The idea that central banks can and should act independently of governments is, fairly clearly, inoperative for the duration of the crisis in many countries. The combination of massively increased liquidity provision and large-scale bank bailouts requires close co-ordination between central banks and national treasuries, though the form of this co-ordination is inevitably different in different countries.

But the failure of central bank independence goes much deeper than this. The underlying idea was that monetary policy should be left to independent experts, and should be the main tool for macroeconomic stabilisation. Governments were expected to avoid active fiscal policy, focusing primarily on maintaining budget balance (there were some differences in view as to whether governments should target annual balance, or balance over the course of the macroeconomic cycle). The shift to independent central banking was closely associated with the adoption (implicit or explicit) of inflation targets as the primary focus of monetary policy, and with interest rates as the primary tool.

Not much of this appears sustainable in the light of the crisis. Inflation targeting failed to prevent unsustainable asset price booms, and it now seems clear that these could not have been prevented without much more direct control over unsound financial innovations. That’s a task where interaction between governments and central banks appears unavoidable. On the one hand, expertise is crucial. On the other hand, as with war, financial innovation is to important, and too dangerous, to be left to finance experts.

The idea that monetary policy alone is sufficient for macroeconomic stability might have looked appealing during the Great Moderation, but does not stand up when examined over a longer period. To put it bluntly, central bank independence appears to work well except when it is most needed.

A more difficult question relates to the separation between monetary policy and prudential regulation. The need to take systematic risk into account suggests that monetary policy must be closely integrated with prudential policy. On the other hand, Australia, with a clear separation between monetary and prudential regulators has done better than countries where central banks are more closely involved. My feeling is that the correct separation is between strategic issues, such as monitoring of systemic risk and the regulation of financial innovations, which belongs with the central bank, and institution-level supervision, which belongs with a specialist agency.

Over the fold, my column in yesterday’s Fin. Not the final version, as I made some last minute changes in response to Lindsay Tanner’s defence of the Razor Gang yesterday.

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This month’s unemployment news was the worst so far in the recession, with the headline rate rising from 4.8 to 5.2 per cent and some of the components looking bad as well (part-time replacing full-time employment, for example). The main good point was that the participation rate rose, so that the increase in unemployment was (in an accounting sense) largely due to people entering the work force, rather than to net job losses.

We are still doing far better than most other countries, and, if a global recovery emerges towards the end of the year, could still get by with only a moderate recession.

The government has reacted promptly with the fiscal stimulus[1], and the relaxation of monetary policy has also helped. But there doesn’t seem to have been much action to develop direct labour-market policy responses to unemployment (I discuss responses to unemployment here). And there’s a real risk that a contractionary budget will wipe out much of the benefit of the surplus (My Fin piece on this will be up soon).

fn1. In this context, I thought Turnbull’s response, treating every piece of bad news as evidence that the government’s policies have failed, while offering nothing positive of his own, has been both incorrect and politically tin-eared.

Every now and then back in the Dark Ages, I would have to deal with the late, unlamented MS-DOS operating system. It wouldn’t be long, as a rule, before I encountered the message “Abort, Retry, Fail?”

Of these, “retry” sounded the most hopeful so I’d choose it a few times, but I don’t think it ever worked. Usually the best thing was to shut down the machine and start again.

This trilemma struck me when looking at the options for US-based banks, and Citigroup in particular.

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Most of the attention in discussion of the December quarter national accounts was focused on the negative sign of the aggregate GDP number, combined with the seemingly unkillable belief that there exists a “technical definition” of a recession, namely two consecutive negative quarters. An aggregate number anywhere zero is pretty good by comparison with the world economy as a whole, so the real interest is in the components. Ross Gittins The Brothers Grimm move has a nice piece going through the details, and concluding, unsurprisingly that we are in a recession. The aggregate number has some negative bits that should be temporary (inventory rundown and the statistical discrepancy) but against that, we are bound to get more bad news on exports over the coming year. Our terms of trade, which rose consistently during the term of the last government (one reason things turned out so well in terms of the macroeconomy) have started turning down, but there is a long way to go.

The (possibly temporary) good news is that household savings have risen greatly, to 8 per cent of income. It’s reasonable to assume that this reflects a combination of precautionary saving as the prospect of recession hits home, reactions to the huge capital losses of 2008 (reversing the process by which illusory capital gains prompted people to run down household savings), less home equity loans (can anyone find me some data on this?) and the fact that some part of the money handed out in the stimulus package was saved. Unfortunately, as the recession hits home we are likely to see lots of households with declining income, raising the question of whether the improvement in savings can be sustained.

There’s been a lot of confused discussion about the stimulus in this context. On the one hand, it’s obviously desirable that the stimulus should increase consumption. On the other hand, the resolution of a financial crisis requires, among other things that household balance sheets are made sustainable, that is, that household debt should be brought down to manageable levels relative to income (not relative to inflated asset values). This is a tricky problem, but its obvious that if households are going to increase savings, and aggregate demand is not to decline too much, someone else needs to increase their net demand. Since private investment and export demand are almost certain to shrink, that leaves government as the only candidate.
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