Introduction:
One of the most important institutions in our countries today are our central banks. Central Banks around the globe play a key role in setting economic conditions of a nation. Central Banks such as the Reserve Bank of India, The Federal Reserve of the US, Bank of England for the UK etc. with the various available monetary instruments control and shape the money supply and conditions of a country through different instruments such as interest rates like that are the most well-known. Given that today these central entities fundamentally play a crucial role in setting the macro-economic conditions, I would like to argue that it is very important to understand the functioning and their role that they play in the economy especially during times of crisis. The last decade saw a host of economic shocks from the 2008 Financial crash to most recently the Covid-19 pandemic, where one of the key players and responders to these events of crisis are the central banks.
The 2008 Financial Crash and the US Federal Reserve:
In the last half century, the 2008 Financial crash in the United States has been one of the seminal events that threatened the stability of the global economy although it being largely at the time a crisis that largely affected those integrated with the western and US based financial systems. In order to avoid another great depression, the key intervention that saved the collapse of the financial system, was the intervention of the US Central Bank that is the US Federal Reserve or commonly referred to as “The Fed”. As the author and economic historian Adam Tooze in his book “Crashed: How a decade of financial crises changed the world” [1] and his other work has noted the role of The Fed cannot be underappreciated. Writing for the Foreign Affairs magazine he argues that the US Fed played not a role only in saving the US economy but its interventions in supporting other economies mainly in the Euro area or the European Union also prevented another big contagion that would further lead to a collapse of economies in the EU. This was done through the mechanisms of liquidity swap lines are contracts between two central banks that is namely the US Fed with central banks like the Bank of England, the European Central Bank for the euro area. The swap lines are basically contracts that see the temporarily exchange of currencies. In this case it was to provide US dollar support to other central banks to prevent a wider contagion. As he notes “between December 2007 and August 2010, the Fed provided its Asian, European, and Latin American counterparts with just shy of $4.5 trillion in liquidity, of which the ECB alone took $2.5 trillion.” (Tooze, 2018, Pg 207, Pg 204-210) [2]. At the same time the intervention of The Fed domestically was equally important.
Going beyond their conventional monetary tools in times of crisis like cutting interest rates most central banks have had to innovate and come up with new tools and ways of dealing with economic crisis and shocks. This I believe has been one of the single most consequential impacts of the recent economic shocks that the global economy has faced in the last decade.
As the Vice Chairman of the Federal Reserve during 2010 Mr. Donald L. Kohn in a speech at the Carleton University in 2010 summarizes the key tools that The Fed used between 2007 and 2010 is important to note for future crisis events. Mr. Kohn notes that the mandate of The Fed in times of crisis allows it to lend and provide liquidity support to institutions with s sound depository base. However there had to be an exception in this case where the Fed provided support to other institutions that carried more risks such as nonbank financial institutions [3]. To indicate the different programs undertaken by the Fed in this period the below graph from an Asian Development Bank Working paper highlights the measures taken by the Fed.
Figure 1: Balance Sheet of the Federal Reserve (July 2007–March 2009)
These were further supported by in terms of other monetary policy measures leading to reducing the key policy interest rates to close to zero to stimulate economic activity and thus lead to a reversal in the trend of a recession caused by the 2008 crash. In the years following 2008 central banks also developed other tools in order to stimulate economic growth and support the economy. One such tool that has been used widely since and has also had negative effects is that of quantitative easing.
Quantitative Easing (QE):
Quantitative Easing as the Bank of England notes is “QE involves us buying bonds to push up their prices and bring down long-term interest rates. In turn, that increases how much people spend overall which puts upward pressure on the prices of goods and services” [5]. The idea behind QE to put it more simply is to keep the key rates of interests that affect the wider economy low and enable a low interest rate environment to encourage more spending and thus meeting the central mandate of central banks, to control inflation in the economy. In the last 10 years since its introduction as a tool it has been widely used by various central banks. This has been most evident during the economic downturn during Covid-19. The process of QE fundamentally involves the printing of money in terms of reserves rather than the use of government taxation or borrowing for the use of this tool.
Central Banks during Covid-19:
Central Banks played a key role during the economic downturn during Covid-19 as well. Central Banks used all their tools used since 2008 as mentioned earlier at an even greater scale. As the lockdown induced downturn had a direct and immediate impact in terms of a recession for economies in the world, it meant that central banks needed to provide monetary stimulus and support at a much larger and quicker pace than before. This in turn has meant the growth of the balance sheet of the central banks to keep financial conditions favorable for economic growth in times of downturn. The chart below from the Atlantic Council’s Monetary Policy Hub shows the growth in central bank balance sheets after the introduction of QE in the last decade.
Figure 2: The Big 4 Central Banks Balance Sheet Assets
Source: Atlantic Council [6]
The Era of Quantitative and Financial Conditions Tightening:
The last two years in many countries has seen the growth of inflation to record level highs. As the mandate of central banks to keep inflation under control remains their central target. This fundamentally has meant a tightening of conditions that is now upon us. The different interventions of various central banks to support the economy are now in reversal. This as many have argued with which I concur is the end of the “era of easy money”. The conditions set by central banks in the last decade are now at a turning point where all around the world as fears of inflation remaining high, the regime of relaxed financial conditions for the foreseeable future has come to an end. This sentiment has been wonderfully argued and captured by economist and author Mohamed El-Erian of Cambridge University in his article for the Financial Times titled “Central banks and markets share a secular awakening”, as he notes in his piece as central banks around the world began the process of tightening of conditions with raising interest rates and other tightening measures. This remarks a fundamental shift in central bank policy that will have an effect in times of future shocks and crisis following the policy of intervention and support in the last decade [7]. The below two graphs from the Council on Foreign Relations Global Monetary Policy Tracker signifies this shift around the world.
Figure 3: Index of Global Easing (-) / Tightening (+) as of November 2021
Figure 4: Index of Global Easing (-) / Tightening (+) as of January 2023
Source: Council on Foreign Relations [8]
Conclusion:
Therefore, in conclusion I would like to argue that in today’s economy, central banks play a fundamental and a crucial role via their interventions in determining the direction of our economies. Their interventions in the case of the last decade following 2008 have been consequential and as they embark on an era of tightening financial conditions, this will have a direct impact on our financial future. Something I believe all of us must be aware of.
References and Citations:
[1] Crashed – adam tooze. (n.d.). https://adamtooze.com/crashed/
[2] Tooze, A. (2018). The Forgotten History of the Financial Crisis: What the World Should Have Learned in 2008. Foreign Affairs, 97(5), 199–210. http://www.jstor.org/stable/44823921
[3] The federal reserve’s policy actions during the financial crisis and lessons for the future. (n.d.). Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/newsevents/speech/kohn20100513a.ht
[4] Bosworth, B., and A. Flaaen. 2009. America’s Financial Crisis: The End of an Era. ADBI Working Paper 142. Tokyo: Asian Development Bank Institute. https://www.adb.org/sites/default/files/publication/155997/adbi-wp142.pdf
[5] Quantitative easing. (n.d.). https://www.bankofengland.co.uk/monetary-policy/quantitative-easing
[6] Monetary policy hub. (n.d.). Atlantic Council. https://www.atlanticcouncil.org/monetary-policy-hub/
[7] Central banks and markets share a secular awakening. (2022, June 20). Financial Times. https://www.ft.com/content/77665e8d-e3bb-4fc7-8547-b368c8b90f47
[8] Global monetary policy tracker. (n.d.). Council on Foreign Relations. https://www.cfr.org/global/global-monetary-policy-tracker/p37726
India and the World | Hritik Bhasin 