S9 Ep46: Absorbing shocks since 1891

Episode Summary

Executive Summary: Eric Monnet argues that the classic monetary-policy trilemma understates central bank power. Drawing on a new historical dataset of weekly and monthly balance sheets from 1891-2019, he shows that central banks repeatedly expanded liquidity and intervened in domestic and foreign markets to cushion global interest-rate shocks, giving them more autonomy than standard models imply—though only where currency credibility and market depth were sufficient.

Main Topics: The limits of the classic trilemma (Priority: 5/5): Monnet explains the Mundell trilemma and why open capital markets were thought to force countries to choose between exchange-rate stability, capital mobility, and monetary autonomy. Why the real world departs from theory (Priority: 5/5): He notes market imperfections, transaction costs, and global risk aversion mean arbitrage is incomplete and shocks can be transmitted through a global financial cycle. Central banks as active balance-sheet managers (Priority: 5/5): The paper adds central bank assets and liabilities to the international macro framework, emphasizing liquidity provision, domestic lending, and foreign-exchange intervention beyond just setting policy rates. Historical data from central bank archives (Priority: 4/5): The team digitized detailed weekly and monthly balance sheets collected by the Bank of France since the late 19th century, enabling cross-country analysis over more than a century. Systematic reaction to global interest-rate shocks (Priority: 5/5): Across open economies, central banks consistently adjusted balance sheets in response to changes in the leading global central bank’s rates, helping stabilize domestic money markets and exchange rates. Autonomy is real but not unlimited (Priority: 4/5): Central banks can absorb shocks because they can create money, but their effectiveness depends on market functioning and currency credibility, especially in emerging markets with dollar liabilities.

Key Arguments: The trilemma is too rigid: open economies do not always face a hard choice among the three policy goals because capital-market imperfections reduce arbitrage. A global financial cycle and investor risk aversion can transmit shocks internationally, making domestic interest rates and exchange rates partly driven by external conditions. Central banks are financial institutions with balance sheets, not just rate setters; their asset-side operations matter for macroeconomic outcomes. Historical evidence shows central banks systematically responded to changes in the leading world interest rate by expanding liquidity and intervening in markets. These interventions help explain observed movements in interest and exchange rates, which should be interpreted conditionally on central-bank balance-sheet reactions. The ability to absorb shocks comes from the power to create money, but it is constrained by credibility, market depth, and foreign-currency debt exposure.

Data Points: Historical sample period: 1891-2019 - The paper analyzes central bank balance sheets across more than a century. Number of central banks/economies in sample: About 20 - The dataset covers roughly 20 economies, representing most central banks in the world in the pre-World War I era. Late 19th-century data collection start: 1891 - The Bank of France began collecting weekly and monthly balance sheets in 1891. Bretton Woods reopening period: About one decade - Monnet describes the postwar period as one in which international finance was almost nonfunctioning for roughly ten years. Year of the Mundell trilemma formulation: 1960 - He notes the famous trilemma was formulated just after the reopening of world capital markets. Federal Reserve creation: 1913 - The US joined the central-banking system with the creation of the Federal Reserve.

Pivotal Quotes: "We have underestimated how much autonomy central banks have." — Eric Monnet: Opening framing of the paper’s main conclusion. "They are the ultimate shock absorbers in financial globalization." — Eric Monnet: Explaining why central banks can offset global financial shocks using money creation. "We have underestimated how much interest rates and exchange rates that we observe depend on the reaction of central banks." — Eric Monnet: Summarizing the implication that observed market variables are shaped by central-bank balance-sheet actions.

Implications: Listeners should rethink monetary autonomy: central banks often cushion global shocks more than standard models allow, but effectiveness depends on market structure and currency credibility. For policymakers, balance-sheet tools matter as much as policy rates.