Tuesday, November 8, 2011

On the stupidity of (some) Central Banks

The short answer from history to the question of how stupid can a central bank be? is: a central bank can be really, really stupid.

I am using ‘stupid’ in a technical sense: doing things that seriously adversely affect lots of people with no justifying benefits to any wider public good—that is, which show a lack of intelligence, understanding, reason, wit or sense. The actions may seem a good idea to the central bank at the time—due to perverse incentives, policy framings disconnected from economic reality or whatever—but in terms of wider public policy, they are (to varying degrees) disastrous. Central banks exist to serve, so how that “serving” is framed can make a great difference.

For example, hyperinflation is usually a deliberate attempt to inflate away government debt and/or generate revenue well beyond the willingness or ability to tax. It may be wicked, but it is not stupid in quite the above sense. (There are justifying benefits for decision-makers, without necessarily justified benefits.)

Beware of the French and central banks
Among stupid central banks, the all-time winner is the interwar Bank of France turning the gold standard into a doomsday device (pdf), helped by the US Federal Reserve, by building up its gold reserves without issuing money to match, so taking gold out of the monetary system, thus driving up the price of gold in the monetary system (and so the price of money, as such gold set the price of money) and thus driving down the prices of everything else. It and the Fed created the Great Deflation of 1929-32 we call ‘the Great Depression’ and so mass unemployment, the impoverishing of millions, the unravelling of much of (pdf) the world trade system, the fall of Weimar Germany and the rise of Nazism (followed by the Fall of France). It was a disaster of monumental proportions.

It was hardly the only disaster of central banking, however. Another (in)glorious episode also came from France with John Law’s Banque Générale gaining the right to issue paper money, which stimulated economic activity. The Regent, the duc d’Orleans, decided that if some paper money was good then even more paper money must be even better, leading to the truly spectacular Mississippi Bubble. This French disaster was based on the same logic (using that term loosely) as that which created the Great Deflation/Depression namely, “if some is better (some paper notes, some level of gold backing of the franc) then more is better and even more is better still.” One is reminded of the Abbe Sieyes dismissing the argument for bicameralism on the grounds that if the upper house agreed with the lower it was pointless and if it disagreed it was pernicious. Pernicious simplification passing itself off as sophistication: how very French. (Perhaps the baleful influence of Cartesian rationalism?)

By contrast, the Bank of England has a long history of considerable policy success, starting with vast improvement in management of government debt. The South Sea Bubble was rather less of a problem than the Mississippi bubble precisely because the Bank of England had disapproved from the beginning. While the Bank’s management of the gold standard over the two centuries up to 1914 suffered various bumps and problems, it had nothing to equal the aforementioned French disasters.

In our own time, the Bank of Japan’s management of the yen since the collapse of the bubble economy has come in for much criticism. However, the demographics of Japan make some of that criticism less clear-cut than is often suggested.

Even though some of the ECB’s problems are “built in”, there are also plenty of grounds for criticism for the European Central Bank (ECB), until recently with a French head (perhaps not encouraging; especially as the euro is effectively an artificial gold standard for its member countries).

Doing right
A contemporary example of successful central banking is the Reserve Bank of Australia. It has run an inflation target since 1993 (pdf). Its website is very clear on its policy target. In the words of the Reserve Bank:
The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3 per cent, on average, over the cycle. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.
The minutes of its Board meetings are published two weeks after each meeting: this matters much less than that it has a clear monetary policy regime.

The Reserve Bank sees its role as providing an anchor for private sector inflation expectations and it does so by being upfront about its policy target. That it has an explicit target since 1993 is no coincidence: the experience of the severe 1992-93 recession where inflation was squeezed out of the Australian economy in a particularly costly way made it clear to policy-makers that being explicit about monetary policy was preferable. As had the problems with monetary policy in the 1980s:
In the early 1990s, the Reserve Bank did not enjoy the largely uncritical press it receives today.
The conduct of monetary policy in the 80s was fundamentally incoherent, unsuccessfully pursuing multiple objectives and shrouded in a veil of secrecy.
Without a policy commitment to price stability, the Australian economy lacked a nominal anchor.
(Does any of this sound familiar, by chance, to American readers?)

The success of the Australian economy since then has provided strong evidence for the good sense of this approach of a clear monetary policy regime via an explicit target. But there is also no mystery about why being explicit has been a successful approach. The point of money is to facilitate transactions by massively decreasing transaction costs. Not only are the search costs that barter imposes avoided by use of money, but there are a range of problems with barter than using money eliminates or greatly ameliorates, thereby greatly facilitating transactions.

If people have reasonably accurate expectations of how (money) prices in general will go, they can make arrangements (including contracts) based on those expectations. As Canadian economist Nick Rowe points out, inflation targeting in Canada came out of pressure from the private sector. They wanted reliable expectations about prices so as to set wage contracts.

Sudden, unexpected changes in prices can leave these arrangements misaligned with actual prices. If, for example, that results in changes in the terms of labour—the ratio of labour costs to the price(s) of what the firm sells—so that wages become seriously over-priced (in normal, somewhat imprecise, economic speak, “real wages have risen”) then firms will stop hiring, workers may be sacked, firms may collapse (i.e. they absolutely stop hiring and all their workers lose their jobs). It is not good to have significant, unexpected downward shifts in price movements, since that essentially guarantees that the terms of labour will rise unexpectedly. (So unexpected disinflation can have similar effects to deflation.)

Doing wrong
Which is what happened at the beginning of the Great Recession in the US. When uberblogger Matt Yglesias calls it a “huge failure of central banking” he is absolutely correct. To put it another way, serious expectation failures were imposed on the US economy, resulting in a dramatic drop in transactions. (That the Federal Reserve decided to surreptitiously disinflate as a financial crisis—the sub-prime crash—was building made things much worse: including the financial crisis, providing some reprise [pdf] of the Great Depression.)

How did this happen? Have a look at the US Federal Reserve website. There is no statement about what the specific aim of US monetary policy is. The US Federal Reserve provides no explicit anchor for expectations in the economy. So, the US Federal Reserve can decide to disinflate—to significantly reduce the inflation rate—and there was no warning for private agents that this was happening. To act in this way is to actively degrade the level of information in the economy and so misdirect expectations.

This is deeply stupid in both theory and practice. There is no economic gain from changing monetary policy surreptitiously, there are only unnecessary costs. Australian policy makers found this out the hard way in 1992-93. They learnt the lesson and have moved on. But, alas, almost no one takes what Australia does seriously: we are too small, too far away, too “lucky”, too “colonial”. Europeans and Americans tend to be deeply parochial people, seeing themselves as the measure of all things, and so are rather bad at learning from the policy experience of others.

[Read the rest at Skepticlawyer or a slightly revised version at Critical Thinking Applied.]


  1. You are rather unfair on Orleans here. The real problem was lack of overall control, and divided motives at the heart of government.

  2. Anon: I am relying on P D Jonson's Great Crises of Capitalism (hence the link). But comments such as yours are one of the quiet joys of blogging: expansions on obscure historical happenings.