Central Banks and Global Crises – Who Really Controls the Global Economy?

The worldwide credit crisis that began with the collapse of the housing market in the United States in 2008 was just one of many crises that central banks and other financial authorities have had to deal with during the first part of the 21st century.

But the enormity of the 2008 financial collapse required government and central bank intervention never before seen in the global economy. After Lehman Brothers, one of America’s biggest investment banks, was allowed to go bankrupt, the Federal Reserve was required to bail out AIG, the world’s largest insurance company. The $85 billion bailout was, until then, the biggest bailout in American economic history.

When banks began failing across the globe- primarily because of bad investments in U.S. subprime securities, but also because of the freeze in interbank lending- it was clear that a full- blown worldwide crisis had arrived. Stock market declines of more than 50% in some countries presaged a global economic meltdown. The concerted action of the world’s central banks, including the U.S. Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan, helped calm things down for a while. But when countries began failing-Iceland and the Ukraine were the first of many national economies that had to be bailed out- it was clear that the fallout of the 2008 crisis would last for years to come.

The key to finding the right solution to economic crises is to somehow solve the immediate problem without making things worse in the future. Some say that the reaction of the Fed to the meltdown of the dot- com sector at the end of the 20th century- increased liquidity and drastically lower interest rates- set the stage for the meltdown of financial markets several years later, with massive defaults of mortgage holders who probably shouldn’t have been given home loans to start with, but were lured in by artificially low interest rates. The result was a recession that was much worse than that which the central bank was trying to avoid.

Just as the speed of an engine is regulated by its fuel supply, a country’s economy is controlled by regulating its money supply- and each country’s monetary policy is the responsibility of its central bank. In Britain, it’s the Bank of England; in Switzerland, it’s The Swiss National Bank; in the United States, it’s the Federal Reserve; in the euro zone countries, it’s the European Central Bank; and in Japan, it’s the Bank of Japan. These quasi- public institutions are set up by governments, but are then given the independence needed to keep an economy under control without undue interference from dabbling politicians. Despite the tendency of the media to concentrate on the latest economic statistic, there is no one single indicator that tells us how fast an economy is growing- or if that growth will lead to inflation down the road. And, unfortunately, there is no way to know how quickly an economy will respond to changes in monetary policy. If a country’s central bank allows the economy to expand too rapidly- by keeping too much money in circulation, for example- it may cause “bubbles” and inflation. If it slows down the economy too much, an economic recession can result, bringing financial turmoil and rampant unemployment.

Central bankers, therefore, need to be prescient- and extremely careful- keeping one eye on inflation, which is the product of an overheating economy, and one eye on unemployment, which is the product of a slowing economy. In the 21st century economy, however, regulating money supply has become a much more difficult task. With the amount of capital flowing around the world dwarfing many countries’ money supplies, it’s almost impossible to know with certainty what the effect of any monetary decision will have on a local economy-let alone on the world.

Inflation and unemployment have become the yin and the yang of the 21st- century economy. When one rises, the other tends to fall. Although neither is perceived as good, in recent years, inflation has become the dominant preoccupation of economic decision makers. It used to be that reports of a surging economy brought euphoria to the markets. If factories and businesses were producing at full capacity and everyone had a job, the markets would greet the news with approval, confident that in a booming economy, everyone would be better off. However, after the severe inflation scares of the past decades, with prices rising out of control in many countries, leaders realized that an economy growing too quickly can be too much of a good thing. Reduced unemployment means that companies are forced to pay higher wages for scarce workers, and prices of goods and services need to be raised to pay for the increased cost.

In a booming economy, inflation can grow quickly as consumers and businesses begin to compete for increasingly scarce goods and services- and scarcity leads to higher prices. The result is usually a vicious circle of wage and price increases that end up hurting almost everyone- especially those on fixed incomes, who see their buying power decline when prices rise.

The international markets watch each country’s inflation rate carefully- always on the lookout for signs that an economy is stalling or overheating. International investors, including gigantic pension funds, hedge funds, and international banks, move billions and sometime trillions of dollars, pounds, euros, and yen around the world on any given day, looking for the best return on their investment. When a country’s economy looks like it is growing too strongly, and inflation is about to rear its ugly head, international investors can move their money out of an economy at a moment’s notice, preferring to invest their funds in countries with more stable economic growth and low inflation.

Just as a prudent driver keeps an eye on the road ahead, a country’s central bank tries to keep the economy on a steady course. Central bankers need to look at all the economic data, such as factory orders, housing starts, consumer credit, retail sales, manufacturing, construction and employment figures-some of which are leading and some of which are lagging indicators-in an ongoing effort to keep the economy from overheating or sliding into recession.