Since it was independence day yesterday, I thought I would try to do something patriotic, so here’s a dry look at central banking policy.

Louis-Philippe Rochon wrote a determined lit review of papers critiquing central bank policy objectives (“The more things change… inflation targeting and central bank policy,” Journal of Post Keynesian Economics, Summer 2006, vol. 28 no. 4). Early on he details the three constants in central bank policy-setting “irrespective of whether central banks are governed by monetarists, mark I and mark II, or by new Keynesians, mark I or mark II.” These are, in order:

  1. “Some degree of price stability” is desirable
  2. Inflation is an excess-demand phenomenon
  3. Monetary policy is long-run neutral

His main focus is on the foibles of inflation targeting. It’s popular, he writes, due to “the fact that most mainstream authors consider inflation targeting an impressive success, although for them, success is defined exclusively in terms of a reduction in the rate of inflation.” He points out, though, that

the success of inflation targeting is usually measured in terms of its impact on inflation rates, with little or no consideration for real factors or other economic policy goals, such as the reduction of unemployment and poverty as well as the maximization of output. Yet inflation was on a downward trend years before any inflation targeting strategies were adopted, thereby seriously undermining the notion that inflation targeting strategies had anything to do with lowering inflation.

Rather, he argues, that if central banks want to have any effect on the inflation rate, they “must raise interest rates repeatedly until the economy finally collapses,” which is probably not preferable to high inflation, but who knows? Maybe it is. His main point is that central banks, despite their hidebound commitment to inflation targeting, “are not efficient in fighting inflation, and as a consequence, inflation targeting strategies may do more harm to the economy.”

Fortunately, there are significant reasons to believe that some central banks at least are neither so hidebound nor so doctrinally simple as Rochon warns. Galbraith tells a hilarious history of the Federal Reserve’s policy changes since the 1960s in an essay called “Endogenous doctrine, or, why is monetary policy in America so much better than in Europe?” (I promised patriotism!; Journal of Post Keynesian Economics, vol. 28 no. 3). Not only has the Fed not been totally committed to any particular goal; it has at different times moved the same tools in opposite directions to achieve the same goals.

The Fed reacted to the early 1970s oil shocks with tight money policy, or high borrowing rates for banks. What followed was relatively high inflation and high unemployment, so tight money as a rule died. From 1979 to 1982, the Fed followed monetarist doctrine and a stable rate of growth in the money supply — Friedman knew best, after all, unless you buy that Volcker “never believed monetarist doctrine but only used it as a cover for anti-inflationary shock therapy” —  until that became inconvenient, at which point interest rates crashed and the Fed had swung all the way back to easy money. Monetarism’s only survivor was the non-accelerating inflation rate of unemployment (NAIRU), but that would die soon.

Alan Greenspan had a problem in 1987. Domestic expansion couldn’t continue as long as defaulted foreign loans were holding down commercial banks, but academic economists were “preoccupied with the NAIRU and the phobia of runaway inflation.” Greenspan ignored them and made “unlimited liquidity” available, averting one crisis. Then, in 1991, he attempted to increase demand for credit by decreasing short term interest rates. This failed. Banks recapitalized instead. In 1994, he raised interest rates, which had the effect that lowering interest rates was supposed to because banks had to return to commercial investment to return to more comfortable profit margins. That shouldn’t have happened, but it did, and the 1990s expansion was under way.

The climate of the 1990s, the ensuing crash, and then the early 2000s all required new explanations, finally culminating in a return to the natural rate of interest, even though “no new research of any kind justified its revival [from its death in the 1960s], and no empirical research had established the inflationary threshold implicit in any actual numerical value of the rate of interest.”

Galbraith’s history sounds like a critique. It isn’t. Instead, he highlights doctrinal inconsistency in the Fed’s history — to provide an elastic currency in 1913, consumer power in 1944, full employment and price stability in 1978, and a general rule of “one disaster per doctrine” — to make a point about the salient difference between the Federal Reserve and the European Central Bank. The ECB

has a rigid mandate, doctrinaire in the precise sense: price stability through monetary control. By design, it is constitution bound to the economic ideas predominant in Europe at the moment the monetary union was created; it is therefore unable to adjust when circumstances and beliefs change.

The Federal Reserve, in contrast, changes its goals frequently, as has been seen above. Galbraith writes:

While academic economists… may decry their own irrelevance, one cannot say they did not deserve it. It is impossible to identify any predominant doctrine of the past 30 years whose consistent application over this time would have yielded better results. Given this unhappy fact, the ability of the Federal Reserve to discard flawed and failed doctrines has to be regarded as a distinct institutional virtue. It might be better still if it did not adopt those doctrines in the first place — but once cannot have everything.

I suppose what I’m being patriotic about is that we crafted such a bizarre institution in the first place. In a sense, the Fed is perfectly post-modern, able to shift with the prevailing economic episteme of whatever crisis it’s faced with and to discard its former facts and tools as if they never had any value. I’ll light a day-late firework to that.


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