Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
There are several strands to the mainstream neo-liberal attack on government macroeconomic policy activism. They get recycled regularly. Yesterday, I noted the temporal sequencing in the attacks – need for deregulation; financial crisis; sovereign debt crisis; financial repression and so on. Today, I am looking at another faux agenda – the demand that central banks should be independent of the political process. There has been a huge body of literature emerge to support this agenda over the last 30 odd years. The argument is always clothed in authoritative statements about the optimal mix of price stability and maximum real output growth and supported by heavy (for economists) mathematical models. If you understand this literature you soon realise that it is an ideological front. The models are note useful in describing the real world – they have no credible empirical content and are designed to hide the fact that the proponents do not want governments to do what we elect them to do – that is, advancing general welfare. The agenda is also tied in with the growing demand for fiscal rules which will further undermine public purpose in policy.
The WSJ carried a story today (May 25, 2010) from Eamonn Butler who is attached to the Adam Smith Institute in the UK which calls itself the “leading libertarian think tank” which “engineers policies to increase Britain’s economic competitiveness, inject choice into public services, and create a freer, more prosperous society”. Heavy stuff!
As an aside, I wonder what Adam Smith would think if he saw these libertarian fanatics using his name in vein. I never liked much of what Smith wrote but his weave is considerably more complex than the approach taken by the free-market zealots at “his” institute.
The article – An Economic Responsibility Act for Britain – carried the sub-title “(t)he problem for democracy is not how to choose leaders, but how to restrain them”. You can see a more elaborate version of the same nonsense HERE.
Butler claims that it is in the best interests of nations if “governments were properly restrained in the first place”. He lauds the move made in the early 1990s as the neo-liberal reform agenda was ravaging New Zealand. He says:
Thanks to former Reserve Bank of New Zealand Governor Donald Brash, many countries adopt inflation targeting, and world inflation has plummeted from an average of nearly 30% in the early 1990s to just 3% today. We need the same sort of idea to control government spending and borrowing too.
I dealt with Brash and his New Zealand disaster in this blog – The comeback of conservative ideology. I noted that at the height of their blind devotion to inflation targeting and scrapping the welfare system there were outbreaks of tuberculosis in secondary schools in the working class suburbs and children coming down with ricketts, a disease arising from malnutrition and poverty, which was largely solved in the advanced world.
Moreover when you study the inflation targetting literature you find that the claims about its effectiveness in disciplining inflation are grossly exaggerated. As I explain in this blog – Inflation targeting spells bad fiscal policy – the evidence is clear – inflation targeting countries have failed to achieve superior outcomes in terms of output growth, inflation variability and output variability; moreover there is no evidence that inflation targeting has reduced inflation persistence.
Other factors have been more important than targeting per se in reducing inflation. Most governments adopted fiscal austerity in the 1990s in the mistaken belief that budget surpluses were the exemplar of prudent economic management and provided the supportive environment for monetary policy.
The fiscal cutbacks had adverse consequences for unemployment and generally created conditions of labour market slackness even though in many countries the official unemployment fell. However labour underutilisation defined more broadly to include, among other things, underemployment, rose in the same countries.
Further, the comprehensive shift to active labour market programs, welfare-to-work reform, dismantling of unions and privatisation of public enterprises also helped to keep wage pressures down.
Anyway, Butler thinks it is good for us if we extend the constraints on the use of economic policy. He claims that the Stability and Growth Pact rules that exist in the EMU are too lenient and are largely ignored.
I note this is becoming a common theme and some commentators on my blog have also questioned whether they are binding. Clearly they are not binding because the limits have been exceeded often. I read somewhere that 51 per cent of observations on public deficits since the EMU began exceed the 3 per cent of GDP rule.
But the point is not that they are exceeded. The real issue is that they are used to dictate the direction and magnitudes of the policy shifts demanded if they are exceeded. That is why they are important and damaging to national policy.
Butler wants to go further and claims the UK needs “something more akin to constitutional limits on government budgets – our own Saakashvili-style Economic Responsibility Act”. The reference to Saakashvili (Georgia President) relates to that nation’s harsh fiscal rules.
Accordingly, Butler lists 6 new rules. First, he wants to “cap public spending at one-third of GDP” and says:
Forget the Keynesian argument that a shrinking economy needs the “stimulus” of public spending. That’s like taking blood from one arm of a dying patient and putting it in the other. For every job saved, at least another is lost. And spending caps would prevent politicians setting off boom and bust cycles in the first place.
So he believes as a religious article of faith that there is complete crowding out in the labour market and therefore a multiplier of zero. No empirical research worth anything has found that result.
Further, he has no conception of the relationship between the government and the non-government sector to think that government net spending just recycles demand. You will see if you read this suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – that government net spending and reserves to the non-government sector.
Second, he would “cap deficits at 3% of GDP, and stick to it” which shows he doesn’t understand that the public deficit outcome is an ex post result dependent on private spending (and saving) decisions and external balances. There is nothing sacrosanct about 3 per cent. Even under general conditions of ECB austerity since the EMU began the 3 per cent rule has been violated often because of the operation of the automatic stabilisers.
Third, he wants to cap public “debt at 40% of GDP” because “(i)nternational rating agencies are comfortable with debts of 40%”. So with an independent central bank (unelected and unaccountable) and fiscal policy ultimately capped by what the “international rating agencies” think there isn’t much room for democracy in Butler’s UK.
I find it ironical that the freedom mongers have very limited appreciation of what freedom actually is. Allowing the unemployed to be “bullied” by amorphous bond markets is not a path to freedom.
His fourth relates to independent costing of “off-the-books obligations” and the requirement that they be fully funded. And thereby revealing he doesn’t realise that a sovereign government does have to fund any of its spending.
Fifth, he wants “independent panel of economists, like Britain’s new Office of Budget Responsibility” to allocate borrowed funds to true investment projects only. Another blow for democracy.
Finally, he want to force “public referendums” before taxes can be increased with many types of taxes banned.
The thing I am noting now in the public debate as is it unfolding three years or so after the crisis began is that there is growing denial that fiscal policy actually did anything to stop the meltdown.
I guess all the conservative fiscal policy haters who lay low as the world according to them (that is, the overly deregulated world they had pushed for over the last few decades) was going south fast, have been working on plans to make their comeback. The latest evolution is the denial that fiscal policy matters again and therefore the blithe advocacy of harsh fiscal rules as if they would not constrain economic growth and worsen private spending collapses.
Monetary or fiscal policy?
This theme sort of came up in the WSJ today (May 26, 2010) in two articles. The first article – American Jobbery Act -claims in relation to new Budget discussions in the US at the moment, that:
Sander Levin, the new Ways and Means Chairman, calls this exercise the American Jobs and Closing Tax Loopholes Act. Mr. Levin has waited 28 years to ascend to this throne and this is the best he can do? “Jobs” were also the justification in February 2009 for the $862 billion stimulus that has managed to hold the jobless rate down to a mere 9.9%. Maybe Mr. Levin’s spending can hold it down to even greater heights.
Apart from the nasty insinuation about the carer of this gentleman (Levin), what other point is being made? Is a $862 billion stimulus “big” or something? Big in relation to what? There is no sense in talking about absolute nominal spending figures.
MMT tells me that the $862 billion was not sufficient to keep the unemployment rate down below 9.9 per cent and sufficient to stop it rising higher than that. It is clear that the spending gap in the US was so much larger than anyone initially guessed that the budget plans were deficient. Not to mention the fact that the terrorists were continually yelping at the heels of the Government to modify their injection.
The rest of the article is a diatribe about so-called “unfunded” spending plans (that is, within revenue) that will just blow out the public debt even further.
The other article – Japanese Lessons for the Fed – was in contradistinction.
The author noted that the US central bank chairman Ben Bernanke was in Tokyo yesterday at a Bank of Japan conference (more about which later) and should take a lesson from Japan while he is over there. The lesson? That monetary policy has limited scope to deal with a major spending collapse which then evolves into an entrenched period of deflation.
The article says (with reference to the BOJs quantitative easing experiments):
The Japanese helicopter is running out of fuel. For the better part of 15 years, the BOJ has tried everything it can possibly think of to coax more growth and rising prices, including its zero-interest-rate policy; buying commercial paper, bonds and stocks; cramming capital into banks; and various short-term lending facilities. On Friday the BOJ floated one more idea: lending banks an as-yet-undetermined amount of money at the current benchmark interest rate (now at 0.1%) to support lending that “strengthens the foundations of economic growth”-basically, productive investments.
The emphasis on monetary policy is consistent with the dominant themes in this neo-liberal era – that fiscal policy should be passive and monetary policy should be the primary counter-stabilisation tool.
However the author notes that “Japan’s banks are not facing a liquidity shortage” and that “Japan’s economy is so weak that there aren’t enough companies that need capital to finance growth”.
While the author is still in the mainstream mould, the point is totally consistent with Modern Monetary Theory (MMT). Commercial banks create deposits when they make loans and get the reserves later. Their propensity to make loans is constrained by the number of willing and credit-worthy borrowers. End of story.
So given that experience, what advice is forthcoming for the US Fed chairman?
… for an economist who has famously examined Japan’s lost decade to avoid a recurrence in America, Mr. Bernanke could usefully come away from his Tokyo sojourn with a few updated lessons in mind. The most important message he could spread when he gets back to Washington is that for all monetary policy’s importance, it’s no substitute for pro-growth fiscal and regulatory policies.
There is overwhelming evidence to support the case that fiscal policy was effective in the recent downturn in putting a floor in the spending collapse. This viewpoint permeates the IMF’s official position down through various central banks and treasuries and is well-grounded in empirical research.
Anyway, this led me to read the speech that Bernanke gave in Tokyo yesterday because it relates back to the discussion earlier about central bank independence and the need to have as little policy freedom for governments as possible. So the theme reconnects.
Ben Bernanke in Tokyo
US central bank chairman Ben Bernanke gave this speech – Central Bank Independence, Transparency, and Accountability – to the Institute for Monetary and Economic Studies International Conference, hosted by the Bank of Japan in Tokyo yesterday (May 25, 2010).
He began by noting the extent to which central banks around the world intervened to overcome the financial instability and arrest the spending collapse as the crisis unfolded.
He then turned to one of the themes that is around at the moment. The neo-liberals (such as the Peter G. Peterson Foundation) are arguing that so-called central bank independence is going to be compromised by governments bulging with debt. Allegedly, governments will force the central banks to inflate the economy and/or “monetise” their deficits to reduce the public debt ratios.
On this, Bernanke said:
In undertaking financial reforms, it is important that we maintain and protect the aspects of central banking that proved to be strengths during the crisis and that will remain essential to the future stability and prosperity of the global economy. Chief among these aspects has been the ability of central banks to make monetary policy decisions based on what is good for the economy in the longer run, independent of short-term political considerations. Central bankers must be fully accountable to the public for their decisions, but both theory and experience strongly support the proposition that insulating monetary policy from short-term political pressures helps foster desirable macroeconomic outcomes and financial stability.
Central bank independence (CBI) refers to the freedom of monetary policy-makers to set policy without direct political or governmental influence.
The idea took hold in the mid-1970s as the neo-liberal onslaught began to dominate policy-makers. This dominance was consolidated by the early 1980s. It was time when the OPEC oil price rises had not worked their way out of cost structures around the world and inflation was still an issue.
The central bank independence push was based on the Monetarist claims that it was the politicisation of the central banks that prolonged the inflation (by “accommodating” it). The arguments claimed that central bankers would prioritise attention on real output growth and unemployment rather than inflation and in doing so cause inflation.
The Rational Expectations (RATEX) literature which evolved at that time then reinforced this view by arguing that people (you and me) anticipate everything the central bank is going to do and render it neutral in real terms but lethal in nominal terms. In other words, they cannot increase real output with monetary stimulus but always cause inflation. Barro and Gordon (1983) ‘A Positive Theory of Monetary Policy in a Natural Rate Model’, Journal of Political Economy, 91, 589-610 – was an influential paper in this stream of literature. It is highly flawed but that is another story.
But underlying the notion was a re-prioritisation of policy targets – towards inflation control and away from broader goals like full employment and real output growth. Indeed, whereas previously unemployment had been a central policy target, it became a policy tool in the fight against inflation under this new approach to monetary policy.
This leads us to consider the NAIRU underpinnings of CBI. Bernanke argues that the justification for CBI relates to the “consequence of the time frames over which monetary policy has its effects”. Thus:
Because monetary policy works with lags that can be substantial, achieving …. [price stability] … requires that monetary policymakers take a longer-term perspective when making their decisions. Policymakers in an independent central bank, with a mandate to achieve the best possible economic outcomes in the longer term, are best able to take such a perspective.
Whether monetary policy is effective or not is another question. But the logic the mainstream believe in as an article of religious faith is that by controlling prices they maximise output over the long-run. In other words they are obsessed with the NAIRU concept. Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.
As an example, in the 1996 Statement on the Conduct of Monetary Policy, issued by the Australian Treasurer and Reserve Bank Governor set out the independence charter for the RBA and elaborated the adoption of inflation targeting as the primary policy target. The 1996 Statement said the RBA:
… adopted the objective of keeping underlying inflation between 2 and 3 percent, on average, over the cycle … These objectives allow the Reserve Bank to focus on price (currency) stability while taking account of the implications of monetary policy for activity and, therefore, employment in the short term. Price stability is a crucial precondition for sustained growth in economic activity and employment.
The rest of the text emphasised the need to target inflation and inflationary expectations and the complementary role that “disciplined fiscal policy” had to play. Price stability in some way generates full employment, which they define as the NAIRU. Of-course, in a stagflationary environment if price spirals reflect cost-push and distributional conflict factors, such an approach can surely never work. So the RBA will always control inflation by imposing unemployment.
How does the RBA answer this apparent contradiction? The RBA says that it is sensitive to the state of capacity in the economy when it pursues a change of interest rates aiming at the inflation target but that the trade-off between inflation and unemployment is not a long-run concern because, following NAIRU logic, it simply doesn’t exist.
Ultimately the growth performance of the economy is determined by the economy’s innate productive capacity, and it cannot be permanently stimulated by an expansionary monetary policy stance. Any attempt to do so simply results in rising inflation. The Bank’s policy target recognises this point. It allows policy to take a role in stabilising the business cycle but, beyond the length of a cycle, the aim is to limit inflation to the target of 2-3 per cent. In this way, policy can provide a favourable climate for growth in productive capacity, but it does not seek to engineer growth in the longer run by artificially stimulating demand.
As I noted above – the evidence is clear – inflation targeting countries have failed to achieve superior outcomes in terms of output growth, inflation variability and output variability; moreover there is no evidence that inflation targeting has reduced inflation persistence.
And in the related blog – Inflation targeting spells bad fiscal policy – I provide the evidence to show that the real effects (so-called sacrifice ratios) remain high whether you target or not. In other words, this era of monetary policy dominance has not delivered anything like full employment.
Central banks operating under this charter have forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities have further worsened the situation with complementary austerity.
Bernanke compares his preferred CBI to the case where “a central bank subject to short-term political influence” and:
… may face pressures to overstimulate the economy to achieve short-term output and employment gains that exceed the economy’s underlying potential. Such gains may be popular at first, and thus helpful in an election campaign, but they are not sustainable and soon evaporate, leaving behind only inflationary pressures that worsen the economy’s longer-term prospects. Thus, political interference in monetary policy can generate undesirable boom-bust cycles that ultimately lead to both a less stable economy and higher inflation.
So if you ever thought that Bernanke wasn’t a 100 per cent mainstream New Keynesian who believed in long-run neutrality (the inability of monetary policy to influence the real growth in the long-run) then that statement will disabuse you of that leaning.
What is the evidence that CBI delivers superior inflation results?
The so-called Cukierman index of CBI is widely used and “assesses the fulfillment of 16 criteria of political and economic independence using a continuous scale from zero to one, with higher values also indicating higher CBI. The overall index is based on a weighted average of the individual criteria” (Source)
The following graph uses the values of the CBI index for the year 2000 and plots inflation against it for various countries. This is not a robust test of the hypothesis but visually nothing is happening to suspect that nations with more CBI (as measured) have lower or higher inflation rates.
The more robust empirical work on the subject delivers mixed results and the methodologies are highly compromised. First, they usually cannot control for other factors which might explain differences in inflation performance across countries. Studies that have gone to some trouble to introduce credible control factors typically find no role for CBI in controlling inflation.
Second, there are the so-called endogeneity problems. The studies tend to treat the CBI index value as exogenous (that is, given and not influenced by other factors in the models). It has been shown that nations that have high levels of “measured” CBI also introduce policies that focus on austerity. In other words, if the political factors supporting the push for austerity were absent, you would not get any traction by making the central bank independent.
The conclusion that I have reached from studying this specific literature for many years is that there is no robust relationship between making the central bank independent and the performance of inflation.
Bernanke went on to talk about credibility – another one of those mainstream jargon tools used to whip democratic decision making. He says that:
However, a central bank subject to short-term political influences would likely not be credible when it promised low inflation, as the public would recognize the risk that monetary policymakers could be pressured to pursue short-run expansionary policies that would be inconsistent with long-run price stability. When the central bank is not credible, the public will expect high inflation and, accordingly, demand more-rapid increases in nominal wages and in prices. Thus, lack of independence of the central bank can lead to higher inflation and inflation expectations in the longer run, with no offsetting benefits in terms of greater output or employment.
First, he claimed earlier (correctly) that “monetary policy works with lags that can be substantial”. This is because it operates, principally, via changing short-term interest rates, which then have to feed through the term structure, and then interest-rate sensitive spending decicions have to change. There is huge uncertainty involved because a rising interest rate helps some and hinders others. There is very little robust work that has been done to show categorically that the winners are overpowered by the losers (so rising interest rates stifle demand).
But the point is, how effective will “short-run expansionary policies” be if there are substantial lags.
Second, at present the expansion of bank reserves has been quite a characteristic of the monetary policy response to the crisis. This expansion has violated all the mainstream beliefs – erroneous as they are. It hasn’t been inflationary. It hasn’t increased bank lending. The sky hasn’t fallen in!
So given we have been experiencing this quite fundamental shift in central bank balance sheets for nearly 3 years now, why haven’t private agent expectations adjusted so that they are demanding “increases in nominal wages and in prices” to insulate themselves from inflation? Answer: Bernanke’s view is consistent with RATEX which has no empirical content at all. It is a far-fetched theory devised by ideologues to hide their contempt for government intervention in some “hard” mathematics.
Bernanke then brings in the bazooka:
… a government that controls the central bank may face a strong temptation to abuse the central bank’s money-printing powers to help finance its budget deficit …. Abuse by the government of the power to issue money as a means of financing its spending inevitably leads to high inflation and interest rates and a volatile economy.
This is the reason governments should directly control the central bank to avoid issuing debt. The point is that it is the act of net spending in a fiat monetary system that drives aggregate demand and exposes fiscal policy to the risk of inflation. The monetary operations (the central bank liquidity management) do not increase or reduce this risk.
So if the government just leaves the net spending impact on the cash system as reserves (earning nothing) that doesn’t increase the risk of inflation resulting from the spending in the first place, relative to if they drain those reserves by offering an interest-bearing public bond.
From a conceptual perspective it is important to understand that a budget deficit records a flow of net spending. It is not a stock. So when we see a figure 3 per cent of GDP, that just says that the flow of net public spending in a year (or whatever) was 3 per cent of the flow of all spending.
With the current voluntary obsession with issuing public debt – the flow adds to the stock of public debt at the end of each period. If you didn’t issue debt the stock arising from the flow would manifest as increased bank reserves. Would the treasury care about that? Why would they?
From a MMT perspective, the concept of CBI is anathema to the goal of aggregate policy (monetary and fiscal) to advance public purpose. By obsessing about inflation control, central banking has lost sight of what the purpose of policy is about.
This analogy by Henry Liu is clever in this respect:
Central bankers are like librarians who consider a well-run library to be one in which all the books are safely stacked on the shelves and properly catalogued. To reduce incidents of late returns or loss, they would proposed more strict lending rules, ignoring that the measure of a good library lies in full circulation. Librarians take pride in the size of their collections rather than the velocity of their circulation.
Central bankers take the same attitude toward money. Central bankers view their job as preserving the value of money through the restriction of its circulation, rather than maximizing the beneficial effect of money on the economy through its circulation. Many central bankers boast about the size of their foreign reserves the way librarians boast about the size of their collections, while their governments pile up budget deficits.
The point is that under the CBI ideology, monetary policy is not focused on advancing public purpose. Fighting inflation with unemployment is not advancing public purpose. The costs of inflation are much lower than the costs of unemployment. The mainstream fudge this by invoking their belief in the NAIRU which assumes these real sacrifices away in the “long-run”.
Bernanke later on in his speech addresses the degree of independence:
I am by no means advocating unconditional independence for central banks. First, for its policy independence to be democratically legitimate, the central bank must be accountable to the public for its actions. As I have already mentioned, the goals of policy should be set by the government, not by the central bank itself; and the central bank must regularly demonstrate that it is appropriately pursuing its mandated goals.
Sure, but when does the public get to elect the central bank board? And with interest rates playing the bogey person role in modern economies given the dependence in the private sector on debt, changes in monetary policy carry political messages for that the government has to sanitise.
The point is that this approach to policy-making forces fiscal policy to adopt a passive role. If it doesn’t then it will be seen to be working against the rigid application of the monetary policy rules. The consequences of that have been the persistent labour underutilisation that has plagued advanced nations for 35 years even during periods of economic growth.
This speech is another indication that the policy approach that took us into the crisis will remain largely intact along the road to the next crisis. Monetary policy will remain the dominant counter-stabilisation tool, despite the uncertainty about whether it actually is very effective, and fiscal policy will become passive again.
The pools of underutilised labour resources will remain high for years to come as a result of this policy mix.
If I was in charge I would merge the central bank with the treasury, release thousands of bright former central bankers via retraining into the workforce to use their brains doing something useful, and also dismantle the public debt issuance machinery.
Fiscal policy would become the dominant tool and short-term interest rates would be set at zero. Please read my blog – The natural rate of interest is zero! – for more discussion on this point. I would control inflation via a Job Guarantee.
But I will write about that structural reorganisation idea another day.
That is enough for today!