Central banks around the world are currently under enormous pressure. Economic shocks triggered by the Corona crisis and the war in Ukraine have led to a further increase in global inflationary pressure. In the eurozone, the European Central Bank is responsible for price stability. But should its core mandate be more narrowly defined, especially in times of crisis?
In a joint Policy Web Seminar hosted by the Leibniz Institute for Financial Research SAFE and the Centre for Economic Policy Research (CEPR) and moderated by SAFE Professor and CEPR Research Fellow Loriana Pelizzon, Enrico Perotti of the University of Amsterdam argued that a core mandate for central banks should be to preserve safe and quasi-safe assets. “This can prevent the emergence of risks and limit panic reactions,” said the Professor of International Finance.
The key drivers in this consideration are the demand for liquidity and safety. Accordingly, Perotti said, the market’s demand for reliable liquidity must be separated from the risk-tolerant, price-insensitive demand for a safe way to store value: “Central banks have a monopoly on public money, so there has to be a corresponding public responsibility.”
According to Perotti’s theses, which he outlined in a SAFE Policy Letter, safe assets represent a steady demand relatively inelastic to interest rates and risk-intolerant. At the same time, liquidity is more price-elastic, highly demanded, especially by corporations, and driven by transaction levers such as gross domestic product or shocks. “Most safe assets are liquid, but many liquid claims are not safe, nor should they be treated as such,” said Perotti, “investors should know that.”
However, there should be no liquidity without basic safety. Perotti cited bank deposits as an example of a key source of safety. So-called bank runs, in which deposits are withdrawn quickly and in large amounts, fundamentally differ from liquidity runs.
“Liquidity runs are inflows into the banking system, while safety runs are outflows from banks as people take their money out of credit institutions,” Perotti explained. He said that a safe core mandate of central banks aimed at safety limits risk by minimizing panic reactions such as bank runs. While there can be no comprehensive safety guarantees, public bonds are safe in the long run. A narrow and safe core mandate also includes guaranteeing public debt liquidity, which creates financial stability.
How should central banks act in a crisis?
In the discussion following Perotti's presentation, Arvind Krishnamurthy, Professor of Finance at the Stanford Graduate School of Business, asked how central banks should act as crisis management institutions, according to Perotti. According to Perotti’s two main theories – price-insensitive safety demand is served only by truly safe assets; liquidity demand is more price-elastic and can be met in different ways - central banks should maintain a core stock of safe assets. “But in a crisis, spreads between safe and less safe assets blow up, so there can’t be enough safe assets,” Krishnamurthy noted.
Perotti countered that the situation would improve if governments expanded the supply of safe assets in a crisis. Central banks would then commit to making bank assets liquid, preventing banks from liquidating illiquid assets and depositors from worrying about the safety of their deposits.