Can central banks make 3 major mistakes in a row and stay independent?

Mistake 1

If you are going to blame anyone for not seeing the financial crisis coming, it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

Monetary policy makers do not see it that way. They will cite the use of unconventional policy (but this was untested, and it is just not responsible to pretend otherwise), the risks of rising government debt (outside the ECB, non-existent; within the ECB, self-made), and during 2011 rising inflation. I think this last excuse is the only tenable one, but in the US at least the timing is wrong. The big mistake I note above occurred in 2009 and early 2010.

What could be mistake 3

The third big mistake may be being made right now in the UK and US. It could be called supply side pessimism. Central bankers want to ‘normalise’ their situation, by either saying they are no longer at the ZLB (UK) or by raising rates above the ZLB (US). They want to declare that they are back in control. But this involves writing off the capacity that appears to have been lost as a result of the Great Recession.

The UK and US situations are different. In the UK core inflation is below target, but some measures of capacity utilisation suggest there is no output gap. In the US core inflation is slightly above target, but a significant output gap still exists. In the UK the output gap estimates are being used to justify not cutting rates to their ZLB [1], while in the US it is the inflation numbers that help justify raising rates above the ZLB. (The ECB is still trying to stimulate the economy as much as it can, because core inflation is below target and there is an output gap, although predictably German economists [2] and politicians argue otherwise.)

I think these differences are details. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis.

Perhaps that is correct, but there has to be a fair chance that it is not. If it is not, by trying to adjust demand to this incorrectly perceived low level of supply central banks are wasting a huge amount of potential resources. Their excuses for doing this are not strong. It is not as if our models of aggregate supply and inflation are well developed and reliable, particularly if falls in unemployment simply represents labour itself adjusting to lower demand by, for example, keeping wages low. The real question to ask is whether firms with current technology would like to produce more if the demand for this output was there, and we do not have good data on that.

What central banks should be doing in these circumstances is allowing their economies to run hot for a time, even though this might produce some increase in inflation above target. If when that is done both price and wage inflation appear to be continuing to rise above target, while ‘supply’ shows no sign of increasing with demand, then pessimism will have been proved right and the central bank can easily pull things back. The costs of this experiment will not have been great, and is dwarfed by the costs of a mistake in the other direction.

It does not appear that the Bank of England or Fed are prepared to do that. If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

I gain no pleasure in writing this. I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this. The Great Moderation is becoming a distant memory clouded by more recent failures. The intellectual case that central bank independence has restricted our means of fighting recessions is strong, even though I believe it is also flawed. Mainstream economics remains pretty committed to central bank independence. But as we have seen with austerity, at the end of the day what mainstream economics thinks is not decisive when it comes to political decisions on economic matters. Those of us who support independence will have to hope it is more like a cat than a criminal.

Postscript (11/04/16). If you think that those who are antagonistic to central bank independence are only found on the left, look at the Republican party, or read this. 

[1] Unfortunately I think some of this survey data is not measuring what many think it is measuring. More importantly, not cutting rates after the Conservatives won the 2015 election was a major mistake. That victory represented two major deflationary shocks: more fiscal consolidation, plus the uncertainty created by the EU referendum. So why were rates not cut?

[2] But not all German economists, as this shows.         

Fiscal council developments

As longstanding followers of this blog will know, I have a particular interest in what are called either ‘fiscal councils’ or ‘independent fiscal institutions’. As I have been and will be preoccupied with other issues for a while, I thought I would try and squeeze in one post on recent developments both in the UK and abroad.

In the UK we had Dave Ramsden’s Treasury review (pdf) of the OBR. The most positive aspect of the review is the recommendation for more resources. I guess the headline news was that the OBR would not be asked to cost opposition policies before elections, as the Dutch fiscal council has done for some time, and as the Australian PBO now does. I would have liked a different decision, but my disappointment is mitigated by three factors:

• the report does recommend the “OBR should ensure greater availability of tools and data to allow third parties to cost alternative policy options”.
  
• in the UK we have the IFS, which does do this and currently (and rightly) has a quasi-official status
  
• the level of the fiscal debate in the UK media is currently so poor that I’m not sure how much such a development would improve things.

This last point raises something of a paradox. People like me hoped that fiscal councils like the OBR would improve the public debate. This paradox reflects in part the particular nature of the OBR, which would not be allowed to say - for example - that the fiscal charter is economically illiterate (i.e. no economist agrees with it). Fiscal councils in some other countries can do that, and indeed were set up to do that. This is a gap the IFS cannot fill. I guess the OBR will not be allowed to comment on the economics of different fiscal rules until the UK gets a more sensible rule. I think it is quite likely that if the OBR was able to say such things, we would not have had this particular fiscal charter and we would all be better off as a result.

With the rapid growth in the number of fiscal councils around the world, the case for some kind of international network has become much stronger. It is therefore good news is that one is about to be established for those in the EU. There are at least two important roles such a network can have, apart from the obvious one of spreading best practice.

First, it can help establish and maintain independence for individual fiscal councils, which may be put under various kinds of pressure by their national governments. Sometimes this pressure is just verbal, and often indicates that the council is doing its job. I have just come back from Ireland, where the Irish fiscal council criticised a pre-election giveaway by the government. Its chairman John McHale also suggested that it might break the Commission’s fiscal rules. The government then revealed that it had obtained agreement from Brussels, but had not told the fiscal council. It managed to spin this as an error made by the council, which journalists dutifully parrotted. Substantive criticism was thereby deflected. That kind of thing from governments is only to be expected. It becomes more serious when governments react to criticism in financial or even existential terms, as has happened in Canada and Hungary. In those cases, the council needs all the defence it can get.       

Second, a network can act as an important pressure group on the Commission. The Commission itself has recently established an Advisory Fiscal Board, which if nothing else can increase the dialogue between the fiscal councils and the Commission. I talked about the dual system of fiscal monitoring within Europe here, and how I hope we will see a gradual reduction in central control and more discretion given to national governments monitored by strong national fiscal councils. If Daniel Gros is right and German hegemony is coming to an end, then maybe it might just happen - one day.