Saturday, August 27, 2011

Central Bank Malpractice

Time inconsistency and central bank credibility have been important aspects of monetary economics for decades.

However, sometimes I think that the concerns central bankers express regarding credibility are better described as avoiding responsibility. They want to pretend they are never wrong.

Listening to Greenspan explain the economic situation in the U.S. in past years, I couldn't help but hear, "It's the economy's fault."

Sure, I understand that matching the quantity of money to the demand to hold money, keeping the market interest rate equal to the natural rate, or stabilizing the growth path of nominal expenditures is difficult. I believe that Greenspan's performance was very good--not perfect--but as good as can be expected.

Still, when money expenditures slowed or expanded too much, rather than just admit that the quantity of money was too small or too high, or interest rates too high or too low, instead, it was the economy that did it.

To me, there is a step where the Fed should take responsibility.

Using our best information and models, we set the quantity of money and short term interest rates at levels we thought were appropriate. Unfortunately, we were in error. (Taking responsibility.) Then, it would be OK to have some excuses. Our models or the information we had available at the time failed to account for financial innovation, or changes in risk premiums, or whatever. It is a difficult job. We are committed to continuous improvement.

But no. The taking responsibility part is dropped. The Fed was right. The problem was that the economy was wrong.

And why is that so important to the Fed? Perhaps it is just the normal human desire to avoid accepting responsibility, but I think the Fed has a "Noble Lie" rationale. By pretending the Fed does no wrong, then it can maintain its independence--it's ability to do what it thinks best. If it accepted responsibility for its errors, then those nasty politicians would start interfering in the Fed's business.

Of course, lately, some have argued that the Fed isn't doing what it thinks best. Apparently, the political consequences of causing too high inflation is preventing the Fed from an appropriately expansionary monetary policy.

Certainly, when Bernanke lectures Congress about avoiding an immediate reduction in government spending, but instead promising to do something about government spending some years from now, he is showing that he believes that money expenditures on output are too low. Then, in order to reassure the market that deflationary free fall should not be a concern, he explains, correctly, that the Fed has a variety of ways of loosening monetary policy further.

So, why not do it now, and raise GDP (nominal) to where it should be? Because then, if it doesn't work out, it will be the Fed's fault. And that would violate the first rule of the Federal Reserve--avoiding responsibility. It is never our fault. It is the economy's fault.

Is that maintaining the Fed's credibility? Or is it just irresponsible malpractice?

1 comment:

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