We Three Kings

As the global economy has headed into what may be its worst crisis in several decades, only one of the world’s three most powerful central bankers has responded decisively to try to stop the bleeding. U.S. Federal Reserve Chairman Alan Greenspan swung into action at the first indications of weakness in the U.S. economy, slashing short-term interest rates in January 2001 and following up with an unprecedented series of rate cuts during the rest of the year. Across the Atlantic, however, European Central Bank (ECB) President Wim Duisenberg was slow to cut rates and cautious when he did so, despite growing evidence of economic malaise in the euro zone. Finally, even Duisenberg’s moves seemed sprightly next to Bank of Japan (BOJ) Governor Masaru Hayami’s glacial approach to monetary easing.

The easy conclusion is that Greenspan is a more skilled policymaker than either his European or Japanese counterpart. But their differing approaches underscore a more complicated fact: For all the apparent power and undoubted global economic impact of the world’s largest central banks, their policies are homegrown and inevitably constrained by local politics and institutions. Different individuals at the helms of the ECB and BOJ might be more willing to pursue aggressive monetary policy, but they could not do away altogether with the real constraints facing Duisenberg and, to a lesser extent, Hayami.

The 66-year-old Duisenberg, former president of the central bank of the Netherlands, has faced the daunting task of launching a new regional currency and running a new central bank with membership drawn from 12 disparate nation-states. Building internal consensus and winning the political backing necessary for effective policymaking was never going to be easy. It was made even harder when the economic environment began to worsen rapidly in 2001 with the euro barely two years old. The weaker economy suggested a need for easier monetary policy precisely when the still fledgling ECB wanted to shore up its credibility as an inflation fighter. The European monetary authority was also blindsided by the foreign exchange market’s persistent vote against the euro, which slid by about 25 percent against the dollar in its first 18 months of existence and has not come close to dollar parity since.

Duisenberg’s efforts to forge consensus on interest-rate policy have been further complicated by European finance ministers calling for looser monetary policy. U.S. politicians, however, have learned that Fed-bashing doesn’t pay. As former U.S. Treasury Secretary Lawrence Summers liked to remark, calling for the Fed to lower short-term rates is worse than useless: It has no impact on the Fed’s decisions and risks unsettling bond markets and pushing up long-term interest rates. European politicians have taken their time to learn this lesson. 

With an explicit focus on fighting inflation, the ECB tends to interpret its mandate more narrowly than does the Federal Reserve, which conducts monetary policy "in pursuit of full employment and stable prices." But in the pre-ECB days, central bank chiefs in Europe often issued pronouncements about curbing fiscal deficits and restraining wage demands, implicitly linking such policies to their own willingness to adjust monetary policy. Similarly, the ECB has tried to pressure governments to help strengthen the regional economy, calling for structural reforms addressing fiscal policy, labor markets, and pension systems. But the impact of such calls has been inevitably diffused when aimed at 12 different countries and governments. Until the ECB establishes a more convincing track record of its own, it will have difficulty persuading national-level economic policymakers to follow its advice.

The troubling story in Japan is less explicable. Established in 1882, the BOJ is hardly a new institution, and the 76-year-old Hayami is a longtime BOJ staffer. However, the institution only recently gained full, formal independence from the previously all-powerful Japanese Ministry of Finance (MOF). Hayami’s desire to safeguard that independence partly explains his zeal in opposing a return to one of the most visible signs of central bank subservience — direct financing of the government deficit. He has also rejected political pressure to adopt a (positive) inflation target and undermined MOF attempts to drive down the value of the yen to support export growth. The BOJ regularly mops up the extra cash created by the MOF’s currency interventions, thereby keeping its own monetary strategy intact.

Certainly, establishing a central bank’s bona fides as an independent institution is important, and being a credible inflation fighter is part of that. But Japan’s far-from-normal circumstances — falling prices, continued economic slump, and a perilously weak financial system — call for imaginative rather than traditional policymaking. With interest rates already close to zero, monetary easing must involve extraordinary measures, such as buying more government debt, selling yen to put money into the economy, and making a clear commitment to turn deflation into (low) inflation. In this context, Hayami’s warning in the fall of 2001 about potential inflationary dangers struck a particularly bizarre note. Ironically, the failure of monetary policy to address Japan’s debilitating deflation has undermined the case for much-needed structural reforms. Politicians are reluctant to implement new policies that, while essential for long-term health, could strike a dangerous short-term blow to an already tottering economy.

So is the global economy hostage to local constraints that fetter the actions of national and regional monetary powers? In Europe, it may take time for the ECB to build the confidence and leadership needed to make decisive monetary policy. It is bad luck that the global slowdown has coincided with (and been exacerbated by) the institution’s growing pains. But no one doubts that the European economy will eventually pick up. In Japan, by contrast, the consequences of policy failures are dire. Bold, concerted action by political and monetary leaders is needed for an economy already trapped in a decade-long slump, but the prospects for change seem worryingly dim.