'The Federal Reserve enters its second century as the closest the world has to a global central bank.' So says Ted Truman, who speaks with some authority as he played a key advisory role for many years with the Fed (the US central bank) and the US Treasury. However, Truman's detailed account of the Fed's international role over the past three decades demonstrates how limited (and sometimes arbitrary) that role has been.
The central issue here is whether the US Fed can act for the global interest where American interests aren't involved or might conflict.
Truman identifies fourteen occasions where the Fed has acted in response to global events, and a clear pattern emerges: where US foreign policy interests are at stake, the Fed will act to assist with global problems. Thus Mexico's crises (in the 1980s and again in 1994) spurred a vigorous and helpful response. The 1998 crises in Thailand and Indonesia hardly rate a mention in Truman's account, while the concurrent crisis in South Korea (where 35,000 US troops were stationed) resulted in a path-breaking (and principles-breaking) intervention in which the US orchestrated controls on capital outflows from Korea. Foreign banks, pressured by their own national central banks, refrained from withdrawing funds which they had lent to Korean banks. An Australian bank (ANZ) was a significant participant in this stand-still, which fortunately turned out well, with Korea able to resume repayments within a short time.
The US Fed's swap operations are akin to global central bank operations, effectively making short-term US dollar loans to foreign central banks, which can on-lend these to their domestic banks to help them through a foreign currency liquidity crisis. This is analogous to traditional liquidity operations, where central banks make domestic currency loans to banks in need of liquidity.
These Fed swap arrangements have been a powerful and valuable stabilising element during global financial crises since 1965 or even earlier. Until recently, however, they have been available only to a small group of advanced economies (including Australia), plus Mexico.
In 2008 the swaps were a crucial part of the crisis response, especially for Europe. The Reserve Bank of Australia was able to use this facility to on-lend US dollars to Australian banks in need of foreign currency liquidity when the New York money market dried up.
The usefulness of this facility was demonstrated even more powerfully in 2008 when South Korea experienced a foreign currency crisis. Its own substantial foreign exchange reserves were not sufficient to stabilise confidence. The crisis ended as soon as the Fed's swap facility was announced, arriving like the US cavalry over the horizon to save the embattled Koreans.
As the Korea experience demonstrates, the swap facility is a more powerful instrument than a country's own reserve holdings. This is a current policy issue, as many emerging economies (especially in Asia) are building up huge foreign exchange reserves in readiness for renewed episodes of capital flow volatility. Such reserve holdings have to be funded, so are expensive and often disrupt monetary policy. Wouldn't it be helpful if the Fed really did act as a global central bank, offering this swap facility to everyone?
Unsurprisingly, the Fed offers swaps only to its trusted friends. In 2008, for example, it refused Indonesia's approach for access to the swap facility. It is not, and is unlikely to become, a global facility that would make the US Fed analogous to a global central bank.
Those, like Australia, in the swap network should be grateful that this powerful facility is available to us, though we might note that Truman reports earlier efforts by the Fed staff to close down the facility.
Truman avoids specifically addressing a vexed current issue. What obligations does the Fed have to consider the impact of its policies on other countries? Financial markets certainly expect a significant global effect from the unwinding of quantitative easing (QE). Raghuram Rajan, the Indian central bank governor, sees the Fed as having important obligations to countries so affected. But beyond ensuring that these QE operations are understood by financial markets, the Fed sees itself as having no wider obligations.
It's hard to see how the Fed could act otherwise. There are, in fact, historical examples where the US has helped its closest friends and paid a price. In 1927 it lowered the discount rate in response to the entreaties of Montagu Norman, governor of the Bank of England, who was struggling to contain the damage from Churchill's disastrous return to the gold standard two years earlier. This lower interest rate encouraged the asset-price boom which ended in 1929 with the Great Crash, ushering in the Great Depression.
If the US Fed cannot be an effective global central bank, what about the IMF? Truman talks of the IMF as if it is a simple extension of US policy. Taken together, perhaps there is some truth in the idea that the US Fed and the IMF can serve as a global central bank. But a precondition for this to be acceptable to the rest of the world is to implement the IMF governance reforms (especially voting shares) which are currently held up, pending US Congressional approval.
Photo by Flickr user jareed.