Wednesday, April 22, 2009

Central Banking in democracies

Through Mostly Economics, an excellent speech by Alan Blinder, on Central Banking in a democracy.

In an indication of how much times have changed, he says, "The story is told that the only way President Kennedy could remember the difference between monetary policy and fiscal policy was that the letter 'M' for monetary was also the first letter of the name of the Fed Chairman at that time, William McChesney Martin".

The Federal Reserve Act has directed the Fed to promote "maximum employment, stable prices, and moderate long-term interest rates". It is effectively a "dual mandate" - full employment and price stability. Interest rates influence investment decisions in the short run, and such decisions in turn affect employment and unemployment in the medium term. "The lag from monetary policy decisions to inflation is even longer than the lag from monetary policy to employment because monetary policy first has to affect spending, and then spending must affect inflation." Prof Blinder feels that the lag between monetary policy decisions and impact on inflation to be about two years. He captures the central dilemma for Central Bankers thus,
"Unless inflation is below the Federal Reserve’s long-run target, which hasn’t been true in a very long time, there is a short-run trade-off between the two goals — maximum employment and stable prices — that are set forth in the Federal Reserve Act. To push inflation lower, the Fed must make interest rates high enough to hold total spending below the economy’s capacity to produce. But if it does that, the Federal Reserve will be reducing employment, contrary to the dictum to pursue 'maximum employment'. So monetary policy is forced to strike a delicate balance between the two goals... (However) while there is a short-run trade-off between inflation and unemployment, there is no long-run trade-off."

As Keynes said, modern industrial economies are not sufficiently self-regulating - total spending sometimes roars ahead of productive capacity, which leads to accelerating inflation, and sometimes lags behind productive capacity, leading to unemployment. But, about what actually happens, Prof Blinder says,

"In principle, either fiscal policy—the government’s taxing and spending policy—or monetary policy could serve as the balance wheel, propping up demand when it would otherwise sag and restraining it when it threatens to race ahead too rapidly. In practice, however, monetary policy is the only game in town nowadays. The reason... The need to reduce large fiscal deficits dictates that budget policy remain a drag on total spending for the foreseeable future, regardless of the state of the macroeconomy. With the fiscal arm of stabilization policy thereby paralyzed, a central bank that decides to concentrate exclusively on price stability is, in effect, throwing in the towel on unemployment."

So Prof Blinder's prescription,

"A central bank could do its part to achieve low unemployment by pushing the nation’s total spending up to the level of capacity, but not further".

About the independence of Central Banks, he says two things,

"In a democracy it seems not just appropriate, but virtually obligatory, that the political authorities should set the goals and then instruct - and I use that verb advisedly — the central bank to pursue them. If it is to be independent, the bank must have a great deal of discretion over how to use its instruments in pursuit of its assigned objectives. But it does not have to have the authority to set the goals by itself.

The second critical aspect of independence, in my view, is that the central bank’s decisions cannot be countermanded by any other branch of government, except under extreme circumstances. Without that immunity, the Fed would not really be independent, for its decisions would stand only as long as they did not displease someone more powerful."

About why countries with independent Central Banks have enjoyed superior macroeconomic performance, apart from the short-time horizon perspectives of the political executive and the need for professionalism, he writes,

"You pay the costs of disinflation up front, and you reap the benefits—lower inflation—only gradually through time. So, if politicians were to make monetary policy on a day-to-day basis, they would be sorely tempted to reach for short-term gains at the expense of the future—that is, to inflate too much. Aware of this temptation, many governments wisely depoliticize monetary policy by delegating authority to unelected technocrats with long terms of office, thick insulation from the hurly-burly of politics, and explicit instructions to fight inflation."

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