Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 14 April 2016

Central bank mistakes: more on count 2

Martin Sandbu in the FT picks up on my post on central bank mistakes. While he says that the first and third I identify are “on point”, he says the second is simply wrong. I think this is because he (and many others) misunderstand the point I am making, which in turn probably means I’ve failed to be clear about it. But it is really important.

My second criticism is that central banks did not make it clear what the impact of reaching the zero lower bound (ZLB) was, and as a result were too quiet about the adverse impact of fiscal austerity. That is not the same as saying there is nothing central banks can do at the ZLB, or that unconventional monetary policy is impotent. As I said in the post, what the ZLB meant is that central banks could no longer do their job effectively, and that unconventional policy “was untested, and it is just not responsible to pretend otherwise”.

Take three instruments: interest rate changes, fiscal policy changes, and unconventional monetary policy. The first two are tried and tested. There is still much uncertainty, but we can have a good guess at orders of magnitude when it comes to working out how much we need to do to achieve some end result (particularly when interest rate changes will not undo fiscal policy’s effects). Unconventional monetary policy has some impact, but we have little prior knowledge of how big that effect will be (or equivalently, how much we need to do to achieve some end result.) Given lags between instrument changes and results, this is a very serious disadvantage.

A simple analogy. The central heating is broken, and it is freezing outside. It can be fixed quickly with the right kit. You ring two plumbers to come and fix it. One says he can be there immediately, the other says they can come in two hours. You are getting very cold, so you naturally choose the plumber who can come straight away. However when they arrive, they tell you their equipment required to fix the problem quickly is broken, but they can nevertheless probably bodge something within the next day or two. You ring the other plumber, and they do have the right equipment. What would you do? Would you not get cross at the first plumber for not telling you their equipment was not working properly when you first contacted them? Now suppose the first plumber did not tell you anything, and you only found out about the kit that could have fixed the problem quickly later on. Would you employ that plumber again, particular when you discover that since his ‘repair’ your central heating is not working as well as it used to?

In a way this strikes at the core of the independence issue. Without independence, the government would be able to choose the best instrument available, which at the ZLB is fiscal policy. But central banks have been made independent and the task of stabilising the economy has been delegated to them. This institutional change should not mean that we no longer use the best instrument to do the job. [1] But if the central bank fails to be frank, perhaps because it feels bad about admitting that it no longer has the best tools to do the job, that is a clear mistake on its part. In this respect it is not important whether the central bank being honest and clear would have actually made a difference on this occasion. That it might have done is all that matters.

I think central banks can at this point get confused with political neutrality. But pointing out the facts as they see it about their own relative competence should never be seen as ‘political’. Here Tony Yates makes a good suggestion, which is that the central bank should be mandated to comment “on whether its ability to meet the inflation target [or whatever its objectives are] was being hampered by government fiscal policy.” 

Advocacy blogging is so ubiquitous that some presume that in pointing out this and other mistakes I must be arguing against central bank independence (CBI). To repeat, I am not. What I think is indisputable is that CBI done badly can be worse than no independence. It does not serve the cause of well designed and well implemented central bank independence to gloss over past mistakes.

[1] Suppose you erroneously think concerns about government debt were valid. Was that a justification for central bankers to argue against fiscal expansion? Absolutely not. With QE, any fiscal expansion could have been money financed. What central bankers should have said is that short term concerns about excessive government debt were unfounded, because they were acting as a lender of last resort. They did not say this.     


  1. I'm quite sure I heard Mark Carney towards the end of an interview on the Today programme last summer refer to the government's fiscal policy as a "headwind" to the economy. But it wasn't reported in the headlines on the hour nor anywhere else, and I've never been able to track it down since. The Bank of England's list of published interviews, on, stops in January of last year. Perhaps he exceeded his mandate?

    1. You are absolutely correct, I even commented on it in this blog at the time. All that was reported in every media channel were his comments on immigration –and that sums up UK media pretty well.

  2. Of course #2 was mistaken, in terms of exacerbating the recession. (But as I said commenting on your previous post a mistake that would a fortiori have been made had the government been in charge of monetary policy.)

    But from the perspective of an independent central bank that is only concerned with inflation, was it a mistake? If the aggregate supply curve is perceived to be flat - a first approximation in a deep recession, then aggregate demand policy, be it fiscal or monetary, has no impact on prices and inflation. So why speak up? You're going to hit your target, you might as well keep shtum.

    You're right of course that the BoE is excessively paranoid about being 'political', but the greater evil is its mandate of targeting inflation regardless of all else that matters.

    To extend/torture your analogy it is as though the plumber is only concerned with the water supply but is indifferent about the temperature.

  3. Why not give the BoE the power to conduct overt monetisation, chanelled to a purpose of their choosing (eg paying down govt debt, infrastructure, other one-off investments) when lowering the interest rate is impossible or inadvisable?

    Presumably the impact of this would be no harder to calculate than fiscal policy, and would have the effect of making it impossible, or at least difficult, for governments to starve the economy of demand in the way the Tories have - because the bank could function as a fail-safe/safety valve.

  4. "concerns about excessive government debt were unfounded, because they were acting as a lender of last resort. They did not say this."

    Oooo yes, they DID:
    “The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.” Alan Greenspan

    “As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational.” Federal Reserve Bank of St. Louis

    “A sovereign government can always make payments as they come due by crediting bank accounts — something recognized by Chairman Ben Bernanke when he said the Fed spends by marking up the size of the reserve accounts of banks.” L. Randall Wray, Professor of Economics at the University of Missouri-Kansas City and a Senior Scholar at the Levy Economics Institute

    More at

    So, yes they did say that, but was anyone listening?

    Buried in the lecture, beginning at about 19:18 in the video, Bernanke explained where the Fed got the money to “pay for” the assets it purchased as part of its Quantitative Easing (QE) policies.

    And another great link to ponder:

    1. Default is not the only concern that has been raised. Indeed, the risk of default has not played a large part in US or UK debates, except when the Republicans in Congress were playing political games with the debt ceiling, and briefly in the UK prior to the 2010 election, although again that was more about politics than economics.

      Other concerns seem to have been given more weight, such as inflationary risk over a longer term, central bank independence, preference for monetary over fiscal policy, the balance between the public and private sectors, impact on interest rates either downwards (return to savers) or upwards over the longer term if the central bank reverses QE, etc. Personally, I don't regard any of these as decisive in current circumstances but they need to be acknowledged and dealt with.

      A government with monetary sovereignty need not default but that's not the end of the discussion.

  5. Joseph Stiglitz finaly took to solving the problem of why monetar policy is inefective. After so many years I have been saying so finaly some economist understood the real world ( and to say it in regular language:

    It is not "Given lags between instrument changes and results" as you say it it is that monetary policy does not work bellow 2%. It Does not work, not that there is a lag.
    You keep trying to call it Failed transmission mechanism, but that doesn't say anything in particular.
    Simply, monetary policy does not work bellow 2%.

    What i am saying is that you are too soft on CB criticism, not that you are wrong.

    Besides, Ben Bernanke was saying that unconventional monetary policy is to give government cheeper borrowing to allow for more debt for stimuluses. But who was listening?

  6. I think that it's worth noting that the BoE is not being silent. Statements in recent years, such as a recent one on Brexit have suggested at the banks impotence. The essential claim of these statements is that there is not enough demand in the economy, and so (combined with the fact that from the bank's point of view at least they couldn't lower rates further) to anyone at HMT with a basic understanding of macro it should therefore be clear that the bank is implicitly stating its impotence to carry out its mandate.

    Sure it is not explicit enough, but it might be reasonable to assume hat someone at the treasury understands macro

  7. The statement “central banks have been made independent and the task of stabilising the economy has been delegated to them” is not quite accurate. Section 4.1 of the 1946 Bank of England Act originally read “The Treasury may from time to time give such directions to the Bank as, after consultation with the Governor of the Bank, they think necessary in the public interest.” Section 10 of the 1998 Act added the phrase “except in relation to monetary policy”. There is no mention of ‘stabilisation’ in the Act’.

    It was assumed at the time that monetary policy would suffice to stabilise the economy but that’s not what the legislation actually says. So government cannot hide behind the operational independence that has been given to the Bank to avoid taking fiscal measures when needed to stabilise the economy.

    John McDonnell accepted this responsibility in his speech to the RSA last month, stating: “So it is right that, if conventional monetary again becomes constrained by hitting a lower bound as it did after the global financial crisis, we understand when fiscal policy has to take some responsibility. And that is why we will reserve the right, for as long as monetary policy is unable to undertake its usual role due to the lower bound, to suspend our targets so that monetary and fiscal policy can work together. Rather than an arbitrary cut off for GDP forecasts, we will suspend our rule in the circumstances when it is clear that fiscal policy needs to work together with monetary policy to get the economy moving again.”

    It would be better if the Bank admitted the limits of the powers it has been given but there is nothing to prevent Osborne taking fiscal measures to stabilise the economy.

  8. "My second criticism is that central banks did not make it clear what the impact of reaching the zero lower bound (ZLB) "

    Why do you keep using the acronym ZLB? The Swiss and the Danes have shown us that there is no effective lower bound at 0%. It lies somewhere beneath -0.75%. Which means that central banks have room for additional *conventional* interest rate policy, even as rates fall to, and through, 0%.

  9. "My second criticism is that central banks did not make it clear what the impact of reaching the zero lower bound (ZLB) was, and as a result were too quiet about the adverse impact of fiscal austerity."

    Wasn't it more that interest rate cuts were not enough to help the economy earlier on?

  10. Always so near, always so far!

    HOW do we manage to miss the point in EVERY scandal?

    SOMEBODY knew...!

    ...Even if it was only the perpetrator, with 'no-one to turn to' in whatever their trouble.

    Disaster, when it 'impends (whether obviously or only to a sixth sense), needs 'on-side' detectors, whether front-line workers 'or academics', people who are able and wiling to communicate, to live by conscience, NOT 'corrupted' by inequality and insecurity, NOT silent on universal fear and fostered greed, free to be 'explicit enough'!

    IF we wish the fruits of democracy, then let it be understood - and so chosen - as equal partnership.

    WITH informed agreement 'for democracy', it will be our shared duty and civic pleasure - in mutual respect - to have our (agreed equal) incomes and our (agreed limited) savings checked, to be kept for the sake of ALL in mutually-respectful touch of democratic equality (consumer-voices equal in the market).

    In today's argot, we are obliged to ask for 'real equality'.

    NO hope, as well 'they' know, in 'more equality'.

    The 'clear mistake' of the central bank came long before hitting ZLB: it was in non-appreciation, or non-insistence on appreciation by others, of the significance of their own (and all others') 'feeling bad about admitting'…!

    ...Our enslavement by fear is non-trivial, compounding to our ruin. Our scandals are but clues to the greater horrors of planetary degradation and self-extinction, worst of all as perhaps by hypocrisy 'DESERVED'.

  11. It has taken two stolen elections, but now the people KNOW, in simple terms as well or better than our academics, NOT in the detail planned by a quisling elite, but well enough: NO real good has come - or CAN come - from being 'led from behind' into this People's Austerity, a race to the bottom attracting hot money to London, undermining further the EZ, betraying all who look to our SHAM democracy.

  12. I agree that the central banks can be blamed for not commenting on fiscal policy. On that note, I have an interesting hypothesis as to the underlying cause for the current issues.

    Fundamentally, I think there is significant misunderstanding as to how exactly monetary policy works in the first place, and I think there is a very good argument to be made that while there are short-term effects due to frictions (sticky prices, liquidity preference, portfolio rebalancing, etc.) monetary policy is neutral in the long run and actually has a longer-term effect only indirectly, through its influence on fiscal policy.

    My argument is that the underlying reason behind the current situation is actually that there's a fundamental asymmetry in *public perception* of government debt / money. In other words, people worry about there being too much government debt / money, but they don't worry about there being *too little* of it.

    Thus the central bank adopting a policy of "tight money" actually works by inducing the government to tighten its belt over the long run, to avoid excessive interest payments on its "debt". On the other hand, given the current state of public discourse, "loose money" is much less effective because debt-obsessed governments are less amenable to the signal this is supposed to send, and have not sufficiently increased their deficits by spending on infrastructure or simply lowering taxes. As a consequence, because loose money cannot work via the usual way of inducing loose fiscal policy in the medium term, the effect this ends up having is actually to *reduce* inflation by lowering the amount of interest the government pays for its debt.

    In other words, current monetary policy around the world is actually counter-productive, because fiscal policy isn't responding to monetary policy the way it normally ought to.

  13. See Sandbu latest on Keynesian resurgence, in response to recent IMF advice in favor of fiscal stimulus "if fiscal space permits"

    Sandbu "If the IMF want to keep referring to fiscal space, it would help if they provide official measures" (he then goes on to say: if they can't then shutup)

    This seems rather contradictory to his apperent advocacy of unconventional monetary policy. Especially when 'fiscal space' outside of the ECB seems at face-value to be obviously greater than zero.


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