Irreverent Economics

Not having my future too much tied into the fortunes of Euroland, I can watch the news from there with amusing  detachment.  Tomorrow I’ll talk about how to render Spanish bankers speechless with Euro speculation (eureculation anyone?).

For now, todays successful auction on 1.6Bn. of  half a year Greek debt. It went rather well with yield at 4.65%.  Big buyers were …  Greek banks. They can refinance it at the ECB at 1%, and if the Greek state stays solvent, it’s a nice little earner. If the Greek state defaults they are done for anyways.

So effectively the ECB is subsidizing the auction. When I took my monetary economics course I don’t recall this being listed as one of the main objectives of a successful central bank. The ECB is effectively subsidizing speculators holding Greek debt. If it really really really wanted to help the auction, why not just buy the stuff directly? Nah, that would be too obvious.

If the euro was my currency I would want the ECB to stay away altogether. But  politics triumphs over economic common sense. And this is one of the small things that make life so interesting.

One reason is that the world’s central banks and regulators have not had to deal with a global liquidity crisis in living memory. Instead, the successful battles of the central banks were with a different enemy — inflation. Because of that success, many commentators and central banks have suggested the the sole objective of central banks should be price stability. Financial stability and supervision belongs elsewhere — perhaps with an independent regulator.

This represents a large shift in the obligations of a central bank. In the 19th century a central bank had to guard both monetary and financial stability, and repeated liquidity crisis helped reinforcing this view. Indeed, the reaction of the Bank of England to 1914 crisis shows how successful central banks had become in meeting those twin objectives.

However, in the design of central banking during the second globalism, following the collapse of the Bretton Woods system, it was as if liquidity crisis and financial stability didn’t matter.

In a way, the central bankers became a little like generals planning war strategies by always fighting the last one, thus getting blindsided by a new enemy.

Over the past few decades, the world’s economy and financial systems have become increasingly integrated, a phenomena often called globalism. This time period is, however, not the first time we have seen the globalism. The  global economy prior to World War I was also highly integrated, in many aspects even more than now.

During the first globalism we saw repeated liquidity crisis, and the recognition that financial stability was an essential function of central banking, along with monetary policy. I discussed these themes here and here.

As a consequence, central banking was very much focused on the twin objectives of monetary and financial stability,  With the central banks much more effective in the execution of the first objective, see the 300 years of FX stability discussed by me here.

Sill, the central banks did react to the repeated liquidity crises in a way that would seem familiar today.

Unfortunately, these lessons seem to have been forgotten during the second globalism.