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.

Comments

[Edward J. Dodson]

One must ignore crucial aspects of our history to conclude "the past quarter century has been a great period of growth and stability for most of the world."

Economics needs to re-examine some of its fundamental methods of analysis.

Understanding the causes of the business cycle is impossible relying on the neoclassical assertion that the price mechanism operates to return unstable markets to a circumstance of general equilibrium. The only way the mathematical equations even make sense is by recategorizing nature as a form of capital. The political economists understood the distinction, and they debated at length whether "rent" -- as a claim on production -- ought to be treated as common property or as private property. Economists early in the 20th century abandoned this line of investigation because it involved questions of moral significance and with greater frequency came to redefine "rent" as any return above what is minimally required to bring any factor of production to market.

And, then, there is the unwillingness to discard GDP as a measurement of anything that provides insight into the well-being of a society. Redefining Progress came up with a much more accurage gauge in the 1990s -- the GPI (Genuine Progress Indicator). By the GPI, the quality of life for a majority of the U.S. population has been declining since the mid-1970s.

[neilehat]

The Grand Illusion? The Grand Illusion is the idea that the U.S. can have an economy without employment. In excess of a half a million Americans lost their jobs in November. going forward, how many in Dec., Jan., Feb., March, April, May, June, July, August, September, Oct.? And going backwards ... how many millions of jobs lost? Remember the experts said there "IS NO RECESSION besides they're only temporary dislocations"!

The secret of a well functioning economy is Employment, Stability, Security, and the elimination of FEAR. The problem is how do we get to there from here. Now that the system has been wrecked.

[Greg Ransom]

In 1954 the price of a stamp was 3 cents.

In 2008 the price of a stamp is 42 cents.

That Mr. Becker is MASSIVE inflation, and it's a massive institutional failure, a failure of the first order.

The job of money is to be a store of value.

An constantly inflated currency is an ongoing act of theft -- its a currency that robs class of economic agents for the benefit of another.

3 cents in 1954, 42 cents in 20008 -- that's a LOT of theft.

[Bob K.]

Economists from the Austrian School were not unprepared for this crisis.

[Richard]

It seems to me that some recessions have more clearly followed the inflation-got-too-high-and-The-Fed-stepped-on-the-brakes model than others. The 1969-70 and 1981-2 recessions are clearly of that type.

But some are caused by factors that are largely exogenous to inflation and interest rates. I would include in that category the recessions of 1973-5 (oil shock), 2001 (dot-com bubble) and 2007-? (imprudent mortgage lending). Of course, the 1973-5 recession was accompanied by high inflation, but there seems to have been more to it than overly expansive monetary policy.

Monetary policy might be less efficacious (if at all) for this second category of recessions. Therefore, if one sees monetary policy as a panacea for all recessions, yes, I suppose that is a grand illusion.

[Dan]

Richard, the Fed's monetary policy certainly contributed to the current crisis by maintaining a low rate for too long.

But I do agree with your point that too much faith has been placed in the relatively meager tools of current monetary policy.

I think medical analogies are apt here. The human body is a highly complex system but that fact alone does not discourage the developments of new treatments. It seems to me the development of treatment modalities for different economic ailments should be an incredibly exciting field to be in but most of what I read here is the same old same old.

[Guy]

I think you overstate the benefits. Introducing capitalism into countries without institutions equipped to handle it has resulted in disgusting displays of inhumanity. While improving the monetary lives of many, the destruction left in the wake of unregulated (quasi-pure) capitalism (in 3d world countries) is, at least, a counter-balancing consideration. Further, the wealth gap has increased in many of these countries (and in the US, I might add), creating a system that makes it more difficult for the impoverished to lift themselves out of the doldrums.

[Grad Student]

Greg,

You can't define inflation as the price of a stamp. Inflation has to do with all prices.

[ZR]

Here in Malaysia, the fact that rapid growth in global trade and stability in the global economy has led to rising standards of living is a reality, not merely something that is read off textbooks. In almost 4 decades since 1971, the poverty rate here has declined from more than 50% to 3.6pct in 2007.

As a country that continues to be dependent on global trade (our total trade amts to more than 100 pct of GDP), Malaysia will surely be greatly affected by a global recession, if it comes to pass. But I don't think any emerging country, Malaysia least of all, would go so far as to reject wholesale the global economic consensus of the past few decades.

What needs tweaking, should be tweaked. But that opportunity must be seized, now, before the crisis passes and we lose that window of urgency to make the necessary structural changes.

[John Papola]

I don't see how anyone can view the fiscal picture of the US government and feel that our policies have been reasonable or sustainable. All of this wonderful "moderation" for the past 25 years has been bought on a credit card called the national debt. If you gave me the kind of unlimited credit the government gives itself, I guarantee you'd see my personal economic situation be very prosperous and moderate looking too.

Add to that the fact that our monetary policy has been at the heart of the two enormous bubble/bust cycles in the past 20 years and I see more justification than ever for the elimination of the central bank. And, of course, one can't underestimate the moral hazard problems inherent in have a "lender of last resort". Bank failures, like all business failures, are part of the creative destruction that teaches the market what does and does not work. The Fed's existence has enabled banks to reduce their equity and capital to dangerous levels and, combined with pyramid scheme of fractional banking, we're now seeing the result: systemic fragility on an epic scale.

I just don't get it. Mainstream economists decry the negative savings rate of the average American, yet seem to miss the fact that Central bank price-fixing of interest rates as well as inflation fundamentally undermine savings. These policies literally FORCE people to speculate with their savings in investments lest they watch inflation destroy them.

Then there's the immoral redistribution of wealth from the average person to the banks and government contractors who get the Fed's new money first and subsequently drive up prices for the rest of us.

Even more bizarre and insidious is the irrational fear of deflation that has been propagated by the Federal Reserve and it's supporters.

I see no reason to fear the gentle, productivity-driven price deflation of a fixed or slow-growing money supply based on precious metals. The technology industry has been fundamentally deflationary since it's inception with no ill effects on the growth of the business and huge benefits for consumers. Prices SHOULD go down as the cost of production go down in competitive markets.

The past 25 years have had unique successes driven in large part by new information technology and deregulation but our public fiscal and monetary policy has been a total disaster. The Fed has gotten away with massive inflation on behalf of the government and the banks while the effect on consumer goods has been muted by the deflationary forces of globalization. But those forces couldn't mask the destructive mal-investment in unproductive assets and speculative commodities at the heart of this enormous crisis.

It's time to kill the fed and re-instate the gold standard. Clearly the government and the politically connected economists don't deserve the discretion of a fiat money supply. Clearly.

[Gu Si Fang]

Pr. Becker,

I am confused that you chose to so ignore the austrian business cycle theory. The Nov 9 post displayed no acquaintance with ABCT, and described it as an old-fashioned theory aiming at "removing the poison from an economy that builds up during good times". In response to this post, Robert Murphy has written an open letter which can be found here : http://mises.org/story/3220

One of Milton Friedman's immense contributions was to convince academia that the expansion of the money supply was the main cause of inflation, at a time when some economists were still denying this assertion. He was also very critical of the arbitrary power of central banks and wished they were replaced with a laptop computer. But they were not, and no one seems to understand the consequences better than the austrian school.

What they say is basically that central banking etc. are the cause of business cycles. They are still there, and they certainly cannot be expected to rid us of business cycles. Quite the contrary.

[Dan]

Inflation by itself is not necessarily harmful. If everything else (salaries and interest rates, especially) keeps pace with inflation, it's a wash. You don't lose buying power as long as your wages keep up with inflation.

Where inflation is a problem is when your savings account gives you a 2.5% interest rate but the annual inflation rate is 3% or 5%. Then you really are losing buying power.

[thanks]

thanks

[Phillip Huggan]

I guess if you define economy as GDP it is been a nice run. But real earning power has fallen for most Americans since Reagan. It is the opiate of Moore's Law and cheap electronics in everything that have pacified the masses. I'm sure the latter could occur in a way that doesn't induce a depression among the economy of most Americans.

China has been a beneficiary but saw most of its growth not even noted by economists as massive food production gains and associated nutrition gains. Russia and Africa haven't been so lucky (alcoholism and AIDS, respectively).

I'd call the performance mixed. There really haven't been any innovations since the Great Depression and a central bank can't tell the difference between supply and demand inflation.

Skimming through the CB wiki: interest rates were obviously set way to low since 9-11. Federal debt should be treated as if it were increased inflation; is ignored. Reserve requirements for banks have been lowered while derivative gambling increases?! No novel advances for assets to replace millenia old gold reserves. I'm thinking things like wheat reserves, nationalizing rich mineral reserves, copper reserves, nickel reserves, natural gas reserves...
Banks will change lending rates through time, but not penalize investment banks and banks with shoddy accounting?!
Mixed record. No creativity. You'd swear Central bankers are nothing but old white Republicans.

[Redmund Sum]

I am amused by one of the above post that says the postage rise from 3 cents in 1954 to 42 cents in 2008 is a LOT of theft.

It is not that at all. Nor is money's function a store of value.

The function of money is a mediating agent for trade; a "lubricant", if you will. As such, it is also a temporary store of value.

If you had put your 3 cents in the bank at compound interest rate of 5 percent per annum, your bank would have exactly 42 cents today.

[Chris Graves]

Professor Becker's title to his essay this week is fitting. It is a grand illusion to believe that one person or committee of people can discern the ramifications of tinkering with the money supply continually. Contrary to some comments above, the complexity and dynamism of the economy prevents central planning of any sort, including continuously managing the intricacies of money supply. As F.A. Hayek observed, as those in authority on high have more discretion in discharging their responsibilities, those who make decisions on the spot correspondingly have less discretion to alter their actions to meet the demands of the moment.

Also contrary to comments above, inflation is not harmless. The fact of the matter is that some people receive the increases in money first and they benefit unduly as prices have not yet responded to the injections of money as the new money has not yet worked its way through the system. These people not only gain personally at everyone else's expense, but they also bid up prices in selective sectors of the economy creating distortions in relative prices. Monetarists falsely believe that inflation is only manifested in rises in the general price level while changes in relative prices are only due to market fluctuations in supply and demand. This assumption is tragically false as Greenspan and Bernanke have found out the hard way. The distortions in relative prices created by inflation, even if the general price level is stable, creates the overinvestment in certain sectors of the economy that not only misallocate resources but sow the seed for bubbles and their subsequent collapses as we are in the process of witnessing once again.

I am sorry to see Professor Becker praise the Fed for lowering interest rates to stave off recession (depression). Once again, if the Fed artificially lowers interest rates without the necessary attendant real savings to sustain investments undertaken, then entrepreneurs spurred on by the false signals sent out by the Fed will overinvest in projects that cannot be sustained over time. We will just have another round inflation followed by a more severe correction later.

What both Professor Becker and Judge Posner, along with most Keynesian and Monetarist economists, completely overlook in this crisis and macroeconomic theory generally is the importance of Say's Law especially in the essential area of the circular flow of savings and investment as well as a theory of capital.

[Sr Max Higgins]

Bank of America and Mr. Higgins missing $millions, It can happen to you, my fellow Americans

More info: http://mrhigginsbank.blogspot.com/

[nathan]

more on influence costs

Distinction between treasury and fed was interesting

[اس ام اس عید نوروز پیامک عید نوروز]

Merry Chrismas and happy new year for becker-posner-blog.com team & everyone!
New year new becker-posner-blog.com

[Joyce]

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

Joyce

http://www.videophonesguide.com

[Joyce]

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

Joyce

http://www.videophonesguide.com

[Eddie Allen]

CHICAGO - WE HAVE A PROBLEM. What about the '97-98 Emerging market meltdown. What about '94 Tequila Crisis. What about the Japan bubble and "Lost Decade" of the 90s. I somehow fail to see the brilliance of monetary management of the past 25 years; I also see a big hole in our understanding of the economy which has completely been ignored by the Chicago School and white water macroeconomists. (Lucas will regret his AEA Presidential Address where he basically said the big problems of the business cycle are not as important as growth.)

If this crisis does not put a nail in the coffin of the real economy dogmatists, then they are beyond saving.

[Eddie Allen]

CHICAGO - WE HAVE A PROBLEM. What about the '97-98 Emerging market meltdown. What about '94 Tequila Crisis. What about the Japan bubble and "Lost Decade" of the 90s. I somehow fail to see the brilliance of monetary management of the past 25 years; I also see a big hole in our understanding of the economy which has completely been ignored by the Chicago School and white water macroeconomists. (Lucas will regret his AEA Presidential Address where he basically said the big problems of the business cycle are not as important as growth.)

If this crisis does not put a nail in the coffin of the real economy dogmatists, then they are beyond saving.

[Eddie Allen]

CHICAGO - WE HAVE A PROBLEM. What about the '97-98 Emerging market meltdown. What about '94 Tequila Crisis. What about the Japan bubble and "Lost Decade" of the 90s. I somehow fail to see the brilliance of monetary management of the past 25 years; I also see a big hole in our understanding of the economy which has completely been ignored by the Chicago School and white water macroeconomists. (Lucas will regret his AEA Presidential Address where he basically said the big problems of the business cycle are not as important as growth.)

If this crisis does not put a nail in the coffin of the real economy dogmatists, then they are beyond saving.

[Anonymous]

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