One of the biggest lessons from the ongoing financial crisis is that the single-minded pursuit of low inflation could indirectly endanger financial stability.
Independent central banks with a clear mandate to focus on inflation control were undoubtedly successful in keeping prices stable and output volatility low through the past two decades, an achievement that is often described as the Great Moderation. But this led to the creation of so-called Minsky moments, derived from the insight of economist Hyman Minsky that long periods of economic calm embolden firms and investors to take huge risks that eventually create asset bubbles.
The experience of the last two years seems to have led to some attempts at rethinking the role of central banks. The Obama administration in the US is trying to make the Federal Reserve into a systemic risk regulator, besides its usual central banking duties.
George Osborne, the UK Conservative Party’s shadow chancellor of the exchequer, said earlier this month that he would like to abolish the Financial Services Authority (FSA) and revert the job of regulating the financial system to the Bank of England. If Osborne does this in case the Conservative Party returns to power in the UK, he will be rolling back Tony Blair and Gordon Brown’s decision to ask the central bank to focus on inflation control while FSA oversees banks, insurance companies, other financial institutions and the financial markets.
In India, the Reserve Bank of India (RBI) made financial stability an explicit goal of monetary policy long before it became global fashion.
However, reports commissioned by the finance ministry and the Planning Commission in recent years on financial sector reform swing the other way. They are enthusiastic about inflation targeting as the main function of RBI. The recent Economic Survey released by the finance ministry before the Union Budget even suggests that the Securities and Exchange Board of India rather than RBI should be asked to oversee most financial markets.
The Minsky revival and the lessons of the financial crisis clearly show that the central bank is best placed to protect financial stability.
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