Should Central Banks Discipline Governments?

The collateral frameworks of central banks have always been a core aspect of monetary policy, but they have rarely been subject to scholarly scrutiny. Kjell Nyborg’s (2017) recent book is a notable exception. Focusing on post-crisis central banking in Europe, Nyborg argues that market inputs to the collateral policies of the European Central Bank (ECB) are so limited that they have inadvertently undermined market discipline, to the detriment of resource allocation and economic growth and, notably, to the detriment of fiscal prudence in EU member states. Nyborg holds that the way forward in central banking is to give collateral policies a disciplinary role, such that the costs of central bank funding increase when fiscal deficits and public debt approach and surpass agreed thresholds.

Nyborg’s work is misguided, however, both in terms of its analysis and the policies it advocates. Drawing upon the money view literature (Mehrling 2011, 2012, 2014), we argue that disciplinary central banking along the lines advocated by Nyborg would be destabilising, economically as well as politically. In fact, the proposed modality of central banking is the opposite of what is needed to foster financial stability in financial systems where money and capital markets are closely intertwined. The very notion of “market discipline” – core to much mainstream thinking on central banking – is predicated on a funding liquidity logic, ill-suited for market liquidity concerns.

The upshot is that the more collateral policies embed the asset valuation practices of financial market participants in central bank crisis interventions, the more destabilising those interventions will be. If central banks are to succeed in preserving market liquidity, two criteria are key: central banks must backstop the market values of core collateral assets, and their collateral policies must be unequivocally non-discriminatory and countercyclical.

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