« Housing Stimulus Bill Has Little Help for Homeowners | Main | Brad DeLong: Anatomy of the Global Economy »

Saturday, April 05, 2008

"Demythologizing Central Bankers"

Thomas Palley on central bankers and the Great Moderation:

Demythologizing Central Bankers, by Thomas I. Palley: It is often said that the winners get to write history, which matters because the way we tell history frames our understandings. What is true for general history also holds for economic history, and the way we tell economic history affects our expectations and aspirations for the economy.

The last twenty-five years have witnessed a boom in the reputation of central bankers. This boom is based on an account of recent economic history that reflects the views of the winners. Now, with the U.S. economy entering troubled waters that reputation may get dented. More importantly, there is an opportunity to tell an alternative account of recent history.

The raised standing of central bankers rests on a phenomenon that economists have termed the “Great Moderation.” This phenomenon refers to the smoothing of the business cycle over the last two decades, during which expansions have become longer, recessions shorter, and inflation has fallen.

Many economists attribute this smoothing to improved monetary policy by central banks, and hence the boom in central banker reputations. This explanation is popular with economists since it implicitly applauds the economics profession by attributing improved policy to advances in economics and increased influence of economists within central banks. For instance, the Fed’s Chairman is a former academic economist, as are many of the Fed’s board of governors and many Presidents of the regional Federal Reserve banks.

That said, there are other less celebratory accounts of the Great Moderation that view it as a transitional phenomenon, and one that has also come at a high cost.

One reason for the changed business cycle is retreat from policy commitment to full employment. The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of two decades of wage stagnation and a rupturing of the link between wage and productivity growth.

Disinflation also lowered interest rates, particularly during downturns. This contributed to successive waves of mortgage refinancing and also reduced cash outflows on new mortgages. That improved household finances and supported consumer spending, thereby keeping recessions short and shallow.

With regard to lengthened economic expansions, the great moderation has been driven by asset price inflation and financial innovation, which have financed consumer spending. Higher asset prices have provided collateral to borrow against, while financial innovation has increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices have supported increased debt-financed spending, thereby making for longer expansions. This dynamic is exemplified by the housing bubble of the last eight years.

The important implication is that the Great Moderation is the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. Those factors now appear exhausted. Further disinflation will produce disruptive deflation. Asset prices (particularly real estate) seem above levels warranted by fundamentals, making for the danger of asset price deflation. And many consumers have exhausted their access to credit and now pose significant default risks.

Given this, the Great Moderation could easily come to a grinding halt. Though high inflation is unlikely to return, recessions are likely to deepen and linger. If that happens the reputations of central bankers will sully, and the real foundation and hidden costs of the Great Moderation may surface. That could prompt a re-writing of history that restores demands for a return to true full employment with diminished income inequality. How we tell history really does matter.

For more about the reasons for the Great Moderation, see this search of the site, or this podcast.

I have to disagree that economists have focused solely or mostly on monetary policy as the central factor n the Great Moderation, though it is usually cited as one potential factor.

Brad DeLong cites three factors:

First, some economists argue that we have just been lucky, because there has been no structural change that has made the world economy more resilient. Second, central bankers have finally learned how to do their jobs. ... The final explanation is that financial markets have calmed down. ...

and he agrees with Thomas Palley:

my guess is that we would be well-advised to put our money on the theory that our central bankers today are more skilled, more far-sighted, and less prone to either short-sightedly jerking themselves around or being jerked around by political masters who unpredictably change the objectives they are supposed to pursue year after year.

I added:

There are actually more than three hypotheses. The ones I can recall are:

  • Better technology, e.g. information processing allowing better inventory control and management
  • Better policy, e.g. inflation targeting
  • Good luck so that no big shocks hit the economy
  • Financial innovation and deregulation
  • Globalization leading to dispersed risk
  • Better business practices (this is less common, here's the link)
  • Increased rationality of participants in financial markets
  • Demographic shifts (again, since this less commonly offered as an explanation, here's the link)

The cross-country evidence on moderating output fluctuations does not correspond as well as you would hope to the adoption of inflation targeting if better policy is the primary factor behind the Great Moderation. So, while I think central banking is part of the explanation, particularly for moderating inflation, I don't think it's the whole story (the explanations are not mutually exclusive, and the reasons for declining output variability may differ from the reasons for declining inflation).

Though it's difficult to sort out because many of these factors occurred at roughly the same time (e.g. computers and inflation targeting both appeared at about the time output and inflation began moderating in the 1980s), and different papers offer different answers, I believe that technology, digital information technology in particular, has also made a big difference in smoothing fluctuations in recent decades.

Recent events force me to reconsider Brad's final explanation for the Great Moderation, i.e. that "financial markets have calmed down," since it does appear that increased volatility in financial markets is causing increased volatility in both inflation and output. In that regard, I think one explanation given above for the Great Moderation - financial innovation and deregulation - needs to be reexamined. If anything, over the longer run those factors appear to be the source of increased volatility rather than increased stability.

    Posted by on Saturday, April 5, 2008 at 01:29 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (29)


    TrackBack URL for this entry:

    Listed below are links to weblogs that reference "Demythologizing Central Bankers":


    Feed You can follow this conversation by subscribing to the comment feed for this post.