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 U.S., where holding executive power accountable verges on religion, the Federal Reserve has won for itself remarkable freedom of action.
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.
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 U.S., 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.)
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