Central Bank Confidence in Taming the Business Cycle: A Grand Illusion? Becker
For many years economists and central bankers have congratulated themselves on the remarkable stability of US economy. Since the early 1980s, inflation has been under excellent control, and business cycle fluctuations in real GDP have been modest. For example, in no year since 1955 was US average unemployment as high as 10 percent. The highest annual rate was 9.7 percent in1982 during the recession then, and the next highest was 8.5 percent during the recession related to the first oil price boom. Moreover, many economists attributed the quite high average rate growth rate of American GDP in large part to the low rate of inflation and the stability of the economy.
Stable prices and mild business cycles were in turn explained not only by the underlying strength of the American economy, but also in an important way by policies learned by the Fed and other major central banks. Inflation targeting explicitly guided the European Central Bank, the New Zealand Bank, and a number of other central banks. It was also important to the Fed. Through such targeting, central banks would raise their interest rates and tighten up access to credit when inflation exceeded say 2 per cent. Inflation has been remarkably mild for the past quarter century. Japan experienced deflation, not inflation during its stagnant 1990s.
To control real business cycles, central banks relied on formal or informal versions of generalized inflation targeting to include real output changes. In these Taylor-type rules, central banks responded not only to inflation rates, but also to slowdowns in the growth of GDP relative to what was estimated as their long-term trend values. When the growth rate slowed relative to trend, central banks would loosen up their interest rates and access to credit. They would tighten when growth rates were above trend values. By "leaning against the wind" in this fashion, steps were taken to dampen the magnitude of fluctuations in real output.
In light of the severity of the recession that the world economy is now experiencing, for example in the US, Europe, and the UK, can this widespread confidence in our knowledge of how to tame the business cycle through central bank policy be called "a Grand Illusion"? In answering this question, one does have to recognize that the Fed and other central banks learned major lessons from the Great Depression about the value of loosening its purse strings when times were bad. And no one can deny that the past 25 years was a remarkable, and perhaps unprecedented, good run for the American, British, Chinese, Indian, and the world economy.
Clearly, however, central bankers and we economists were unprepared for the magnitude of the present financial crisis, and even less for its large effects on the real economy through the drying up of credit for mortgages and business investments. This recession is still ongoing, but it appears as if it will be the most severe recession since 1982, when American unemployment peaked in some months at about 10.5 percent. One year into the recession according to the NBER dating, unemployment has reached 6.7 percent, and it is still rising at a fast pace.
Central banks, especially the Fed, did respond rather rapidly to the unfolding of the financial crisis, even before it had a large impact on the economy. The Fed employed all the weapons in its traditional arsenal, such as lowering interest rates and easing access to the discount window. It also innovated beyond traditional approaches by allowing investment banks access to its credit, and by helping to arrange for the takeover or elimination of weak investment banks, such as Bears Stern and Lehman brothers.
In contrast to the Fed, the US Treasury took a series of actions with dubious merit, including bailouts and a fiscal stimulus, that had few consistent principles. The latest as reported in the NY Times and Wall Street Journal is to use Fannie Mae and Freddie Mac to encourage banks to drop mortgages to 4.5 percent in order to raise housing prices and encourage home building. Yet Freddie and Fannie and their government guarantees contributed to the housing mess by encouraging excessive building of residential dwellings. Any effect of this proposed price ceiling on housing prices on mortgage rates would be small, but the damage to adjustments in the housing market would be major. The goal of policy should be to reduce, not increase, the power and distortions caused by these two institutions.
In any case, the Fed and Treasury's actions combined obviously were not sufficient to greatly contain the damage to the real sector. The retreat from risk has been so large that treasury bills and bonds are selling at very low interest rates, other measures of risk are way up, and lenders are reluctant to lend, even when expected rates of return on their investments are high. Not surprisingly, the confidence of central bankers and economists that we have learned how to moderate greatly the real business cycle has been shattered. It is revealing how many leading macroeconomists have been silent during the unfolding of this crisis. Perhaps the prudent approach is to go back to the drawing board before offering an interpretation of what happened, and how to combat it.
Despite the seriousness of the present crisis, we should not forget that the past quarter century has been a great period of growth and stability for most of the world. Hundreds of millions of men, women, and children were pulled out of extreme poverty in China, India, and elsewhere by the rapid growth of their economies, due in considerable measure to the steep expansion in world trade, and the stability of the world economy. Even with two years of a rather deep world recession added in, the period since the early 1980s would look good by historical standards.
True, as I argued in prior posts on our blog, additional regulations of financial institutions are desirable, and the Fed has to think deeply about how to expand its arsenal of weapons. Yet it would be a major mistake to seriously hamper a worldwide competitive market engine that has brought so many benefits to the world's population.