"I have not failed. I've just found 10,000 ways that won't work." Thomas Edison
Modern economies are built by businesses that take risk. As Edison’s defense suggests, successful risk-takers need scope to experiment without distraction. Economies lacking institutions to support risk-taking are prone to stagnation.
By securing economic and financial stability, central banks play a key role in promoting the risk-taking that is fundamental to innovation and capital formation. On rare occasions, it is officials’ bold willingness to do “whatever it takes” that does the job. More often, it is a series of moderate, gradual actions. Yet, even then, the understanding that the central bank has the broad capacity to act—and, when necessary, to do so without limit—is a key factor underpinning the stability of the system.
To be clear, it is our strongly held view that, despite the prevalence today of very low (and, in some cases) negative interest rates, and enormous central bank asset holdings, monetary policymakers retain the scope to continue supporting the risk-taking that underpins growth. Put differently, they are not “running out of gas” even though some of their tools (like negative interest rates in Europe) have natural limits.
Before turning to the specifics of what it is that central banks can and cannot do, let’s step back and consider how it is that they foster an environment that promotes effective risk-taking. One of the most important tasks of the central bank (and the government more generally) is to minimize the systematic—undiversifiable—risks that we all face. Expressly because it is systematic, the risk of recessions, inflation, financial crisis, sovereign default and the like cannot be fully hedged. Only the central bank (and, in some cases, the fiscal authority) is in a position to reduce such risk.
How do central banks do it? As we have seen in recent years, central banks have developed a broad range of interest rate and balance sheet tools. Their willingness to use these tools—usually in moderation, but sometimes in extreme ways—is key in limiting the systematic risks that would otherwise make businesses cautious and diminish economic expansion.
To see what we mean, consider why it is that the Great Recession of 2007-2009 did not turn into the second Great Depression. The collapse of U.S. housing prices that triggered (and was amplified by) the Great Recession generated a plunge of household wealth that was broader (and probably no less severe) than the stock market bust that triggered the Depression of the 1930s. The ensuing financial panic that followed the Lehman bankruptcy in 2008 was easily the worst since the 1930s.
But, while the Great Recession was the deepest and broadest downturn in 70 years—with nominal GDP falling by 3½ percent peak to trough—it was modest compared to the Great Depression when nominal GDP plunged by 45 percent between 1929 and 1933. In our view, the key reason for this difference is the extraordinary actions of the Federal Reserve and other central banks to contain financial spillovers. The rapid and unprecedented expansion of central bank credit preserved the payments system and, where necessary, substituted for dysfunctional markets, like those for housing finance and commercial paper.
By dramatically reducing the probability of disaster, central banks narrow the range of bad outcomes that businesses need to consider when judging whether to undertake a new project. Even so, investor willingness to acquire insurance against left-tail risk grew notably in recent years as the equity market rebounded. See, for example, the chart below of the CBOE’s SKEW index, which uses out-of-the-money put options on the S&P 500 to construct an estimate of left-tail risk. (The index is constructed to equal 100 if the distribution of log returns is symmetrical, and rises above 100 as left tail risk increases.)
CBOE SKEW Index, 1990-1Q 2016 (quarterly averages of daily data)
Perceptions of tail risk can matter greatly for economic performance. As Kozlowski, Veldkamp, and Venkateswaran show in a recent paper, adding the really awful (left tail) realizations from the 2007-2009 downturn to the observed annual distribution of returns on capital since 1948 is consistent with a large and sustained weakening of investment and growth. Not only that, but rare, severe crashes drive up the equity risk premium—the excess return on a portfolio of equities above the risk-free return on Treasury debt. The ERP has averaged about 6 percent over more than a century. One means of accounting for this persistent large reward to shareholders is as compensation to risk-averse investors for infrequent adverse events, such as the crash during the Great Depression. Interestingly, the inflation-adjusted one-year return on the S&P500 in 1932 (-37 percent)—the lowest on record—was only slightly worse than the outcome in 2009 (-35 percent) (see following chart).
S&P 500 Inflation-Adjusted One-Year Returns, 1872-2016
Imagine how much worse the long-run impact on growth would have been had the central banks not acted as aggressively as they did during the crisis. Today, investment would be even lower and risk premia even higher.
To be sure, we share the common view that the effectiveness of the array of unconventional central bank policy tools diminishes with the extent of their use. So long as central banks are willing to supply notes and coin on demand, there is an effective lower bound for nominal interest rates determined by the transactions costs of storing, transporting, and insuring cash (see here). Furthermore, while central banks can expand their balance sheets without limit in theory, the experience in Switzerland and elsewhere highlights that there are practical political limits (see here). Similarly, there is far less scope than a few years ago for central banks to subsitute for financial intermediation that, in many jurisdictions, now functions reasonably well.
And yet, consider the converse: Were the U.S. economy today hit by a large deflationary shock, how would Federal Reserve policymakers respond? We expect they would do “whatever it takes” to stabilize prices, employment and the financial system. In addition to the well-known unconventional tools (including open-ended quantitiative easing, or QE infinity as it has been called), there remain an array of untried practices that—if push came to shove—the central bank can introduce. As former Chair Ben S. Bernanke argued in 1992 (shortly after joining the Board of Governors, and several years before becoming Chair), these might include: (1) establishing a ceiling on the yield of longer-maturity Treasury debt (as was done from 1937 to 1951); (2) lending at low fixed-term rates to financial intermediaries against a wide range of collateral, including corporate liabilities; and (3) cooperating with the fiscal authorities for a money-financed tax cut or public spending increase (a “helicopter drop” of money).
The point is that the public’s awareness of a central bank’s credible commitment to act to the very limits of its legal authority in a crisis is key to stabilizing expectations for prices and promoting economic activity in normal times. It encourages the Edisons of today to take productive risks, rather than retreat in the fear that the economy and financial system could collapse at any moment.
The need to underscore the central bank’s policy commitment also has important implications for the way in which authorities communicate outside of crisis episodes. For example, it is critical that the public understand the range of tools that are available to a central bank to make good on its promise to do “whatever it takes.” Consequently, when central bankers are called upon to explain the limits of any particular tool, such as the effective lower bound on nominal interest rates, it is important that in the same breath they explain that they have alternative policy tools that will be used if needed. The point is that, while policy is invariably set in response to current and anticipated future conditions, it should always be clear that authorities are committed to alter policy settings to achieve their statutory objectives when conditions evolve unexpectedly.
The most powerful example of such a credible commitment is ECB President Mario Draghi’s July 2012 statement that he and his colleagues would do “whatever it takes.” At the time, 10-year sovereign yield spreads over Germany for Ireland, Italy, and Spain ranged as high as 555 basis points. By summer 2013, a year later, the maximum spread had narrowed to 310 basis points. Today, it is only 155 basis points, while measures of financial integration within the euro area (such as the cross-country standard deviation of lending rates and balances in the Target2 system) improved again as confidence grew in the ECB’s commitment. And, because of the ECB’s credibility, it never needed to implement the conditional lending program (labelled “Outright Monetary Transactions”) that stood behind its commitment.
An unfortunate counterexample is what then-Professor Bernanke called the “self-induced paralysis” of the Bank of Japan after deflation began in 1994. For nearly two decades, BoJ policymakers appeared reluctant to use the tools at their disposal. This evident lack of commitment reinforced persistent deflationary expectations that are now so difficult—even for an aggressive Bank of Japan—to undo.
So, can a central bank really run out of gas? In theory, yes. Imagine that, amid a sustained deflation, nominal interest rates on public and private liabilities sink to the effective lower bound across the entire maturity spectrum without buoying other financial conditions or stimulating the economy. In that case, aside from purchasing corporate equity (or lending against equity collateral without recourse), the only instrument left in the central bank’s toolkit would be the use of base money to finance public expenditure. But, in this extreme scenario, why would fiscal authorities (other than the most hardened ideologues) oppose public borrowing to undertake projects that might be self-financing (see our earlier post here)? That is, it is difficult in practice to imagine a case where neither monetary nor fiscal policy can provide further stimulus.
So, what can today’s central banks do to keep the Edisons of the world exploring new frontiers and adding to the capital stock? First and foremost, they need to make sure that everyone is convinced of their willingness to use their tools to the fullest extent to secure price stability and maximum sustainable employment. Put differently, they should always be prepared to act boldly, and they should never say never.