It is the 21st century indeed. Phillips curves became flat, inflation is a global phenomenon, financial market is global and ensuring its stability is a global mandate. No single central bank is able to fulfill this mandate therefore we should not be surprised to see more and more often that these global issues dealt with in a co-ordinated global manner. Global imbalances were discussed by Eurozone. US, Japan, China and Saudi Arabia. Global liquidity/confidence crisis was met with a co-ordinated response as well, by central banks in US, EMU, UK, Switzerland and Canada, see FT article. The Federal Reserve press release on creation of temporary Term Auction FAcility (TAF) is here. Swedish Riksbank positive reaction to TAF and swap arrangements with other central banks is here and Bank of Japan statement is here . A qoute from FT article is below:
“The Fed said it was creating a temporary credit auction facility, as revealed in Wednesday’s Financial Times, and entering into foreign exchange swap agreements with the ECB and the Swiss to tackle the shortage of dollar funds in Europe. […]
The issue of co-ordination between central banks has become particularly important in recent months, since the most severe funding problems have often occurred in the dollar markets – but many of the victims of these pressures have been European institutions, which have not always had access to the dollar market on the same terms as US banks.[…]
As part of the measures, the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window.
The [Fed] official said: “This is not about particular financial institutions with particular problems. This is about market functioning.”
The [Fed] official added that “this facility will accept a wide range of collateral – the same range as is available at the discount window,” saying “there is no reason to believe there would be stigma associated with the use of this facility”
Markets reaction to this news was very positive, stock exchanges rebounded strongly.
When such unusual measures are taken, it requires deep thinking about the range of possible outcomes. The next weeks, months and quarters will give us hard evidence whether the confidence crisis of 2007 will not translate into a recession or major growth slowdown, especially in those countries which witnessed huge excesses in housing markets in recent years. Economists will continue debate whether “regulatory preemptive action” is better or whether mopping after the bubble is better.
My own view on this topic is the following. The ultimate goal of a central bank is to maximize nation welfare in the long run. It is agreed that the best way to achieve this goal is to delegate price stability mandate to independent central bank. We know that price stability is closely linked to financial stability. We also know about time inconsistency issues and that is why price stability was delegated to institutions independent from politicians. When it comes to maintaining financial stability in the long run, there is a need for more research about time inconsistency in my view. And outcomes of decisions should be judged in the long term. Wile mechanics of each crisis is different (1st, 2nd, 3rd generation crises have already been well explained) the primary reason of each crisis is the same – bad lending practices (be it to governments or to households). It is also obvious that next crises, when they emerge, are not totally independent from the way the previous crises were dealt with. I think that in the future we should do more regulatory preemption and rely less on post-crisis mopping up. That way central banks will better achieve its goal of maximizing welfare in the long run.