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Understanding Central Banks

November 5, 2020 by Twan van de Kerkhof

Nout Wellink is not an insecure man. The former president of De Nederlandsche Bank, the Dutch Central Bank, has written an interesting book about, amongst others, the financial and monetary consequences of the corona crisis, the increased role of central banks, the limits of regulation and the role of China in the world. He leaves no doubt that his view is the right one.

If this storm is over, the world will have changed unrecognizably, he writes about the the impact of the corona crisis. The economy will not bounce back; according to Wellink financial and political crises lead to a permanent loss of output of 5 to 15 percent. We will have to adjust to a lower level of prosperity than we expected. Moreover, the corona crisis will hit banks harder than any stress test takes into account. Banks need to be careful in saying that they will be part of the solution this time.

The European Central Bank has a huge problem in Wellink’s view. Its mandate is to achieve and maintain price stability. But the ECB has gone beyond its mandate and needs to keep doing that by massive interventions in financial markets and taking governments debts on its balance sheet. But this will have potentially very large side-effects. Monetary normalization should have started much earlier, but the middle of a crisis is not the right time. Wellink warns for a new debt crisis as a result of the disbalance between what is needed from a monetary perspective and what is right from a macroprudential perspective (interactions amongst financial institutions and between financial institutions and the economy). He says that authorities react too slow on the increasing debts. Moreover, when the next crisis emerges the tool kit of monetary authorities will be empty.

A discussion about the indepence of central banks is necessary, because their impact on society has increased dramatically. The policies of governments and central banks have become intertwined and that makes total independence of those central banks harder to maintain. Wellink calls for more self-restraint in how central banks implement their monetary policy; it would increase their democratic legitimacy.

Wellink also raises interesting questions about regulation. There is a regulation paradox, he says: it is always too much or too little: if things run smoothly, everyone says that rules can be relaxed; if things go wrong, there is a call for more and tighter rules. Prevention is never foolproof, Wellink warns; regulators will always overlook or underestimate things. He also asks who should regulate the regulator to ensure that they are strict enough on the one hand but also keep measure on the other.

The corona crisis is an existential moment in the history of Europe, Wellink writes. We either solve the debt problems together or the EU will collapse. Burden sharing is unavoidable; Wellink’s view is thus opposite to the official Dutch policy. Countries that don’t want burden sharing now will get the bill later, he says.

Wellink also looks back to the financial crisis of 2008. He says that it can’t be explained from greed; greed is timeless, but a crisis happens only occasionally. The causes were over-indebtedness, management that didn’t really understand the risks in their own company, regulators that didn’t either, financial products with a risk profile that was hard to fathom and capital buffers of insufficient quality. But Wellink follows Ben Bernanke, who led the Fed during the crisis, in stating that anxiety in financial markets was ultimately decisive, no matter what the real causes were.

Wellink has read the notes of 2008 board meetings of the Fed again and it is sobering to read that the authorities had no clue of what was happening around them. Lehman Brothers collapsed on 15 September 2008 and there was a Fed-meeting one day later, in the eye of the storm so to say. The notes reveal that Ben Bernanke was ‘decidedly confused and very muddled about this’. The meeting was mainly about inflation, not about an upcoming crisis. Which teaches us that we might be on the verge of a new crisis without knowing it.

Nout Wellink. Ontgelden. Monetaire crisis, corona en het Chinese perspectief. Arbeiderspers, 2020