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What is the future of central banks? It will be busy, because they are now expected to deliver both monetary and financial stability. It will be controversial, because the decisions they make have a huge impact on the distribution of income, people’s access to finance, the way the financial system operates and even the solvency of governments.
The immediate task is to manage an exit from the interventions. Critics exaggerate the difficulty of this task. The fears of imminent hyperinflation are idiotic. As Ben Bernanke, chairman of the Federal Reserve, explained in an important speech on April 13, central banks have expanded their balance sheets because those of the private financial sector collapsed. That is what a lender of last resort is supposed to do during a severe panic. We have known this since the 19th century.
Then, as and when private lending recovers, the central banks will reverse course, selling assets into the market and reducing their credit to banks. But this will be a lengthy and fragile recovery. A far greater danger exists of premature retrenchment than of excessive delay. The risk of inadequate action and premature retrenchment is greatest in the eurozone. If so, there is a chance that the euro and much of the fabric of post-war European cooperation will be swept away. Central banks are not playing for small stakes.
Then, if they manage the exit successfully, which we will probably not know until the 2020s, central banks will confront a new world. They will need to balance their old roles as formulators of monetary policy with new roles as guardians of financial stability. Making this still harder will be the dire fiscal legacy of the crisis. The higher levels of public sector debt threaten a return to “fiscal dominance” in which central banks will, willy nilly, be forced to finance the government, however inappropriate that may be.
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