A good discussion at Cato Institute.
One of the discussants mentioned about making Fed chief completely irrelevant:
It is amusing to say the least how media continues to cook stories over rifts between Indian finance ministry and central bank. One day there is a rift and just the next day the rifts are bridged.
First and foremost, central bank independence is a very strong and wrong term. At best, one can talk about central bank autonomy like any other public sector organisation. The broad objectives are set by the government and central bank tries to work towards them. In terms of autonomy, the idea is that the govt does not interfere in day to day activity of the central bank and lets it function. When we say independence, the idea is the central bank is completely independent to do what it wishes to do which is just wrong. How can an organisation be completely independent when it is funded completely by the govt.? Moreover, all the senior appointments are made by the govt just to provide credibility and in India’s case most are required to work at finance ministry before the central bank (and rejoin FinMin after the central bank stint to get to IMF/World Bank etc). So where is the case for independence as we mean by the term really?
Second, the word became fashionable after western economists who have tried to minimise the role of government and fiscal policy in whatever possible way. So we have lots of papers on the fancy word forgetting the basic structure of the central bank which has govt written all over it. The ignorance of central bank history has also played a major role. There is a feeling that this bank has suddenly sprung up and govt is trying to intervene in it. They forget that all central banks have been created by govt to give them control over currency and finance issues. It is nothing but a govt body. Monetary policy is much like subset of govt./fiscal policy in many ways. Those who forgot these lessons have learnt it the hard way in the recent crisis. So all this talk just creates media noise and nothing else. It is like a Principal-Agent relationship where there can be some disagreements between the two which is natural and healthy.
It is ironic (as Austrian school proponents suggest), that those who talk about independence wanting to limit govt.’s role in economy, should actually argue for a limited central bank (if at all). By taking Austrian economics out of books, we hardly discuss this aspect. We have highly overdone the control central banks have over macro variables even inflation. At best, central banks can regulated the banking system as they have a monopoly over currency/money matters.
Anyways, this continuous media focus reminds me of a joke. It is like this. There is a man who is once asked by another ” Sir are you a Chinese”? The man who is an Indian responds amusingly as no. The question becomes a continuous one as the second man keeps asking the same question over and over again. The first man keep replying no with rising irritation. The questioning does not stop and the first man commits suicide in frustration. The second man follows him in heaven and asks again. The first man says “Yes I am Chinese. Now what”? The second man quips ” Well, you don’t look like one”..
In similar vein, media keeps cooking stories over differences between the two. Is there a rift? Both the govt and central bank say no. As the question becomes repetitive, the exasperated officials say yeah there is..now what? To this the media says does not look like and game goes on..
Autonomy is fine and every management need it but independence is a highly overdone term. It makes us think of central banks as some holy cow which they are not. They are actually a central planner which continue to determine prices (interest rates) of sector they regulate. No other regulator does it anymore. But thanks to the dominance of monetary policy thinking , no one even questions why should a central bank be setting interest rates for an economy? Why can’t banks change interest rates as per their financials?
Brad De Long takes on Friedman and his venerated monetarist ideas.
Ideas matter. That is the lesson of Hall of Mirrors, the American economist Barry Eichengreen’s chronicle of the two biggest economic crises of the past 100 years: the twentieth century’s Great Depression and the ongoing Great Recession, from which we are still struggling ineffectually to recover.
Eichengreen is my friend, teacher, and patron, and his book is to my mind the best explanation to date of why policymakers in Europe and the United States have reacted to the most dramatic economic collapse in almost four generations with half-hearted measures and half-finished interventions.
According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.
In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.
This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.
What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.
The debate over which interventions would be needed to put a halt to something like the Great Depression should have been a simple matter of analyzing the evidence. In economic hard times, did interest rates have little impact on the velocity of money, as Friedman suggested? Was Keynes correct when he described the concept of a liquidity trap, a situation in which easing monetary policy further proves ineffective? Is the stock of money in an economy an adequate predictor of total spending, as Friedman claimed, or is the smooth functioning of credit channels a more important factor, as Minsky argued?
This has always been the problem of economics. We hype certain individuals/ideas a bit too much. There is a lot of context, situation, local knowledge and above all luck for any policy to work. And here we do not even know whether monetarism would have worked in Great Depression. But we still bought the ideas as if they have delivered.
The dominance of Friedman’s ideas at the beginning of the Great Recession has less to do with the evidence supporting them than with the fact that the science of economics is all too often tainted by politics. In this case, the contamination was so bad that policymakers were unwilling to go beyond Friedman and apply Keynesian and Minskyite policies on a large enough scale to address the problems that the Great Recession presented.
Admitting that the monetarist cure was inadequate would have required mainstream economists to swim against the neoliberal currents of our age. It would have required acknowledging that the causes of the Great Depression ran much deeper than a technocratic failure to manage the money supply properly. And doing that would have been tantamount to admitting the merits of social democracy and recognizing that the failure of markets can sometimes be a greater danger than the inefficiency of governments.
The result was a host of policies based not on evidence, but on inadequately examined ideas. And we are still paying the price for that intellectual failure today.
The price is not just paid in US but across the world. All these ideas transmit quickly to rest of the world. What did not even work in the place where it was supposed to work is expected to work in places where it is completely ill-suited.
David Glasner says it was not even Friedman but likes of Hawtrey and Cassel which had started the monetarism ideas. Even they did not look narrowly at interest rates alone but gave a more broader perspective saying going back to gold standard in 1920s was a really bad move. Points well taken. I mean how many of us really know the works of Cassel and Hawtrey.
All these ideas keep saying one thing – know your history…
Bernanke joins the quorum of econ bloggers, was bound to be a splashy event.
The blog is here. The introductory post says:
When I was at the Federal Reserve, I occasionally observed that monetary policy is 98 percent talk and only two percent action. The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has. The downside for policymakers, of course, is that the cost of sending the wrong message can be high. Presumably, that’s why my predecessor Alan Greenspan once told a Senate committee that, as a central banker, he had “learned to mumble with great incoherence.”
On January 31, 2014, I left the chairmanship of the Fed in the capable hands of Janet Yellen. Now that I’m a civilian again, I can once more comment on economic and financial issues without my words being put under the microscope by Fed watchers. I look forward to doing that—periodically, when the spirit moves me—in this blog. I hope to educate, and I hope to learn something as well. Needless to say, my opinions are my own and do not necessarily reflect the views of my former colleagues at the Fed.
Civilian again is an important lesson for Indian policymakers. They either remain policymakers forever or join some university in US remaining in the news circuit. Most keep coming back into some commission/report.
Anyways, the second post is on low interest rates:
Why are interest rates so low? Will they remain low? What are the implications for the economy of low interest rates?
If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.
To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.
Lot of mumbo jumbo here. If markets determine so called real rates why does Fed intervene?
A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be? The best strategy for the Fed I can think of is to set rates at a level consistent with the healthy operation of the economy over the medium term, that is, at the (today, low) equilibrium rate. There is absolutely nothing artificial about that! Of course, it’s legitimate to argue about where the equilibrium rate actually is at a given time, a debate that Fed policymakers engage in at their every meeting. But that doesn’t seem to be the source of the criticism.
The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States. What features of the economic landscape are the ultimate sources of today’s low real rates? I’ll tackle that in later posts.
Being a historian, he would obviously know that things did work without Fed/central banks around. With central bank not even knowing what the rates are and just guessing their way, most of the time things only go wrong.
Interesting posts to follow. ..
A discerning friend retaliated strongly to yesterday’s post on the confusion amidst econs around Rupee valuation. The reaction was ” Do economists know value of anything? They are a highly overvalued commodity themselves”. :-)
TO add to the frustration, Robert Skidelsky has a piece on messed up macro:
AN interesting tribute to Richard Fischer who retired from Dallas Fed.
There is little doubt that he was truly a cowboy central banker in true Texan style. His speeches were easily one of the best with lots of anecdotes and humor.
Krugman adds to the article.
All the best for your future Mr. Fisher. You surely entertained us if nothing else..
Prof Shiller says based on his research so far low bond yields do not show a crisis. But never say never:
I have been thinking about the bond market for a long time. In fact, the long-term bond market was the subject of my 1972 PhD dissertation and my first-ever academic publication the following year, co-authored with my academic adviser, Franco Modigliani. Our work with data for the years 1952-1971 showed that the long-term bond market back then was pretty easy to describe. Long-term interest rates on any given date could be explained quite well as a certain weighted average of the last 18 quarters of inflation and the last 18 quarters of short-term real interest rates. When either inflation or short-term real interest rates went up, long-term rates rose. When either fell, so did long-term rates.
We now have more than 40 years of additional data, so I took a look to see if our theory still predicts well. It turns out that our estimates then, if applied to subsequent data, predicted long-term rates extremely well for the 20 years after we published; but then, in the mid-1990s, our theory started to overpredict. According to our model, long-term rates in the US should be even lower than they are now, because both inflation and short-term real interest rates are practically zero or negative. Even taking into account the impact of quantitative easing since 2008, long-term rates are higher than expected.
But the explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation.
Bond-market crashes have actually been relatively rare and mild. In the US, the biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5% in the 12 months ending in February 1980. Compare that to the stock market: According to the GFD monthly S&P 500 total return index, an annual loss of 67.8% occurred in the year ending in May 1932, during the Great Depression, and one-year losses have exceeded 12.5% in 23 separate episodes since 1900.
It is also worth noting what kind of event is needed to produce a 12.5% crash in the long-term bond market. The one-year drop in February 1980 came immediately after Paul Volcker took the helm of the Federal Reserve in 1979. A 1979 Gallup Poll had shown that 62% of Americans regarded inflation as the “most important problem facing the nation.” Volcker took radical steps to deal with it, hiking short-term interest rates so high that he created a major recession. He also created enemies (and even faced death threats). People wondered whether he would get away with it politically, or be impeached.
Regarding the stock market and the housing market, there may well be a major downward correction someday. But it probably will have little to do with a bond-market crash. That was the case with the biggest US stock-market corrections of the last century (after 1907, 1929, 1973, 2000, and 2007) and the biggest US housing-market corrections of all time (after 1979, 1989, and 2006).
It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence.
Keep watching. We have seen many things in last few years which were least imagined in the fancy finance world..
The hype over how much central banks can achieve continues. Instead if relying their limitation we keep looking for ways to glorify them.
William Pesek of Bloomberg points to how Australian economy is a two-speed one. One part of economy (housing) is booming and other (unemployment) is problematic. First wants a tighter policy and second an easier one. In the end RBA did nothing:
Does Australia need two central banks? The dilemma that faced Reserve Bank of Australia GovernorGlenn Stevens on Tuesday certainly begs the question: The argument for hiking rates was almost as compelling as the one for cutting them.
In the end, Stevens did neither, surprising markets that were betting on a 25 basis-point cut in the 2.25 percent overnight cash rate. The decision will strike many peers around the region, who have been racing to slash borrowing costs, as odd. With Australia facing the highest unemployment rate in 12 1/2-years, slumping business spending and deflation spreading around the globe, a little moreRBA stimulus would seem in order.
That’s until you consider the out-of-control housing market, which is in the grip of an irrational exuberance arguably beyond anything the U.S. experienced in the mid-2000s. In February alone, Sydney homes surged 14.7 percent from a year earlier, the fastest pace in five months. According to economist Lindsay David, author of the new book “Print: The Central Bankers Bubble,” Sydney land prices rose 512 percent faster than inflation between 2001 and 2011, while the city’s population only grew 16 percent. Perth in the West outpaced inflation by 1,094 percent with population growth of 28 percent. Stevens is damned if he responds to slowing growth (which would add more fuel to the property bubble) and damned if he doesn’t (the first recession in over 20 years may be on his watch).
A much better deal would be to let markets function on their own. By relying on central bank for cues, people just delay certain decisions they would have taken.
And then most such articles then simply blame it all on the government. First expectations are raised from central banking. If central bank is in a fix and unable to react, blame it on the govt. Eith tales or heads, central bank wins:
This is really the lousiest of all possible agreements. It looks like a leaked document of sorts.
After so much noise and hype, the least that was expected was a proper document on a government letterpad with seal. Instead of the finance secretary, the agreement should have been signed by the finance minister. After all it says finance ministry signs on behalf of the President of India which should have followed some protocols to show sincerity towards the cause. And then do Indian President and government officials know anything about this agreement?