The ECB and its Watchers - almost a decade

The ninth annual conference the ECB and its Watcher was held Friday, September 7, in Frankfurt. The subject s were the role of money in monetary policy, how central banks should signal their future policies, the consequences of diverging unit labour costs, the revised stability and growth pact, and the credit crisis. You can look and download all the conference papers at the Centre for Fianncial Studies website.

 

We are focusing on a couple of highlights.

 

1. The first, and this is quite rare for a large conference, was the keynote address by ECB president Jean-Claude Trichet, and the subsequent discussion. In his rather technical speech, Trichet pointed towards a puzzle. On the one hand, the euro area enjoys relatively robust economic growth at much lower and more stable rates of inflation than a number of comparable regions. On the other hand, the euro area suffers from continued rigidies in price setting. How can this be?

 

Trichet’s explanation was that this was possibility related to the ECB itself and its credibility. But this observation if true raises a potentially valid question, which was posed in succession by Charles Wyplosz and Willem Buiter. If that was the case, there would be no need for entry criteria for new members. Countries would be able to join, and immediately enjoy the benefit of higher price stability. The ECB is what does the tricket, Prof Buyter mischievously pointed out.

 

Trichet did not produce a hard answer, but the question can be answered nevertheless. First, it is not clear that Trichet solution to the puzzle is correct. It is only an assumption, which although plausible should not be used to change an important legal process. Second, if Trichet’s assumption is correct, it is not clear whether it can be extrapolated from the current set of members to other potential members. The assumption logically applies only to a group of countries that have already met the convergence criteria. If the euro area had consisted of more divergent countries, the combined benefits of stable economic growth and stable prices may not have occurred. Third, and perhaps most important: The current euro area members are inherently risk-averse. They do not know what’s going to happen, and they distrust economists’ projection. As a result, they are only comfortable to enter into a monetary union with countries that are similar to them, hence the convergence criteria. While some of these criteria, like famously the inflation criterion, no longer make literal sense, they still find it more use to have this criterium in place than not to have any inflation threshold at all.

 

 2. The second highlight was Stephen Cecchetti’s presentation, which is one of the most succinct summeries of the credit market hiatus since August 9 we have seen. He made a couple of interesting points. Why does hardly anybody in the US take up the emergency funding facilities, which the Fed provides under what is known there as the discount window? The answer is that you do not remain anonymous when you do that. There are commercial bankers on the board of every regional Fed, and the lending data are presented in full detail to the board. Cecchetti says discount operations is like borrowing from your parents, except that all your friends know that you have done it. He also showed a graph showing the crisis in the commercial paper market is almost entirely due to the crisis in asset backed commercial paper, not the variant where the backing is through the banks’ balance sheets. That suggests that this present cricis is really a crisis of collateral.

Cecchetti concluded with two questions. Do central banks have the tools to handle the crisis? And do we have the tools to mitigate the information problems in financial markets. On the first questions, he says that changing the Federal funds rate is not the answer, since the problem is how to value collateral. “The idea, as I understand it, is that when financial markets seize up, central bankers should start to offer to buy and sell thesecurities that investors and traders refuse to trade. But I would assume that the reason for market disruptions is that the high-paid mathematical financial whizzes inside the investment banks can’t figure out how to price the securities. For the central bankers to make a market, their staff will need to determine the prices at which the illiquid assets should be trading. My guess is that the people insid the Federal Reserve System who are better at this than the employees of Goldman Sachs have already left the public sector.”

On the second question, he said the best hope was a new regulation of rating agencies to make them more conservative.

 

There was lots more interesting stuff. For more details, see the above mentioned papers. Axel Weber’s presentation on central bank information policies was also quite interesting.

 

 

 

 

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