Lambert here: “[U]Under the pressure of events, the public sector is playing an increasingly important role in protecting private actors from economic difficulties. Delicately posed! One wonders who exactly these “private participants” are….
By Francesco Papadia, Chairman of the Selection Committee of the Hellenic Financial Stability Fund (HFSF). He was, between 1998 and 2012, Director General of Market Operations at the European Central Bank. Originally published by Bruegel.
While headline inflation in the Eurozone is moving in the right direction, core inflation remains stubbornly high, close to 6%. Unemployment is historically low, but growth prospects are mixed. Financial stability is considered to be at risk, in particular due to possible tensions around Italian bond yields. In this context, the International Monetary Fund in April summarize a recurring storywriting that Europe must strike a balance between “sustaining the recovery, defeating inflation and preserving financial stability”.
In dealing with this trilemma, the focus is largely on central bank policies. The measures taken by central banks are considered critical for the economies in which they operate. The importance of the trilemma and central bank policies should not be underestimated, but both issues need to be put into context.
Central banks must of course find the right balance between competing objectives. The primary objective of price stability does not mean that they should forget about financial stability and the risk of weighing too much on economic activity. But this balancing act is the essence of central banking, and conditions could easily be more difficult than they are now.
The current situation is not one of stagflation, which would create an acute dilemma between the fight against inflation or against recession: unemployment is very low and the outlook for economic activity is uncertain but not necessarily negative. Financial stability must be preserved, but for the moment the situation is not worrying, neither in terms of the stress of the financial system, nor of the spreads between the rates of the peripheral countries and the core. The European Central Bank can devote itself to the objective of restoring price stability with the reasonable expectation that it can do so without causing financial instability or too much damage to economic activity and employment.
The assessment that central bank policies are critically important also needs to be qualified. Central bank action is only decisive for inflation. The possible fragmentation of global trade and production, poor demographics, immigration tensions, climate risks, and geopolitical developments and crises are more serious issues to address and solutions will only be feasible, if at all, only in the longer term. In any case, it is not the central banks that have the primary responsibility for dealing with these longer-term problems.
The fact that the ECB and the Fed were able to continue to focus on inflation and thus were able to raise rates further confirms the interpretation that the possible damage to economic activity and unemployment, as well as the risks to financial stability, must be taken into account, but are not. overwhelming. This attitude reinforces the market’s view that central banks really want to bring inflation back towards 2%, even if their success is far from assured.
Adding to a favorable reading, at least relative to the mainstream narrative, of the situation facing central banks, their reactivation of dollar swaps, complementing what they are doing at the national level. Swaps allow central banks in some economies to “print dollars,” in the sense that they can influence the Fed’s balance sheet, with the Fed’s consent of course. Thus, the tool is powerful and its mere existence can have beneficial effects, even if it is not used.
All this does not mean that there have not been problems in the policy response of central banks to recent crises. The main issue for central banks is part of a more general problem: under the pressure of events, the public sector is playing an increasingly important role in protecting private players from economic difficulties.
With the global financial crisis, COVID-19 and Russia’s invasion of Ukraine, this was justified from a short-term perspective. But the negative consequences in the medium and long term must be controlled. A difficult balance must be maintained between providing immediate relief while minimizing its moral hazard consequences. In the same vein, the bank resolution framework created after the Great Financial Crisis – providing for the bailout of private investors – is proving difficult to implement. It is unclear whether the answer is a better implementation of the bail-in solution or a return to the old bailout approach. The former may be preferable, but practical difficulties hinder its implementation.
In conclusion, the task of central banks is difficult, but the balance between restoring price stability while avoiding financial instability and excessive damage to economic activity and employment could be more demanding – as has been the case in the past. The real difficulty right now is the economic uncertainty. Fundamental economic relationships, such as that between unemployment and inflation, have become more confused, making decisions much more difficult to make. This, rather than dealing with the trilemma, is the more difficult challenge.