his life. But there's also the political aspect. His successor will be nominated by the President, and then confirmed by the Senate. As an original Reagan appointee, he'd rather have a Republican President and a Republic Senate decide on who succeeds him. 2004 is too late, because that would come in the middle of a presidential election cycle (although it already seems to have begun with the Democratic candidates), and 2005 brings the uncertainty of who'll be in charge of the White House and Senate. Besides, in 2005 he'll be 79.
So it's going to be an exciting year in the world of central banking. But the reason is this is an important issue is also troubling. The central banks have a huge impact on the course of the world economy. They're the single point of failure that can sink an otherwise healthy economy. If they make mistakes, and they certainly do, the impacts are felt far and wide. Central banking is the last big bastion of centralized decision making in the world economy. It brings with it the inherent dangers of having a single centrally-directed policy. Get it wrong and the consequences are severe. In this age of fiat money it's hard to imagine a world without central banks. But the Federal Reserve system is less than 100 years old. This means this US economy managed to do just fine without a central bank at its helm for a long time. Of course, the economy has grown infinitely more complex since the Federal Reserve System was established.
But that would argue even more for decentralizing the decision making process of monetary policy. The greatest economic tragedy of the 20th century, the Great Depression was largely caused by wrong-headed monetary policy at the Federal Reserve. The ratcheting up of inflation during the 1970's was also a massive failure of central bank policy in an era of fiat money. It wasn't until the monetarist crackdown on inflation in the early 1980's that central banks found a semblance of competence. But it is a very fragile state of affairs. The central bank has to guess the appropriate amount of liquidity needed without the benefit of a decentralized, distributed price discovery mechanism. Even Alan Greenspan has repeatedly said that despite the successes of central banking in recent years (his critics would demur) one should not assume that we've now cracked the art of central banking. I think it's mostly a matter of time until some more serious mistakes are made in new and unforeseen circumstances.
A return to the gold standard is pretty much out of the question. That's just not going to happen, and I am not sure it's desirable in the first place (but that's another long story). The best way to lessen the dependence of the economy on the skill of the central bank is to decentralize the provision of liquidity, and the idea of using private providers of currency has seen some academic interest in recent years. This is also a very far-fetched possiblity, especially with Europe now actively moving towards more centralization rather than less. Mistakes made by private currency providers would affect their market share and thus their profitability. The best-managed currencies would have the biggest market share. One could imagine a situation in which one issuer uses gold as a store of value, giving those skeptical of fiat money the option of using "real" money again. With the advances in technology, conducting transactions in a world with many parallel competing currencies is now technically possible. In theory it should all work quite well, and indeed better than the current central banking paradigm. Competition can be introduced gradually, and indeed the first providers already exist.
Far-fetched? Yes, and I don't really see that happening either anytime soon. However, the current situation in which we are so dependent on a few central bankers' good judgment makes me very uneasy. We need a better solution for the provision of liquidity, which means some form of market-based feedback will be necessary.
Posted by qsi at January 19, 2003 07:22 PM
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