This post is just short response to „Central banking – Doomed to fail?“ at Free Exchange – some random thoughts.
Free Exchange suggests by quoting Minsky and Greenspan that central banking itself may play an important part in the genesis of financial crises. This is due to their job of reducing volatility and thus fuelling unsustainable debt levels.
There is certainly a lot right with this observation, but it kind of misses one point: Is it really the central banks job to reduce volatility at all cost? I don’t think so. Central banks shoul commit themselves to supplying the economy with enough but still scarce money. If companies are stupid enough to pile up more and more debt and go bust: so be it. This kind of volatility is healthy for the economy, nevertheless painful. It is a central bank’s job to reduce random volatility by reacting to fluctuations that have nothing to do with the business cycle, but NOT to smooth the cycle. Companies come and companies go, that is just markets. I rather have some bust companies and layoffs distributed over the business cycle than big crises that are much worse because of correlated risk.
One may argue that this „companies, don’t be stupid“-approach is wishful thinking because of free-riding. True, this a version of the prisoners‘ dilemma and companies will choose the non-cooperative solution. IF the game is played once and the central bank is weak. The more committment the central bank has to let bad companies go bust, the more cooperative the solution will become.
To suggest an answer to the last question of Free Exchange’s blog, what the role of central banking might be: Uncorrelate risk. Make risk as uncorrelated and random as possible.
How? I have to think about that. Maybe you have some suggestions. Feel free to leave a comment.