Since the start of the financial crisis in 2008, the world has relied on central banks to prevent the world from following a script inspired by a Hollywood disaster flick. Banks everywhere were saved, at the cost of trillions of dollars, to prevent global financial collapse, and quantitative easing was launched to prop up economies, inflate asset values and create jobs.
It worked, more or less, in the sense that outright depression was avoided (although not in Greece and a couple of other lost economic causes). Confidence in central banks rose. They would protect us from the consequences of our worst sins.
That confidence might be on the verge of evaporating, especially in Europe, where it is dawning on families and investors that the central banks' ability to control broad economic events can be severely limited or virtually non-existent.
Worse, central banks are capable of missteps, in spite of their best intentions, that can compound the very damage they strove to prevent. That became abundantly apparent in a flash, on Thursday, when the Swiss National Bank (SNB) ended its three-year currency peg against the euro. The move, entirely unexpected, was a shocker, sending the Swiss franc soaring as much as 39 per cent while the Swiss stock market galloped off in the opposite direction. Currency traders around the world got walloped. Alpari, a retail currency broker in Britain, declared insolvency after the losses in clients' accounts exceeded their equity.
The shock was compounded by an untimely comment from SNB vice-chairman Jean-Pierre Danthine. He declared only three days before the franc melt-up that "the minimum exchange rate must remain the cornerstone of our monetary policy."
All in all, the SNB's performance this week was a confidence buster. Its long and expensive campaign to push the franc down to keep the Swiss economy competitive failed spectacularly as euro zone deflation took hold and the European Central Bank (ECB) moved toward full-blown quantitative easing, putting downward pressure on the euro and making the franc more attractive. The assurance from Mr. Danthine that the peg would remain in place could not have come at worse time.
Central banks have every right to change course when a cherished strategy is unsustainable or in danger of backfiring. But it seems doubtful that the debate, however informal, within the SNB to kill the peg started only after Mr. Danthine made his assurances on the status quo. If there was even the slightest doubt that the peg would endure, saying nothing would have been the sensible ploy.
The ECB has its own credibility problems, for entirely different reasons. Its effort to prevent potentially damaging deflation from gripping the euro zone and stalling the recovery does not appear to be working. But it's not entirely the ECB's fault, for it, reluctantly, is proving to be a political as well as a monetary beast. Since Mario Draghi became the ECB's president in late 2011, he has been fighting powerful forces, largely from the German camp, who dislike bond buying and quantitative easing and like austerity.
Mr. Draghi started his job with a bang. Only a few months before he took the job, the crisis (then called the debt crisis) threatened to eject Greece from the euro zone. In the summer of 2012, he swung into action, pledging that the ECB would do "whatever it takes" to keep the euro zone intact. In came a bond-buying program, called outright monetary transactions (OMT), that would see the ECB buy the sovereign bonds, in unlimited quantities, of any country in danger of getting shut out of the debt markets. It worked brilliantly, even though the ECB spent not one euro on OMT. Its mere presence was enough to send bonds plummeting.
Too bad the effort to prevent falling inflation to transform itself into deflation has been less successful. Euro zone inflation went below 1 per cent – half the target rate of 2 per cent or close to it – more than a year ago. As inflation went from a shallow to a steep decline last autumn, Mr. Draghi hinted that full-blown quantitative easing was coming. The teasing continued even though consumer prices, year on year, in the euro zone turned negative in December. Why has he not pulled the trigger?
Maybe because the ECB is less independent than advertised. If you doubt that, note that the German Constitutional Court asked the European Court of Justice to rule on the legality of the untapped OMT program. An interim opinion from the ECJ came this week and, in essence, said the ECB has the restricted and conditional right to buy bonds. While the ruling was unrelated to quantitative easing itself, it was seen as opening the legal door to quantitative easing, which may come as early as next week. It is possible that Mr. Draghi was waiting for that opinion before working out the details of any quantitative easing program.
An ECB that is constrained by legal and political pressures is an ECB that either cannot move quickly or, in some cases, may not be able to move at all to fight a crisis. With deflation a clear and present danger, and the prospect of Greece's exit from the euro zone suddenly back in the news, the ECB will need all the firepower it can muster in 2015.
The SNB's abrupt U-turn on currency policy, and the ECB's slow-motion response to the deflation threat, show that central banks are fallible, can make mistakes and can have their legal wings clipped. Investors, finance ministers and families might want to put less faith in central banks' vaunted fix-it abilities.