The Paradox of Central-Bank Cooperation

Now, as the Fed contemplates its next move, emerging-market central bankers are becoming increasingly concerned about the destabilizing effects of monetary tightening on their economies. At September’s G-20 summit in Saint Petersburg, between discussions of the security challenge posed by Syria, world leaders attempted to tackle the issue by creating a formula for international monetary cooperation. But their limited efforts resulted in a fundamentally meaningless appeal.

The modern view is that the Fed’s mandate requires it to act according to inflation and employment outcomes in the US, leaving it up to other countries to combat any spillover effects. This means that other countries must devise appropriate tools to limit capital inflows when US interest rates are low and to block outflows when the Fed tightens monetary policy. But emerging economies missed their chance to limit inflows, and impeding outflows at this point would require draconian measures that would contradict the principles of an integrated global economy.

Moreover, unanticipated shifts in market expectations make it extremely difficult to anticipate the need for such tools. In this sense, the recent G-20 injunction that advanced-country central banks carefully calibrate and clearly communicate monetary-policy changes is unhelpful. Given how difficult it is to communicate coming policy changes accurately, markets tend to be skeptical about long-term forward guidance.

This highlights a fundamental difference between central-bank cooperation in the 1920’s and today. Back then, monetary policy was viewed as an art practiced by a brotherhood of central banks. Modern central bankers, recognizing the limits of such personal ties, often attempt to formulate official rules and procedures.

But adhering to rules can be difficult when policymakers are confronted with the conflicting goals of preserving stable employment and GDP growth at home and ensuring that international capital movements are sustainable. When things go wrong (as they almost inevitably do), there is a political backlash against central bankers who failed to follow the rules – and against the cooperative strategies in which they engaged.

We are thus left with a paradox: While crises increase demand for central-bank cooperation to deliver the global public good of financial stability, they also dramatically increase the costs of cooperation, especially the fiscal costs associated with stability-enhancing interventions. As a result, in the wake of a crisis, the world often becomes disenchanted with the role of central banks – and central-bank cooperation is, yet again, associated with disaster.

Harold James is Professor of History at Princeton University and a senior fellow at the Center for International Governance Innovation (CIGI).

Copyright: Project Syndicate, 2013.

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