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The “Art of Central Banking” in yesterday and today’s crises

di - 27 Giugno 2013
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The non existence of “advances to the Treasury” testifies for one of the canons of a gold standard central bank, the independence from the Treasury, the prohibition to lend to it; the limited amount of Treasury securities in its portfolio is an indication of an underdeveloped financial market for open-market operations (purchase and sale of securities for money supply control); the intervention in bail-out operations is shown  through the item “Istituto di liquidazioni”. Istituto was the “special purpose vehicle” (in current parlance) that the Bank used during the banking crisis of early 1920s, in order to formally separate these “exceptional” bail-out interventions from its “ordinary” activities (a practice similar to the Fed’s, today, when various “vehicles” with fancy names, as “Maiden Lane”, have been created to bail-out the most diverse financial institutions and activities) .
Such were the constraints of central banks, that even the country with the largest gold reserve and surpluses in its balance of payments, the US, under the gold standard adopted a restrictive monetary stance, despite the serious deterioration in its economic performance, as we have seen. Fig 1, above, shows that a similar pattern was adopted in the same period of the Great Depression by the UK and Italy. Their central banks’ balance sheets remained basically flat, even though Britain suspended gold standard in 1931 and the US devalued the dollar in 1933-34 (Italy kept the standard, together with other countries, like France, until 1936: the so called “Gold Bloc”).
Gradually, Keynes’ works, an evolving socio-political climate, and economic distress, led eventually to the demise of the gold standard, and to the widely shared conclusion that, in Richard Sayers’ worlds, “working to rule is the antithesis of central banking”. Sayers criticized “the Ricardian view that the nation had decided…that the value of the monetary unit should be made to depend upon the word value of gold, and that the supply of money should be so closely tied to conditions on the market for gold that there should be no room for human manipulation, however well intended” (Sayers, 1957).

3. TODAY’S CRISIS: THE GREAT CONTRACTION
How has central banking evolved in today’s world? We are in a world of “fiat money”, where money is created by a central bank’s “stroke of pen”. A full discretion appears to be granted, but this would be a simplistic answer. Let us look at the three banks under consideration. Not surprisingly, their institutional framework is remarkably similar from a technical standpoint. In their legislation we find a general prohibition to finance directly government’s deficits, but of course the possibility to make transactions in government securities – buy and sell – on the secondary market (open-market operations). The main difference seems to be in the objectives of their policies. The Federal Reserve Act, Section 2A, states that the Fed shall operate “to promote efficiently the goals of maximum employment, stable prices, and moderate long-term interest rates”. In this connection, the Fed has recently (January 2013) adopted  numerical targets for both inflation and unemployment rate, as a guide of its policy.
Compare this with the ECB’s strategy, according to its official documentation. It is based on the assumption that “the central bank cannot influence economic growth by changing the money supply”…”A change in the quantity of money will be reflected in a change in the general level of prices [the ECB has also an inflation target rigidly defined] and will not induce permanent changes in real variables such as real output or employment”.
The Bank of England, in its Monetary Policy Framework, states that, in addition to price stability – again, with an inflation target, however less rigidly defined – the Bank has to support the government’s objectives, including growth and employment.
Importantly, the inflation target is in the UK determined by the government, while in the Eurosystem by the ECB itself. The US is a case apart, because it is the Fed that has defined the target, but in a flexible way and together with an unemployment threshold.
Therefore – within a common framework of “discretion” – it is not surprising how the three central banks have reacted to the crisis according to their official Strategies. A very telling story of “central banking art” is the unorthodox  behavior of the Federal Reserve. We have already given above the dynamics of the Fed balance sheet in both crises (Fig 1). Now we’ll see more in detail the balance sheet composition before and after the recent crisis (if “after” has a precise meaning, given the current circumstances…).

Table 6. Federal Reserve balance sheet (asset side) 2007 and 2012 (bln USD)

2007Q4
2012Q4
Official reserve
75,1
8%
85.8
3%
Credit market instruments:
740.6
78%
2670.1
90%
(Treas. securities 740.6)
(1666.1 56%)
(GSE-backed securities 0)
(1003.4 34%)
(Loans to banks 0)
( 0.6 )
Other (inc. disc. window)
135.6
14%
199.0
7%
Total assets +195%
951.3
100%
2954.9
100%

Source: FedReserve Flow of funds

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