Tuesday, April 24, 2012

Central Bank Firepower

Bundesbank's Jens Weidmann (via Bloomberg):
"Monetary policy is not a panacea and central bank firepower is not unlimited, especially not in a monetary union,” he said. “We can only win back confidence if we bring down excessive deficits and boost competitiveness. And it is precisely because these things are unpopular that makes it so tempting for politicians to rely instead on monetary accommodation."
As a factual matter, Weidmann is just plain wrong (and I think he knows it - perhaps this was just a poor word choice on his part).  In a fiat money system the central bank's firepower - its ability to create money - is unlimited.  There are good reasons why central banks choose to exercise restraint, but it is a policy choice.  In the case of Europe today, the ECB could create money to buy government bonds.  A mere expression of willingness to use its "firepower" this way could significantly bring ease the pressure on bond spreads.

The objections to this are twofold: (i) it creates "moral hazard" by allowing governments to escape the consequences of their own fiscal policies (though as Krugman and others have pointed out, the standard narrative about profligate peripheral governments is not really accurate) and (ii) money creation could lead to inflation.  Some of us think a little more inflation in Europe would actually be quite helpful, but others - particularly in Germany due to the memory of hyperinflation in the 1920s - are quite averse to it, and modern central bankers worry alot about maintaining the "credibility" of low inflation expectations.

In any case, the ECB has the firepower, its just choosing not to use it.


The Arthurian said...

Parallel play: In a world of nuclear weapons the central government's firepower - its ability to wage war - is unlimited. There are good reasons why central governments choose to exercise restraint, but it is a policy choice.

Yeah, maybe.

Bill C said...

Thanks. I suppose Weidmann's view is that any use of a little more "firepower" risks escalation to "nuclear anihilation" (the analogue to hyperinflation). I disagree, but that would be a defensible statement, and I could see where people with views like that are coming from.