Even before the Great Recession,
mainstream economics offered few clear-cut policy prescriptions.
At the top of an embarrassingly short list were two rules of
monetary policy: keep prices stable and politics out of central-
bank operations. Now, it may be time to rethink both.
Economists advanced these principles with great confidence
until recently — and the confidence seemed justified. Decades
of theory and practice taught that inflation was economic
poison. It blurs price signals and holds back growth. The idea
that you could create jobs by tolerating a bit more inflation
had been discredited. It might be true for a while, but the gain
wouldn’t stick. Central banks should aim to keep prices stable -
- meaning, in practice, inflation of, say, 2 percent a year.
In carrying out that mandate, the second rule applied. The
task was plain and simple so politics wasn’t required.
Governments could set the objective — stable prices — and let
central banks get on with it. Putting politicians in charge of
monetary policy was a bad idea. With an eye on the electoral
cycle, they would be tempted to let inflation rise, either to
pay for government spending or boost employment (however
briefly). Better to keep central banks independent.
A dispensation like this was no great stretch in Europe,
where executive discretion is well entrenched. But it tells you
something about the grip of this thinking that even in the US,
where holding executive power accountable verges on religion,
the Federal Reserve has won for itself remarkable freedom of
action.
No Restraints
The chairman of the Fed reports to Congress now and then,
and Capitol Hill could rein in the central bank if it chose to.
But it doesn’t. Even in America, the idea that monetary policy
should stay above politics has taken hold. To deny this, as Ron Paul has in his campaign for the Republican presidential
nomination, is to put yourself on the fringe.
Yet the past three years have shown that central banking
can’t be above politics — not, at any rate, for the reasons
previously given. Whether aiming for stable prices makes sense
is actually a complicated question. And the line that separates
supposedly technical issues of monetary policy from the
unavoidably political issues of taxes and public spending turns
out be fuzzy.
Why is the case for low inflation in doubt? Because the
most powerful remedy for recession is lower interest rates. The
deeper the recession, the more aggressive the cut in interest
rates needs to be. A “stable prices” mandate for the central
bank means that interest rates will be low to begin with, and
however deeply the central bank might wish to cut them, it
cannot cut them to less than zero.
In typical recessions this problem of the “zero lower
bound” doesn’t arise, because a moderate cut in interest rates
is all that’s needed. But the recession that started in 2008 was
ferocious. The Fed cut interest rates to nothing, and it wasn’t
nearly enough. On some estimates, it should have cut rates by
five or six more percentage points — but a nominal interest
rate of minus 5 percent isn’t possible.
There were ways around this, and the Fed used them.
However, these alternatives had their own drawbacks.
Quantitative easing, where the central bank in effect prints
money to buy debt, relaxes monetary policy but is less effective
than a further deep cut in interest rates would be. Moreover,
when it works, it does so partly by raising expected inflation,
thus reducing interest rates in real terms. Raising expected
inflation sits awkwardly with the bank’s supposedly simple
mandate to maintain price stability.
Real Resources
Another drawback of quantitative easing and other
unorthodox interventions in financial markets is that they are
fiscal as much as monetary operations. They transfer real
resources. They expose taxpayers to risk, and involve implicit
subsidies on a potentially enormous scale. How to allocate the
costs and benefits of these operations across the economy is, or
ought to be, a political question — as political, say, as the
design of the Troubled Assets Relief Program. In this setting,
the usual case for central-bank independence loses all force.
One simple way to improve the potency of monetary policy
would be to raise the target rate of inflation in ordinary
times. Instead of 2 percent, for instance, make it 4 percent.
Nominal interest rates would be higher, so there would be more
room to cut them if the need arose, and the central bank would
have more firepower in a bad recession. But the disadvantage is
obvious: inflation of 4 percent the rest of the time. Even so,
the idea has been broached by none other than Olivier Blanchard,
chief economist at the International Monetary Fund, an agency
hitherto dedicated to stable-price orthodoxy.
Another possibility sounds outlandish, but don’t dismiss it
out of hand. Find ways of making nominal interest rates go
negative. The main bar to this is the existence of physical
currency, which pays a guaranteed interest rate of zero. Driving
the return on bank balances and other stores of value to less
than nothing — that is, making lenders pay interest to
borrowers — is hard as long as lenders have cash as an
alternative.
One day, this will change. If you have ever used a credit
card to buy a cup of coffee, you should find a world without
physical cash easy to imagine. As the economist Willem Buiter
has pointed out, in advanced economies the disappearance of
physical money would be a nuisance mainly for criminals, who
need it for purposes of anonymity. Once money is entirely in the
form of electronic balances, Buiter argues, there would be no
reason for zero to bind the central bank.
Improvise and Dissemble
Abolishing the greenback seems unlikely any time soon, and
few politicians would advocate a policy of higher inflation. For
now, the only remaining choice is to do what the Fed has done:
improvise and dissemble. Undertake quantitative easing (explicit
or disguised) and other enormous quasi-fiscal interventions,
acting throughout as though such measures fall within the proper
scope of central-bank independence.
Better fiscal policy by the elected governments authorized
to undertake it would lift some of the burden from central banks
and surely help, but in the recent emergency most governments
proved unequal to this challenge. “Good fiscal policy” may be
as remote a prospect as “physical currency abolition.” In the
US, the Fed had to act because after TARP and the stimulus of
2009, Congress no longer would. Faced with paralyzed
politicians, Europe’s central bank has been more cautious, and
the European Union teeters on the edge of another recession as a
result.
What the Fed did was not “monetary policy,” but until
something better comes along, it will have to do.
(Clive Crook is a Bloomberg View columnist. The opinions
expressed here are his own.)
Read more opinion online from Bloomberg View.
To contact the writer of this article:
Clive Crook at clive.crook@gmail.com.
To contact the editor responsible for this article:
James Gibney at jgibney5@bloomberg.net.