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Fundamental questions about the optimal set-up for central banks are examined in this book. In particular, we ask whether the model of an independent central bank devoted to price stability,1 which affirmed itself in most advanced economies at the turn of the last century, is the final resting point of a long and complex development that started centuries ago. We dissect the hypothesis that the Great Recession has prompted a reassessment and a possible revision of that model....

The central banking model prevailing before the Great Recession suffered six hits during the crisis. First, new financial stability responsibilities created dilemmas in the use of the interest rate. Second, quantitative easing blurred the borders between monetary and fiscal policy. Third, the action to support banks and, in the euro-area, peripheral sovereigns created moral hazard. Fourth, the ECB had to take on itself the task of preserving the euro. Fifth, the ECB had to participate in the so-called troika. Sixth, both the Fed and the ECB had to adopt a more global perspective. This chapter concludes that these hits have not basically jeopardized the pre-crisis central bank model. Still, four of the six hits to the pre-crisis central bank model identified above have a good probability of requiring changes in the pre-crisis model, thus some incremental adaptations to that model are proposed.

Monetary policy before the Great Recession rested on three unacknowledged assumptions: first, the central bank could effectively control a short-term rate; second, this short-term rate had a stable relationship with longer/riskier rates; third, the central bank could move the short-term rate up or down as needed. In one or the other phase of the Great Recession one or more of these assumptions no longer held. The Fed and the ECB reacted to these difficulties, adding balance sheet management to their weaponry. After the failure of Lehman Brothers, measures of financial stress exploded and the banking sector was affected by an acute lack of liquidity, large losses, a disproportion between diminished capital and a riskier balance sheet, low profitability, enhanced competition of shadow banks, deleveraging, and difficulties in raising new capital. The Fed and the ECB could address some, but not all, of these problems.

The chapter describes the historical process as well as the analytical and empirical factors that, at the end of the twentieth century, led to the dominance, in advanced economies, of a central bank model based on an independent institution devoted to price stability as its overriding objective. The central bank pre-crisis model was elegant, performing, and efficient. However, it could not easily accommodate the pursuit of a traditionally important central bank objective: financial stability. Indeed, since central banks have, in essence, just one tool, that is, the interest rate, the pursuit of a financial stability objective in addition to a price stability objective could create dilemma situations. In the two decades between the mid-1980s and the mid-2000s, the economies of advanced economies were very stable, and this period was thus identified as Great Moderation. However, subsequent experience showed that, in this period, the crisis was incubating.