What new cold war means for central banks

By Daniel Moss

The battle against soaring prices is little more than a year old and central banks need to gird for the next big trial: Serving their nations in a world defined by protracted competition between the US and China. Policymakers will be reluctant cold war warriors — they are more comfortable aiming at inflation targets and tinkering with guidance on interest rates than fending off strategic adversaries.Unfortunately, they don’t have the luxury of sitting this out.

Today’s new economic era presents a formidable challenge to monetary authorities grappling with the aftermath of the enormous stimulus pumped into the financial system during the early days of the pandemic. It will require not just setting borrowing costs in response to the birth and death of business cycles, but anticipating long-term ramifications of fractured supply lines and a diminished global labor pool. Central bankers will need to get used to aligning their stances even more closely with other parts of government, especially fiscal players, all the while keeping their cherished independence. It’s a daunting task, but not mission impossible.

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That was the underlying message of an address by European Central Bank President Christine Lagarde to the Council on Foreign Relations in New York last week. “We are witnessing a fragmentation of the global economy into competing blocs, with each bloc trying to pull as much of the rest of the world closer to its respective strategic interests and shared values,” she said. “All this could have far-reaching implications across many domains of policymaking.” While this sounds like a statement of the obvious, it’s not every day that central bankers venture into international politics. They are loath to even do it domestically.

Lagarde’s remarks are a call to arms, and she may be the right person at the right time. Because it oversees a currency union, the ECB is, by its very existence, a transnational body. Lagarde’s experience as French finance minister during the 2007-2009 global financial crisis and subsequent stewardship of the International Monetary Fund elevate her stature. The sooner central banks start appreciating the shifting terrain Lagarde described, the easier the transition will be. Think about it now, she says. Not when blocs have already become frozen.

The good news is there are numerous of examples of central banks surviving after aligning themselves with national interest in times of crisis. Some fine illustrations are in Asia. Branches of government worked closely together and, while claims of an erosion of independence dogged these episodes, it wasn’t the end of the world — for bankers or politicians. Indonesia’s adventures in debt monetization during Covid stand out. The direct financing of state budgets by central banks was long considered a no-no. Yet Finance Minister Sri Mulyani Indrawati and Bank Indonesia Governor Perry Warjiyo pulled it off, albeit with some fuss and howls about the sacrifice of autonomy. But no bond vigilantes appeared to punish Jakarta. Encouraged by the relatively benign response, the country passed a law in December that enabled the future use of BI’s balance sheet should an emergency require it.

It’s not just something for emerging markets, where institutional guard rails are sometimes wanting. As an academic and Federal Reserve governor, Ben Bernanke repeatedly urged the Bank of Japan and the government to work together to reflate the economy and banish deflation. Emergencies and long-term national interests required aggressive action, he stressed. In a 1999 paper, Bernanke invoked the New Deal of the 1930s and suggested it was “time for some Rooseveltian resolve.”

The idea is not quite a joining of forces, but a greater recognition of how crucial national agencies can better complement each other. Sounds great in theory, but the optics can be unsettling. It took until 2013 for the late Japanese prime minister, Shinzo Abe, riding high after a dramatic return to power, to wrestle the BOJ and Ministry of Finance into a formal understanding. Critics of the accord claimed the bank’s independence had been eroded. But unless the BOJ went along, Abe was likely to push them even further toward being an arm of the administration. The politics — and needs — of the moment worked against the BOJ. The idea of different strands of policy complementing rather than competing also hung over the work of a panel reviewing the Reserve Bank of Australia, which released its recommendations on Thursday.

To be clear, Lagarde isn’t contemplating monetary policy being subsumed into defense ministries or presidential palaces. “Insofar as geopolitics leads to a fragmentation of the global economy into competing blocs, this calls for greater policy cohesion,” she said. “Not compromising independence, but recognizing interdependence between policies and how each can best achieve their objective if aligned behind a strategic goal.”

It’s time for financial diplomacy to come in from the cold. In my decades as a journalist in Washington, London, Tokyo and in Southeast Asia, I have often been amazed at how little foreign policy types incorporate markets and monetary stakes into their thinking. Macro experts have tended to defer the study of statecraft to others. They belong together. The way the Fed has repeatedly embraced its role as central banker to the world through swap lines is a case in point. Though the Fed bristles at the idea it has a foreign policy role, no US foe received a dollar swap line during the pandemic or the Credit Suisse saga. In recent deployments, most — if not all — recipients have been formal allies or close partners. China has been building its own network of swap lines and acting as a creditor for a swag of developing countries. You think those IOUs are free?

Most central banks have at least a degree of independence, but they can’t afford to be too pure about it. The autonomy often comes with caveats or has gradations. The ECB’s singularity is enshrined in a treaty, but the euro it oversees is itself the culmination of a deeply political project. They live in a political world, tend to derive their mandates from the political class and even the most technocratic decisions have ramifications for hundreds of millions — if not billions — of people. So let’s embrace this emerging world sketched by Lagarde. Politics is already present.