Anthem Press

Chapter Title: THE RELATIONSHIP BETWEEN CENTRAL BANKS AND GOVERNMENTS:

WHAT ARE CENTRAL BANKS FOR?
Chapter Author(s): Sheila C. Dow

Book Title: Central Banking at a Crossroads

Book Subtitle: Europe and Beyond
Book Editor(s): Charles Goodhart, Daniela Gabor, Jakob Vestergaard and Ismail Ertürk
Published by: Anthem Press

Stable URL: http://www.jstor.com/stable/j.ctt1gxpd6m.17

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 Chapter 14
THE RELATIONSHIP BETWEEN
CENTRAL BANKS AND GOVERNMENTS:
WHAT ARE CENTRAL BANKS FOR?

Sheila C. Dow

Introduction
The specification of central banking functions and the institutional arrangements within
which these functions are performed are open for discussion. The need for changes in
central bank goals and operations in the face of the financial crisis has opened up issues
which, during the Great Moderation period, had been regarded as long settled.
One of these issues concerns the goals of central banks. While inflation targeting
had been applied for some time by many central banks, the new economic environment
seems to many to warrant an alternative; candidates for an alternative include nominal
gross domestic product (GDP) targeting, unemployment targeting, and promoting
financial stability. But here we consider the merits of a range of goals pursued
simultaneously, with potential conflicts addressed by means of judgment. Further, while
we will emphasize the importance of the role of central banks, it will be recognized
that they cannot exercise direct control, either of macroeconomic aggregates or of the
financial sector. In attempting to achieve their goal(s), central banks have always had
to tailor their policy instruments to the changing character and strength of financial
markets. The liberalization and globalization of finance since the 1970s, and then the
financial crisis, dramatically altered both the scale and sophistication of financial markets
and the relationship between central banks and financial institutions. But, while such
developments challenge the effectiveness of traditional instruments of monetary policy,
care must be taken not to exaggerate the power previously exercised by central banks.
Even before the 1970s, central banks could only influence the level of credit and money
in the economy, not control it.
A further issue concerns the institutional arrangements within which central banks
pursue their goals and in particular the case for central bank independence. The
return of central banks to major open-market operations in sovereign debt has eroded
previous efforts to separate monetary policy and fiscal policy. At the same time, central
bank activities have had their own direct political consequences, including substantial
redistribution of income. There are good reasons therefore to revisit the presumption

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230 central banking at a crossroads

that central bank independence is beneficial. We will explore this issue in the light
of recent experience. But rather than limiting our discussion to the interdependence
between fiscal policy and monetary policy, we extend the discussion to an issue which
lay at the heart of the banking crisis: the role of the state in providing for society’s need
for money and credit, which brings us back to the goals for central banks. What are
central banks for?
We will see that how we discuss the role of central banks and the appropriate design
of institutional arrangements depend crucially on the theoretical framework employed.
The general equilibrium approach which has dominated the economic literature on
monetary policy and institutional design is ahistorical, founded on assumptions of well-
informed, atomistic, narrowly rational behavior within a stable equilibrium system; the
classical dichotomy, which separates the real from the financial, has been a critical feature
of this approach for the analysis of central banking. Attention will be drawn here, rather,
to the significance of social conventions, both in terms of expectations about the behavior
of institutions, but also in terms of markets valuing assets under uncertainty. This
alternative approach embeds interdependencies between real and financial variables,
between fiscal policy and monetary policy. The first approach treats the complications of
policy practice as separable from, but nevertheless directed by, theory (Colander 2002),
while we will consider them a necessary element in theory, which is to be useful for policy
and institutional design (see further Dow 2012a).
We will consider these pressing current issues for the future of central banking by
taking a historical approach, revisiting the rationale for central banking and its relations
with the state on the one hand, and banks and society more generally on the other. In
the process, we will consider the role of collateral and in particular the possibility of
sovereign debt no longer being regarded as a safe asset. This is part of the more general
problem of an insufficiency of good collateral, given the fiscal problems of governments
and the massive size of the financial superstructure. Put another way, there is not enough
reason for confidence in the value of assets.
A major factor in the buildup to the crisis was an overconfidence in the value of
assets, which was unwarranted given the weak knowledge base on which such valuations
rested. But the fall in capital values during the crisis meant that there was good reason
to be concerned about the exposure of retail banking to risk, and the requirement for
government involvement in bailouts; reasonable doubts about value thus spread to some
sovereign debt. We will thus consider the role of central banks in relation to government
in terms of collateral. In the process, we consider collateral broadly, as an asset which
may be intangible and where claims on it may not be legally enforceable (such as the
source of value of bank deposits). We thus focus on collateral as the basis for confidence
in the financial system.

Banking History and the Role of Collateral

It is important to understand the history of banking and central banking, not only
in order to understand how we arrived at the current situation, but also because past
experience has been a crucial factor in determining social conventions, in particular the

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 CENTRAL BANKS AND GOVERNMENTS 231

degree of trust and confidence (in collateral, broadly defined) which lies at the heart of a
successful system (see further Chick and Dow 2013).
In many countries, retail banking and then central banking arose from the sovereign’s
need to borrow, but in others they emerged (where there was a sufficient basis of trust)
in response to society’s need both for an alternative to specie and for credit. Banks were
able to supply the need for banknotes, and then checking deposits, through the provision
of credit. Money thus arose from the social relation between borrower and lender, which
included crucially an assessment of default risk (whether or not protected by collateral).1
As confidence in lenders increased, this new money in the form of notes, and then
checking deposits, was inside money because there was a matching liability on the part
of the bank. There was confidence in lenders’ liabilities, based on the nature of bank
assets: specie, secured and unsecured loans, and corporate and government debt. But
these assets were limited as collateral because they were not all liquid; fractional reserve
banking meant that not all demands to liquidate deposits could be met. The system
nevertheless worked as long as there was further collateral in the form of confidence in
bank money as a social relation (based on confidence in the banks’ capacity to manage
risk and thus to convert deposits to cash on demand), such that the redeposit ratio was
high. This kind of confidence is not calculable, as in mainstream theory, but is a social
convention, based on experience.2 In time, the obligation to redeem deposits with specie
lapsed.
Chick (1986) explains how central banking evolved to support the emergence of a
banking system. The banking system as a whole could face a crisis if there was a shortage
of liquidity in aggregate such that, even with an interbank market, the banks would be
unable to meet their liabilities. Because of the risk of contagion in expectations, runs could
occur on some banks because of problems identified with other banks. Confidence in
banks to honor their liabilities in cash meant that bank liabilities were not generally called
in but rather continued in circulation. But the valuation of bank assets rests ultimately
on judgment, since there are no demonstrably true measures of default risk. So revisions
of judgments with respect to some banks’ assets might reasonably alter judgments about
other banks’ assets. Further, the valuation of bank assets that reassured depositors was
more generally endogenous to the system: if loans were called in and collateral acquired
on an economy-wide scale, asset values would fall, increasing default risk, and reducing
protection against it. A liquidity problem can turn into a solvency problem.
To protect themselves from more minor calls on their assets, the banks held some assets
regarded as comparatively or perfectly safe from collapse in capital value: short-term
government debt and deposits with the central bank. The latter, together with central
bank notes, were regarded as outside money. The central bank had a matching liability,
but this was disregarded because, if there was risk of default, the central bank could
call on the resources of government. The relationship was mutual. Where central banks
managed government debt and the government’s bank account, governments could
avoid default by borrowing from the central bank. The central bank was thus the lender
of last, if not first, resort for the government. But, following recent experience of central
bank independence and the withdrawal of the facility, the fiscal position of governments
has become a substantial concern for the viability of commercial banks. Until now, the

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232 central banking at a crossroads

lender-of-last-resort facility was generally the subject for debate only as a matter between
central banks and commercial banks; now it is also an issue for governments.
The role of collateral in sharing risk up until recent decades was relatively well defined,
though it was still subject to variations in the value of collateral. It was a major element in
bank loan contracts whereby the specialized knowledge of the borrower on the part of the
lender led to a mutually satisfactory agreement as to how the borrower would compensate
the lender in the event of default. Otherwise, collateral in the form of state support for
banking and for the economy more generally was imperfectly specified, but it nevertheless
inspired the convention of confidence. The success of the banking system, supported
by the central bank, thus provided a good foundation for the massive growth of non-
bank financial intermediaries and securities markets, based on confidence in the value of
sovereign debt, the practices of the central bank, and the real assets of the economy.
But now the role of collateral in bank lending contracts is more diffuse and also more
complex in the relations between the state and the private sector. Debt valuation came
to rely less on the types of client relationship previously at the core of bank lending
and more on pricing based on quantified risk models; transaction costs fell accordingly,
encouraging a much wider participation in lending. The securitization encouraged by
the introduction of capital adequacy requirements in the 1980s distributed the risk away
from the originator of loans. Collateralized debt obligations and credit default swaps
further redistributed risk, such that the knowledge of the original borrower and collateral
became ever more diffuse. Further, the globalization of finance meant that the collateral
ultimately backing assets could be located in a wide range of countries of which borrowers
might have limited knowledge, rendering the ultimate borrower even more anonymous.
This diffusion was compounded by the sheer scale of the financial superstructure relative
to the collateral base represented by the real economy and the support of the state.
In retrospect, markets realized the weak knowledge base on which these assets had
been acquired and bets placed; the connection between structured product valuation and
the value prospects of the underlying assets was very tenuous such that the valuation relied
more on an amorphous (and as it turned out, unwarranted) confidence in financial-sector
pricing. When that confidence was punctured, the value of collateral fell dramatically
across the board. Contrary to the conventional view—based on the efficient markets
hypothesis and the capital asset pricing model—that any deviation of prices from their
“true” value would be reversed by market processes, defaults and the freezing of markets
in particular assets ensued; these were discontinuities which further eroded confidence.
The social conventions which had been built up to support the financial system thus
broke down, resulting in a financial crisis. This challenge to confidence in market forces
refocused attention on central banks for a solution to the crisis. Central banks were thus
forced to address the policy goal of financial stability rather than inflation control and to
design new instruments fit for this purpose.

Central Banks and Financial Stability

While maintaining financial stability had continued to be one of the formal roles of
most central banks during the Great Moderation period, in practice it had taken a

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 CENTRAL BANKS AND GOVERNMENTS 233

back seat to the primary role of inflation targeting, a development dubbed historically
as “idiosyncratic” (Epstein 2013) or an “aberration” (Cobham 2012).3 Indeed, the
content of, and emphasis on, a range of different functions of central banks has varied
over the decades (Goodhart 2011; Buiter 2012; Cobham 2012). These functions have
included the provision of a safe money asset; regulation, monitoring and supervision
of the banking system; exchange rate management; debt management; and lending
to government as required, subject to maintaining the value of the currency.4 These
functions can be summarized as promoting financial stability as the basis for private
sector decision making. But in addition, as Epstein (2013) points out, central banks in
developed and developing countries have also played an active part in supporting, and
indeed promoting, economic development, in particular by encouraging commercial
bank lending to finance investment in particular sectors and regions. Measures have
included credit controls, capital controls, exchange rate management, and financing the
state.
Central banks have thus historically played an important part in promoting economic
goals alongside financial stability.5 Following the narrowing of central bank functions in
recent decades around the inflation-targeting function, central banks have now reverted
to a much wider range of functions in order to address the current crisis; while the form
of the instruments may differ, the principles arguably are close to what was normal in
many countries before the Great Moderation.
The focus on inflation targeting had meant inattention in particular to the role of
banks, and how their practices may impact on the financial system, and on the real
economy. Deregulation had meant that, while retail banks had traditionally held loan
contracts along with (primarily sovereign) debt, now they had securitized loans, and also
extended their asset base to include structured products that had a weak backing of
collateral. Bank regulation had become focused almost exclusively on capital adequacy
ratios, based on an assumption that the risk profile of bank assets was measurable and
that the assets counted as capital were of sound value. But violent swings in asset prices,
and thus valuation of collateral, challenged these assumptions and damaged confidence
in the operations of the financial sector. If the role of the central bank as promoting
financial stability founded on the provision of a safe money asset is to be taken seriously,
then the first task is to ensure a sound retail banking system which inspires confidence in
their liabilities.
Because many have identified the root of the banking crisis in the development of
universal banking following deregulation dating from the 1970s, there is much support
for some kind of ring fencing of traditional retail banking operations from other financial
activities. According to the report by the UK’s Independent Commission on Banking
(2011; the Vickers Report), for example, only retail banks would have the liquidity
support of the central bank, but with the quid pro quo of strict regulation, for example,
of levels of liquidity and capital. Retail banks could thus continue to reap the benefits
of fractional reserve banking, which gives them the capacity to engage in medium-
and long-term debt contracts in advance of deposits, thus financing increased capital
expenditure. But this privilege comes at a cost, associated with regulatory restrictions on
portfolios, and the cost of higher liquidity holdings and capital than in recent decades.

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234 central banking at a crossroads

It was because of the costs of retail bank regulation and the increasing competition from
non-bank financial intermediaries that banks pressured governments to deregulate them.
Indeed, the buildup to the crisis was a symptom of a shift in power from central banks
to commercial banks.
For some commentators, a reversal of that shift to the status quo ante is not enough.
Other proposals have thus been aired which would put the provision of money more or
less completely into the hands of the central bank, effectively putting an end to fractional
reserve banking altogether (see e.g. Kotlikoff 2010; Jackson, Dyson, and Hodgson 2013).
If the cause of the crisis is identified as being too much credit, the solution is seen to
be the removal of the capacity of retail banks to create credit. Yet it is credit to finance
speculation, causing asset bubbles, that has been seen as the problem rather than credit
to finance productive activity. Full nationalization of banking could ensure the direction
of credit to productive purposes only (an opportunity missed currently in the UK, where
two major retail banks have substantial public ownership). Nevertheless, credit would still
be provided outside retail banking, even if not created in advance of deposits. Indeed,
even outside the net of liquidity support from the central bank, what can be classified
as “shadow banking”6 has already increasingly provided substantial proportions of total
credit, and narrow banking proposals would, if anything, encourage even more recourse
to shadow banking.
The role of the central bank can be seen partly in terms of redistributing risk. Much
of the discussion of bank reform with respect to the “too big to fail” problem has been
focused on reducing the risk exposure of the public sector. Beyond that, the proposals to
segment retail from investment banking, with the lender-of-last-resort facility available
only to the former, aim to minimize its risk, even at the expense of increasing it in
the latter. In effect, according to this view central banks should aim to protect retail
depositors by providing collateral in the form of access to liquidity in the repo market. At
the same time, central banks should aim to provide retail banks with sufficient protection
to encourage them to lend to business. But the danger is that the interconnectedness
of financial markets would spread instability from non-retail banking to retail banking,
threatening the provision of a safe money asset and the capacity to lend to business.
There is the danger of a fallacy of composition such that, at one end of the spectrum,
there could be a systemic collapse of asset values across the board, while at the other
end, there could be a run on retail banks for which fractional reserves provide inadequate
protection. While separating off retail banking has been presented (e.g. by King 2009) as
a mechanism for making banks small enough to fail, to contemplate retail bank failure
would subvert the goal for central banks of providing a safe money asset (without the
need for calculative assessment by the general population). The goal rather should be to
have banks too well regulated and supervised to fail.
Nevertheless, separating off retail banking (either in the private sector or moving it
into the public sector) would not be a solution to the possibility of systemic collapse in
asset markets. The success of retail banking in the past provided a secure foundation
on which all the rest of the financial superstructure grew, and grew exponentially. As
Chick (1986) explains, it was the success of mutual support between central banks and
retail banks that encouraged the growth of non-bank financial intermediaries; but then

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 CENTRAL BANKS AND GOVERNMENTS 235

retail banks lobbied, successfully, for deregulation to allow them to compete. Investment
banking was then increasingly conducted alongside retail banking within “universal”
banks and subject to its own regulation. But shadow banking added a further, largely
unregulated, layer to this inverted pyramid, stoking the boom in asset markets and paving
the way for the crisis. The success of retail banking, when combined with deregulation,
thus carried the seeds of its own destruction. As Minsky (1986) had argued, stability
breeds instability. The danger continues to lie particularly in the capacity of shadow
banking to take up the slack left by the ring-fenced retail banks but without the liquidity
support of the central bank. Successfully ring-fenced retail banking would ensure that
a safe money asset was provided, but it would still leave the wider scope for financial
instability. Therefore, while ring fencing would be a step in the right direction, it would
not on its own be enough to prevent a further crisis.
It is insufficient therefore to aim to redistribute risk, but in addition, the aim for central
banks should be to reduce risk in aggregate. Macroprudential policies aim to reduce
aggregate risk by stabilizing bank portfolios directly—for example, by countercyclical
capital adequacy requirements or by limiting leverage ratios. Such policies carry their
own risks; as Minsky had explained in Schumpeterian terms, regulatory constraints are
a spur to innovation. Haldane (2012) accordingly argues for macroprudential regulation
to be as simple as possible (e.g. limits on the size of institutions) because of the danger
of unintended consequences, what he calls the “risk of backdoor complexity.” Even ring
fencing retail banking might be subverted in a way which even complex regulation would
find it difficult to control.
Admati and Hellwig (2012) identify bank capital as the fundamental weakness
that threatens to spread risk around the system (increasing systemic risk), and thus
advocate markedly higher capital requirements. Again, while increased capital would
encourage more confidence in banks’ capacity to absorb losses and thus reduce the
risk of banking crises, it is by no means sufficient to prevent or resolve crises caused by
liquidity constraints (Tymoigne 2010). In particular, it does not address the problem
of financial activity outside the regulatory net, which stricter regulation of course
encourages, and its capacity to create unwarranted swings in asset prices, and thus
liquidity problems.
Frydman and Goldberg (2011) argue that the focus of monetary policy should be
on stabilizing asset markets, given that imperfect knowledge prevents markets from
equilibrating themselves. Mehrling (2011) also sees risk spreading across the system,
arising from unstable asset prices and even frozen asset markets. Shadow banks, which
provide capital markets with essential credit, operate matched books with the aid of
derivative products (unlike fractional reserve retail banks) but are still vulnerable to
price swings beyond the risk measures of derivatives. He argues therefore that central
banks should act as “dealer of last resort” in order to provide liquidity to a range of
asset markets and to stabilize asset prices. Just as we argued above that the capacity for
credit creation provided by fractional reserve banking potentially performs a vital social
function, so potentially does the rest of the financial system. But this potential is only
reached if unstable asset markets do not divert financial activity into self-reinforcing asset
bubbles (and crashes).

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236 central banking at a crossroads

But it is important not to confine the discussion to financial institutions and financial
markets. The risk of value fluctuations (particularly in a downward direction) also arise
from real economic activity. While uncertainty prevents markets from identifying “true”
asset values, such that conventional valuations prevail, these valuations are not purely
subjective. While these valuations may take on a life of their own for a considerable
time (as in the long boom prior to the crisis), eventually reality (particularly in the form
of defaults, but also new data on real economic conditions) breaks through. Against
this backdrop of conventional valuations, the state of banks’ expectations about real
conditions influences their willingness to extend credit to business activity rather than
financial activity. Expectations with respect to the real economy, and actual levels of
output and employment, are also influenced by the government’s fiscal stance, which in
turn is influenced by market pressures. Aggregate risk can thus be addressed by increasing
confidence in asset valuation, not just on the basis of financial-market behavior, but
grounded in evidence of public sector efforts to support the economy, which can include
the efforts of the central bank.
Fiscal policy is relevant, not only in terms of its effect on real economic conditions, but
also in terms of the sustainability of sovereign debt. The rapid growth of the financial
superstructure had increased the need for collateral as a way of giving confidence to
asset holders. At the same time, the crisis eroded confidence in a range of assets that
might have inspired confidence, and this has extended to sovereign debt. There is a
particular problem for the Eurozone: that its design allowed for a range of sovereign
debt of varying quality, while maintaining a common interest rate policy. This has been
a concern from the start (see e.g. EC 1990), but it was overridden by the priority to
proceed with monetary union. This priority can be seen as primarily political, yet there
was an argument current in the early days of discussion of monetary union by those
dubbed the “monetarists” that monetary union itself would generate the forces for
economic convergence. The Maastricht Treaty sided with the “economist” argument
that convergence was a precondition for monetary union. Nevertheless, the varying
perceived quality of sovereign debt within the Eurozone has caused a crisis situation,
to be addressed by the European Central Bank (ECB). Some of the doubts about the
value of sovereign debt arise from the necessity, given central bank independence, for
any central bank involvement in government finance to require public negotiation and
dispute. We therefore turn now to the issue of central bank independence.

Central Bank Independence

While central banks have perforce become more interventionist again in order to deal with
the crisis, the institutional framework is very different from before the Great Moderation
in that central bank independence in some form is now the norm.7 When central
banks were not independent, intervention was generally designed by government and
implemented by central banks. Thus, for example, Goodhart (2011, 140) characterizes
the role of the Bank of England during the period of the 1930s to the 1960s as being
to provide policy advice, to administer a system of controls, and to manage markets. It
was accepted that there was a simple accounting relationship between fiscal policy, its

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 CENTRAL BANKS AND GOVERNMENTS 237

finance by borrowing from the central bank or by central bank issuance of sovereign
debt, central bank management of the stock of public debt, and monetary policy; the
resulting scope for conflict had to be managed.
But the new era of intervention is being implemented within a sometimes
uncomfortable process of negotiation between governments and independent central
banks. For those who anticipate a continuing need for intervention, or simply accept the
accounting interdependencies between fiscal policy and monetary policy, independence
poses problems, particularly for systems of governance (as in the UK), which are otherwise
highly centralized. For those who regard the current era of intervention as a temporary
response to an exogenously generated crisis, normality (including inflation targeting) can
soon be restored, including full central bank independence. It is time to revisit the reasons
why the norm of central bank independence was promoted in the first place.
The Maastricht Treaty provided the impetus for central banks in Europe to be made
independent, even if, as in the UK, membership of the European Monetary Union
(EMU) was not pursued. The rationale, as provided in the summary of European
Community research on EMU (EC 1990), was that an independent central bank
was more likely to achieve price stability, because it would be free from the political
temptation to try to engineer a boom for electoral purposes. Political independence
would thus enhance credibility in inflation targeting. The Maastricht conditions specified
that, in order to make central bank independence sustainable, governments would need
to accept restrictions on fiscal deficits. The argument was that either financing large
deficits or dealing with a financial crisis if governments were forced to default would
threaten central bank independence; this would damage the capacity of the central bank
to meet its inflation target.
The argument for central bank independence (and for fiscal constraints on governments)
was accordingly expressed in terms of the primacy attached to the inflation target.8 The
foundation for this argument is general equilibrium theory, which portrays real outcomes
(production levels, employment, etc.) as determined in the long run by real productive
capacity. Because fiscal policy in general is seen as interfering with equilibrating market
forces, thus reducing growth, limits on fiscal policy are seen as having beneficial real
consequences. Money and prices are separable from the real, but they have the capacity
to interfere with real equilibrating forces in the short run by confusing expectations; an
unexpected increase in the money supply, for example, can raise false expectations of
conditions which warrant increased production levels and new investment, which later
need to be reversed. The inflation that is assumed to follow inevitably from an increased
rate of growth in the money supply thus imposes costs that reduce growth.
The central bank independence literature has thus been focused almost exclusively
on measuring success in relation to controlling inflation.9 The ultimate test is taken to
be how far inflation is lower in countries with more independent central banks. While
the EC (1990) research reported the outcome of these studies as “clearly” indicating a
positive relationship between degree of independence and success in inflation control,
there has in fact been a conflicting range of conclusions drawn from the data in the many
subsequent studies. Indeed, in any case, questions arise as to the direction of causation
between central bank independence and inflation. Thus, even judged in narrow terms

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238 central banking at a crossroads

against the inflation target, the case for central bank independence is by no means
unassailable.
The primacy of the inflation target also distracted attention from the central bank
goal of financial stability, which in many cases continued as a formal requirement, even
if abandoned in practice as unnecessary, given the presumption of efficient markets
(see further Borio 2011). There was a concern that pressure to set interest rates with
an eye to financial stability could conflict with inflation targeting (see e.g. Goodhart
and Schoenmaker 1995). While there is inevitably scope for conflict between the two
goals, the response in terms of institutional arrangements was conditioned by a second
theoretical separation, between monetary policy and bank regulation. The former
was based on general equilibrium macroeconomic theory, which dealt in aggregates
without reference to financial institutions,10 while bank regulation was taken to refer to
microeconomic theory of banks as firms and/or institutional theory. The outcome was
thus an institutional separation between monetary policy on the one hand and bank
regulation and supervision on the other, just as monetary policy had been institutionally
separated from fiscal policy.
But these separations broke down in the face of the crisis, exposing the weakness of
their theoretical foundation. Monetary policy in the form of setting the official (repo) rate
proved to be powerless in the face of escalating rate premia on interbank lending and
even of the drying up of the interbank market. Banks’ collateral in the repo market was
viewed as involving the real possibility of default risk in an environment of collapsing
asset values and highly leveraged portfolios, and thus brought about high-risk premia
as a markup on the official rate. Monetary policymakers turned to asset purchases
(quantitative easing) in an effort to drive down long rates—without the effect on inflation
predicted by general equilibrium theory. While these purchases included private sector
debt, the bulk took the form of sovereign debt. Given the fiscal costs of bank bailouts
and the fiscal effects of the recession arising from the bank crisis, this surge of central
bank funding proved to be crucial. While in the past sovereign debt had been regarded as
a safe asset for underpinning credit creation by banks, now the risk of sovereign default
had become a real possibility, further undermining banks’ own collateral. It was central
banks’ actions that formed a backstop insofar as they could inspire confidence in their
capacity to manage the crisis together with governments; this confidence provided the
broad collateral that has allowed the financial system to survive the crisis (so far).
But the process of addressing interdependencies was made more difficult by the
institutional separation between monetary policy and fiscal policy on the one hand
and between monetary policy and bank supervision on the other. This has been the
case particularly in the Eurozone, where overcoming institutional separations requires
multilateral, international negotiations. If in fact the crisis was in part at least caused
by these institutional separations, then the case is even stronger to develop new, formal
institutional arrangements which address the inevitable interdependencies between
monetary policy, fiscal policy, debt management, and bank regulation and supervision,
as well as more generally between real and financial variables. To do so requires an
articulation of a different type of theoretical framework that takes seriously the real
experience of monetary policy and bank regulation, and the importance of institutional

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 CENTRAL BANKS AND GOVERNMENTS 239

arrangements, as in the body of work of Goodhart, Haldane, and Borio, and work in
the post-Keynesian tradition, of which a few examples are Arestis and Sawyer (1998),
Bibow (2009), Chick (2013), Dow (2013c), Dymski (2010), Gabor (2011), Kregel (2009),
and Morgan (2009).
Any theory abstracts by setting conceptual boundaries—for example, between
the macro and the micro levels. But where these separations are not mirrored in
reality, any policy advice based on these separations may be seriously misguided.
The classical dichotomy, purported to hold between real and financial variables, had
been critical for institutional (and policy) design, yet the evidence of the financial
and economic crisis has demonstrated that this dichotomy does not hold in reality.
This general equilibrium approach, which provided the rationale for independent
central banks, is expressed in terms of the rational expectations view that monetary
policy in the form of interest rate setting would be transmitted to the general price
level by means of expectations, which accorded with rational expectations general
equilibrium modeling itself. Any financial instability would be the result of some
external shock. Such shocks have been explained variously as real technology shocks,
or some kind of irrationality captured by the terms “uncertainty” or “animal spirits,”
or even by sunspots (see further Dow 2013a, 2013b). According to this approach, the
central bank can promote stability by efforts to keep expectations as close as possible
to long-run equilibrium values, which are themselves determined by other, real forces.
Indeed, financial instability had previously been explained by deviations of money
supply growth from its equilibrium path, something which central bank independence
was explicitly designed to prevent.
New Keynesian theory has reinforced the importance of central bank communications
as a means of ensuring that information is as far as possible symmetric. According to this
view, the current financial crisis is explained by various factors that distorted markets
and their capacity to equilibrate naturally. Of these, the main distortions have been
identified as asymmetric information about risk, on the one hand, and the moral hazard
created by the lender-of-last-resort facility provided by central banks on the other. The
aim is to make the subject matter as close as possible to the general equilibrium world,
so that markets may themselves promote financial stability. The role of the central bank
remains one of interest rate setting in order to meet an inflation target, such that real
expectations are not distorted by inflation uncertainty. For New Keynesians, the classical
dichotomy holds, at least in the long run. There is no reason for the central bank not to
be independent.
But we have seen the central role played by confidence (in banks and in the central
bank) in the successful functioning of the financial system and in the economy it serves.
Confidence is only robust if backed up by real experience, and the most profound, recent
real experience has been of financial and economic crisis. This experience has made
clear the interdependencies between the government’s fiscal stance and the value of
sovereign debt, restrictions on and monitoring of bank behavior, monetary policy, and
the viability of the banking system. More generally this experience has demonstrated the
interdependencies between financial stability and economic stability. Confidence is only
now gradually being restored through the experience of central banks intervening in

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240 central banking at a crossroads

sovereign debt markets, attempting direct bank lending, and being more actively engaged
in promoting financial stability by designing new macroprudential policies.
While in some countries, as in the UK, institutional change has already occurred in
recognition of the need for central banks to be more actively engaged with the goal of
financial stability, the need for more formal recognition of the need for coordination
between government and central banks has not been addressed. Yet, the importance of
sovereign debt as collateral for the banking system, and thus of debt management, means
that central banks are dependent on the fiscal stance of governments when aiming to
provide a secure financial system as well as pursuing monetary policy. At the same time,
in pursuing their goals with respect to growth and economic development, governments
are dependent on central banks. During the Great Moderation period, this was taken
to mean dependence on central bank success in meeting an inflation target. The crisis
has demonstrated that such success cannot prevent financial instability and indeed
that prioritizing inflation control may actually facilitate a crisis (Borio 2011). Once the
potential contribution of the financial sector to growth and development is more fully
recognized and understood, there is scope for considering a range of policy instruments
for central banks, such as a more active role in directing credit.
The new skepticism about the capabilities of market forces in allocating credit paves
the way for considering how central banks might produce more socially beneficial
outcomes. Indeed, such thinking is already evident in the actions of many central banks.
But then, since it was inflation targeting that was the basis for central bank independence,
a move toward wider goals addressed to economic as well as financial conditions calls
for the relationship between central banks and governments to be reconfigured in order
for these goals to be pursued as effectively as possible. This is not to argue that central
banks should be completely subservient to government. Central banks could be assigned
a goal such as financial stability, for which they can then be advocates; as Borio (2011)
argues, a financial-stability goal may require central banks insisting on “taking away the
punchbowl” in the face of booming asset markets, something which may be politically
unpalatable to government. Rather it is a matter of designing institutional arrangements
to both reflect and manage the real interdependencies between fiscal policy, debt
management, monetary policy, and financial regulation.
Within this more complex account of behavioral and institutional interdependencies,
it is misguided to seek a “better” macroeconomic model or to seek an alternative singular
quantitative target and policy instrument (Morgan 2009). Rather, models and policy
instruments should be regarded as simply some of the tools available to central banks
in a pluralist approach to knowledge and to policy. For this purpose, it is important to
draw on theory which recognizes interdependencies in real economic relations and
the importance of institutional arrangements for processes. Further, the institutional
arrangements and logistics of policy design and implementation require input from
theory as to behavior within institutions and as to the role of judgment. Policy is more
effective the more robust the knowledge base and the mechanisms for communication,
implying recourse to microeconomic theory of financial market behavior as well as
attention to signs of systemic instability at the macro level. Finally, if, as this line of
argument suggests, central banks go beyond the pursuit of a single, quantified target set

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 CENTRAL BANKS AND GOVERNMENTS 241

by government, then they are engaging in active policymaking, such that independence
from the democratic process becomes an important issue again.

Conclusion
The urgent need for a policy response to the crisis highlighted the limitations of a central
bank being required to put a priority on inflation targeting and relying on official rate
setting as the policy instrument. The crisis demonstrated that central banks needed to
return to their traditional role of regulating and monitoring bank behavior, as well as
managing government finance and public debt, thus internalizing the interdependencies
with monetary policy. The provision of a safe money asset and the capacity for banks
to finance capital investment requires a sound basis for depositors to redeposit and for
banks to lend—that is, good collateral on the part both of banks and their customers.
This requires good bank regulation and monitoring, reliable sovereign debt, and a sound
economy; these in turn rely on financial stability. In other words, the central bank and
the government are interdependent. Central bank independence, designed explicitly for
inflation targeting, is no longer fit for the expanded purposes of central banks, given their
interdependencies with government policy.
Returning to a broader set of functions will inevitably involve conflict and therefore the
exercise of judgment. Markets prefer clarity and the absence of uncertainty. But economic
processes are complex and central bank knowledge is inevitably uncertain. Further, central
banks can only influence developments; attempts to control them by regulation will
generally prompt innovation designed to subvert them. It is important therefore to adopt
a “belt and braces” approach to promoting financial stability, with a range of regulatory
measures acting alongside efforts to stabilize asset prices. Reducing risk in aggregate is the
most effective way to deal with a massive financial superstructure built on a limited stock
of real capital—that is, to address the problem of insufficient collateral. Success would
provide a sound basis for private sector decision making and thus for economic growth.

Notes
1 It was the securing of debt by collateral that Heinsohn and Steiger (2006) identify as the sign
of monetization of the economy; the collateral was both productive in itself and also generated
new credit.
2 It was a notable feature of the banking crisis beginning in 2007 that there was very limited
public knowledge of the system of deposit insurance; the safety of bank deposits was taken for
granted. Only when the risk of default became real did the safety of bank deposits become a
matter of any calculation.
3 Even where central banks had additional formal goals, along with inflation targeting, with
respect to financial stability and economic stability, the potential conflicts between these goals
tended to be resolved in recent decades (up to the crisis) by giving primacy to the inflation
target.
4 Goodhart (2011) includes in the latter function constraining the financing of the state in
normal times.
5 This interventionist role has waxed and waned over time. There has tended to be a pattern of
a less interventionist stance before a crisis, followed by arguments for a more interventionist

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242 central banking at a crossroads
stance to resolve the crisis; Epstein points out that current debates on the role of the central
bank mirror those in the 1930s, when events similarly required interventionist central banking.
6 There is a range of opinion as to how exactly to define shadow banking, e.g. whether it includes
investment banking.
7 The USA is a notable exception. But there governance is dispersed among a range of agencies to
allow a system of checks and balances in a way that would be difficult to achieve in other, more
centralized systems. Among other countries, the degree of independence is highly variable.
8 While this was the main rationale, other possible rationales include preventing governments distorting
fiscal policy because of their ability otherwise to borrow easily and cheaply from the central bank.
9 Quantifying the degree of independence has required particular attention, given the different
organizational arrangements and conventions in different countries.
10 As Borio (2011) points out, these models were effectively real rather than monetary models; see
further Morgan (2009).

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