Central Bank Independence and the Future of the Euro

Central banks are never independent from politics. The bankers who run those organizations may have the institutional power to define their own objectives, the technical capability to adjust the settings on their monetary instruments, and strong legal protections around the terms and conditions for their employment. But none of that is enough to insulate them from politics. Determined politicians will find a way to exercise influence, no matter what the obstacles. More often than not, such politicians will do so without even implicating the legislative process. They do not have to rewrite the laws to violate central bank independence. Politicians only need to take advantage of the fact that central bankers come from society, they (and their families) have to live somewhere, and eventually they will also retire.

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Modern Dilemmas of Central Banking

Central banks have been in the news a lot lately, with Mario Draghi’s dramatic decision to redeploy the full range of unconventional policies alongside Jerome Powell’s more obvious ambivalence about loosening the monetary spigots. In part this is a function of timing. The business cycle is turning and yet central banks have not quite managed to reset their instruments after the last crisis. Part is also due to overload. Central banks have been ‘the only game in town’ for a long time, they have expanded responsibility for prudential oversight, and politicians seem none too eager to assume responsibility for macroeconomic performance. It would be a mistake, however, to focus too much on short term explanations. Three recent books explore some of the deeper forces that have pushed central bankers into the spotlight.

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The Political Economy of Housing Finance: Compelling New Analysis by Gregory W. Fuller

At some point in the early months of 2007, the words ‘sub-prime mortgages’ began to filter into the popular press. By the end of that August, they were ubiquitous. This small section of the high-risk, high-yield housing finance market in the United States sparked a global financial and economic crisis that would scar a generation. The stories that emerged to explain how this happened were the stuff of fiction or perhaps something even stranger. Banks booked mortgages to people with no demonstrable assets or income, at introductory rates that quickly reset to terms that only the most resilient of households could afford. By the time the borrowers defaulted, however, the banks had sold the mortgages to other investors using complicated securitization instruments that effectively hid the risks involved. The institutions left holding the bag were not only unaware of the dangers the faced but completely unprepared for the consequences. In his powerful new book on The Political Economy of Housing Financialization, Gregory W. Fuller explains why that happened, how the dynamics differed across countries, and what we might do to anticipate similar crises in the future.

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Sovereign Debt Restructuring and Debt Mutualisation in the Euro Area

The euro area lacks a framework for sovereign debt restructuring and it lacks a common risk-free asset. Both issues are important in looking ahead to the prospect of any future crisis. Of the two, however, the creation of some kind of sovereign debt restructuring mechanism appears to attract the most political attention. This briefing note outlines the issues that would need to be addressed to bring greater stability to the euro area.

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Trouble at the Fed (and Elsewhere)

As U.S. President Donald Trump starts asking about whether he can fire the Chairman of the Federal Reserve, it is time to start asking how strong the protections are for politically independent central banks.  The answers are alarming: Trump is not the only one challenging central bank independence; he is also not the most successful.  Indeed, the challeges are widespread and they have been growing for some time.  That is reason enough to pick up Paul Tucker’s book Unelected Power — which was recently named by Foreign Affairs as one of the top books published in 2018.  If you want a taster, my review of Tucker’s book from Survival is below.  The punchline is that while people are right to be concerned that Trump would violate the independence of the Fed, that does not mean either the Fed or any central bank should be left entirely to its own devices.

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The Changing Relationship between Finance and Politics in Europe

The turmoil that struck Italian sovereign debt and bank equity markets on Tuesday, 29 June, is a stark reminder that the potential for another crisis is real, even if not imminent.  Important parts of the firewall that separates banks from sovereigns remain incomplete – and central bankers remain vulnerable to political influence as a consequence.  Two recent books help illustrate why.  One, by former Cypriot Central Bank Governor and Leicester University Professor Panicos Demetriades, reveals the limits of central bank independence.  The other, by University of Denver Professor Rachel Epstein, explores the interaction between banks and markets.

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What We Just Learned about Banking Union from Italy

The Italian government passed a series of decrees yesterday to allow Intesa San Paolo to buy the healthy assets of two small banks from the Veneto region – Banca popolare di Vicenza and Veneto Banca.  The state will move the distressed assets into a ‘bad bank’ for orderly liquidation.  This action closes a chapter on the Italian banking crisis that started in late 2015 when regulators made it clear that the two small Veneto banks needed more capital.  Over the intervening period, investors threw good money after bad as the banks continued to haemorrhage deposits and mount up non-performing loans.  The government did not want to step in because it did not want to impose losses on large depositors or junior bond holders.  Ultimately, though, the situation for the two institutions was unsustainable.  Now we know what the solution looks like.  The question is what we learned from the process.  The short answer is that Europe’s banking union is still dangerously incomplete.

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