By Dr. Jim Leontiades,
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The recent move by the US Federal Reserve Bank to lower interest rates by half a point has demonstrated the power such banks exert over our daily lives. Immediately after this decision, the price of shares went up in Cyprus and around the world. Bank credit became easier and the outlook for the economies of many countries improved markedly.
The global impact of such a change has focused attention on how these banks and their management yield this powerful tool. It also highlights an issue which has preoccupied central bankers for the past several decades. To what degree should a central bank intervene in the operation of a market economy? Should such an institution use its power to set interest rates solely to protect the soundness of the national currency or should it interpret its role more broadly, using interest rates to stimulate and otherwise manage economic growth? How this issue is decided will have a global influence on future share prices as well as general economic conditions. There are two distinct views.
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— Conservative vs. Aggressive
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At the risk of oversimplification, we might characterize the distinction as being between an aggressive versus a conservative interpretation of the use of the interest rate. The more traditional, conservative approach is best illustrated by the European Central Bank (ECB). The ECB has been reluctant to change the interest rate except in connection with matters related to controlling inflation and the value of the Euro. Comparatively, stable interest rates have characterized its policy, even in the face of slow economic growth. Protecting the value of the currency has been the first, some would say its only priority.
The more aggressive interpretation is most clearly to be seen in the interest rate decisions taken by the American Federal Reserve Bank (the Fed) under the management of Alan Greenspan. Following the bursting of the dot-com bubble in 2000, Greenspan used the Fed’s power over the interest rate to stimulate the American economy and particularly the level of employment. In a series of rapid moves he lowered the interest rate, from a height of 6.25 % all the way to 1%. Economic growth and employment improved. Once the economy gathered momentum another series of changes moved the interest rate in the opposite direction to keep it under control. From 1% in 2004 to 5.25% were it stood until a few days ago.
During this same period the ECB changed its interest rate very little, despite low economic growth in the Eurozone and levels of unemployment almost double those in the USA. Between 2001 and 2003 the ECB moved the interest rate only a little more than 1% downward (to 3% in 2003). From this low point the ECB subsequently moved its interest rate upward (1.5 percentage points) even though there was continuing slow growth and high unemployment in Europe.
Although both central banks faced problems of economic growth during this period there were also differences. The ECB had to deal with the multiple national economies of the many countries which make up the Eurozone. Some were experiencing economic difficulties, others were growing rapidly. Nevertheless, the fact remains that the two central banks have fundamental differences in their objectives and philosophy. The ECB stated its conservative stance from its very inception. Protecting the value of the currency was to be its main objective. The U.S. Fed also claimed to be an “inflation fighter” but its past practice had demonstrated on more than one occasion that it took a broader interpretation of its objectives. There are also political pressures on both banks. Increasingly the question is raised: can a central bank stay aloof during a financial crisis?
There are powerful arguments on both sides. The more traditional approach points out that any government intervention to manage the economy that is not closely related to fighting inflation represents an interference in financial markets which, in the long run, may actually do more harm than good. For example, in the current mortgage crisis, the decision to lower interest rates may reward some banks which have engaged in risky practices and bad management, making a repeat of this type of crisis more likely in the future.Â
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— High Stakes
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The stakes are high. Under Greenspan’s aggressive stance, the American economy recovered quickly. After a shallow recession it went on to one of the longest periods of sustained growth in its history. But did it, as some say, also bring on the present mortgage crisis? That must certainly be considered a cost. But there was also a benefit in terms of a shorter recession, economic growth and lower unemployment. Is there a trade-off here that should be more explicitly considered, the cost of crises such as the present one balanced against the benefit of higher growth and lower unemployment? That is the more difficult question. It is no doubt one which will preoccupy central bankers in the future.
