Post by RS Davis on Jul 22, 2004 2:46:57 GMT -5
The Mystery of Central Banking
Robert P. Murphy
With the recent rate hike, the mainstream press obediently parrots the macroeconomic analysis offered by our friendly central planners at the Federal Reserve. The average citizen knows that he or she is not nearly smart enough to understand the complex interrelationships of various price indices, yield curves, consumer confidence, and so forth—that’s Greenspan’s job.
But the basic story, as told by our wise overseers, runs something like this: A high interest rate keeps prices down, but stifles business and prolongs unemployment. On the other hand, a low interest rate stimulates output and hiring but causes inflation. It is the job of the central bank to pick an interest rate j-u-u-u-st right, to achieve the optimal balance between these two extremes. (Indeed, I once read a financial analyst who actually used the term "Goldilocks" in describing Fed policy.) A good central banker knows when to cut rates to jump start the economy out of a recession, but he also has the courage to "apply the brakes" by hiking rates when the economy begins to "overheat."
[shadow=red,left,300]Standard Macro Models are Nonsense[/shadow]
As you may have inferred from my tone, I reject this popular analysis as utterly crude and pernicious. In a market economy, the interest rate is not merely a lever to stimulate or depress economic growth, and the connection between interest rates and inflation is far more subtle than the standard story suggests. The price of borrowing money has a "correct" value just as the price of a pair of shoes; the government cannot tinker with this value willy-nilly without causing drastic distortions.
Even putting aside theoretical objections (which we will analyze more fully below), the standard macroeconomic story has no historical support. The most obvious example is the Great Depression itself, which occurred a good fifteen years after the Federal Reserve had been established to ostensibly dampen the vicissitudes of the wildcat free market.
In the 1970s, the US experienced "stagflation," i.e. simultaneous double-digit unemployment and inflation. This was impossible according to the prevailing Keynesian orthodoxy, the equivalent of an economy that was both stuck in a rut and overheating at the same time.
More recently, Japanese policymakers were stumped in the 1990s when they couldn’t improve their lackluster growth, despite nominal interest rates that were very close to or even literally zero percent. At that point, they had hit a wall; you can’t cut rates lower than zero, since lenders would do better to stick their funds under a mattress. (I saw a lecture by Paul Krugman in which he told us that his advice to the Japanese central bankers had been to credibly announce very high rates of future inflation, which would cause the real rate of interest in Japan to become negative.)
As these historical episodes illustrate, even the staunchest proponent of central banking would have to concede that it is more an art than a science. "Exogenous" parameters in macroeconomic models can always change, such that the "optimal" policy move turns out, in retrospect, to be dead wrong. But isn’t this true in all fields? Shouldn’t we just give the macroeconomists more time to accumulate statistics and generate even more sophisticated mathematical models?
No, we shouldn’t give the policy wonks another decade to tinker, because in this case it is the arrogant and ignorant mismanagement of the central bankers itself that is the major source of macroeconomic instability. As with other areas of government meddling in the economy, political "remedies" only serve to exacerbate (or indeed, often cause) the very problems they supposedly solve.
[shadow=red,left,300]An Analogy[/shadow]
To appreciate the damage wrought by central banking, it may help to change the context in order to break free of habitual modes of thought. To that end, imagine that there is no Federal Reserve System, but rather a Federal Housing System. This organization is entrusted with a printing press, with which it can literally run off perfectly legal, crisp $100 bills. Every month, the Fed prints new greenbacks and distributes them to a select group of housing developers, giving the new money in proportion to how many houses a particular builder constructs in a given period. This privileged group then uses the newly printed money (in addition to other funds) to buy lumber, bricks, etc. and to hire workers to construct new houses, which are then sold to homeowners in the normal fashion.
What would be some of the major effects of this hypothetical arrangement? Well, the newly injected $100 bills would allow the builders to bid up the prices of lumber and other materials, siphoning these resources away from other uses, and causing more homes to be built than would otherwise have occurred. Especially on the heels of a bigger than expected injection of cash, there would be an apparent boom in the housing industry, as builders increased their orders for materials and hired more laborers to complete their projects. Because of the government subsidy, the housing industry would be more profitable than before, and competition among builders would eventually lead to a fall in housing prices for consumers.
Of course, running off new $100 bills from the Fed’s printing press would cause a rise in the price level, first in the prices of lumber, shingles, windows, etc., but eventually in the prices of all goods and services, as the extra cash worked its way throughout the entire economy. The people running the Federal Housing System would soon learn that if they injected too much cash too quickly, it would cause massive dislocations in other industries (which need lumber, laborers, etc. too) and would lead to unacceptably high rates of price inflation. Of course, it would be very painful and disruptive to stop the printing press altogether, since this would put many builders out of business and cause a spike in housing prices. After such policy reversals, entire neighborhoods of half-built houses would be abandoned, serving as stark reminders of wasted resources.
After the Federal Housing System had been in place for some time, the private sector would become better at anticipating its actions. Analysts would devote their entire careers to parsing the casual remarks by Fed leaders, and would run statistical tests on the data used by the Fed to determine how much cash to print in the upcoming months. (For example, perhaps the Fed would look at new homes per capita, or the rate of housing growth compared to inflation, in order to determine its "target price" for new homes.) As people came to expect the monthly injections of cash, the Federal Housing System would become less and less able to influence events. In order to boost employment, for example, the Fed would have to inject ever higher amounts of cash, in order to catch the ever savvier home builders by surprise and make their projects more profitable than they had originally reckoned.
[glow=red,2,300]Continued...[/glow]
Robert P. Murphy
With the recent rate hike, the mainstream press obediently parrots the macroeconomic analysis offered by our friendly central planners at the Federal Reserve. The average citizen knows that he or she is not nearly smart enough to understand the complex interrelationships of various price indices, yield curves, consumer confidence, and so forth—that’s Greenspan’s job.
But the basic story, as told by our wise overseers, runs something like this: A high interest rate keeps prices down, but stifles business and prolongs unemployment. On the other hand, a low interest rate stimulates output and hiring but causes inflation. It is the job of the central bank to pick an interest rate j-u-u-u-st right, to achieve the optimal balance between these two extremes. (Indeed, I once read a financial analyst who actually used the term "Goldilocks" in describing Fed policy.) A good central banker knows when to cut rates to jump start the economy out of a recession, but he also has the courage to "apply the brakes" by hiking rates when the economy begins to "overheat."
[shadow=red,left,300]Standard Macro Models are Nonsense[/shadow]
As you may have inferred from my tone, I reject this popular analysis as utterly crude and pernicious. In a market economy, the interest rate is not merely a lever to stimulate or depress economic growth, and the connection between interest rates and inflation is far more subtle than the standard story suggests. The price of borrowing money has a "correct" value just as the price of a pair of shoes; the government cannot tinker with this value willy-nilly without causing drastic distortions.
Even putting aside theoretical objections (which we will analyze more fully below), the standard macroeconomic story has no historical support. The most obvious example is the Great Depression itself, which occurred a good fifteen years after the Federal Reserve had been established to ostensibly dampen the vicissitudes of the wildcat free market.
In the 1970s, the US experienced "stagflation," i.e. simultaneous double-digit unemployment and inflation. This was impossible according to the prevailing Keynesian orthodoxy, the equivalent of an economy that was both stuck in a rut and overheating at the same time.
More recently, Japanese policymakers were stumped in the 1990s when they couldn’t improve their lackluster growth, despite nominal interest rates that were very close to or even literally zero percent. At that point, they had hit a wall; you can’t cut rates lower than zero, since lenders would do better to stick their funds under a mattress. (I saw a lecture by Paul Krugman in which he told us that his advice to the Japanese central bankers had been to credibly announce very high rates of future inflation, which would cause the real rate of interest in Japan to become negative.)
As these historical episodes illustrate, even the staunchest proponent of central banking would have to concede that it is more an art than a science. "Exogenous" parameters in macroeconomic models can always change, such that the "optimal" policy move turns out, in retrospect, to be dead wrong. But isn’t this true in all fields? Shouldn’t we just give the macroeconomists more time to accumulate statistics and generate even more sophisticated mathematical models?
No, we shouldn’t give the policy wonks another decade to tinker, because in this case it is the arrogant and ignorant mismanagement of the central bankers itself that is the major source of macroeconomic instability. As with other areas of government meddling in the economy, political "remedies" only serve to exacerbate (or indeed, often cause) the very problems they supposedly solve.
[shadow=red,left,300]An Analogy[/shadow]
To appreciate the damage wrought by central banking, it may help to change the context in order to break free of habitual modes of thought. To that end, imagine that there is no Federal Reserve System, but rather a Federal Housing System. This organization is entrusted with a printing press, with which it can literally run off perfectly legal, crisp $100 bills. Every month, the Fed prints new greenbacks and distributes them to a select group of housing developers, giving the new money in proportion to how many houses a particular builder constructs in a given period. This privileged group then uses the newly printed money (in addition to other funds) to buy lumber, bricks, etc. and to hire workers to construct new houses, which are then sold to homeowners in the normal fashion.
What would be some of the major effects of this hypothetical arrangement? Well, the newly injected $100 bills would allow the builders to bid up the prices of lumber and other materials, siphoning these resources away from other uses, and causing more homes to be built than would otherwise have occurred. Especially on the heels of a bigger than expected injection of cash, there would be an apparent boom in the housing industry, as builders increased their orders for materials and hired more laborers to complete their projects. Because of the government subsidy, the housing industry would be more profitable than before, and competition among builders would eventually lead to a fall in housing prices for consumers.
Of course, running off new $100 bills from the Fed’s printing press would cause a rise in the price level, first in the prices of lumber, shingles, windows, etc., but eventually in the prices of all goods and services, as the extra cash worked its way throughout the entire economy. The people running the Federal Housing System would soon learn that if they injected too much cash too quickly, it would cause massive dislocations in other industries (which need lumber, laborers, etc. too) and would lead to unacceptably high rates of price inflation. Of course, it would be very painful and disruptive to stop the printing press altogether, since this would put many builders out of business and cause a spike in housing prices. After such policy reversals, entire neighborhoods of half-built houses would be abandoned, serving as stark reminders of wasted resources.
After the Federal Housing System had been in place for some time, the private sector would become better at anticipating its actions. Analysts would devote their entire careers to parsing the casual remarks by Fed leaders, and would run statistical tests on the data used by the Fed to determine how much cash to print in the upcoming months. (For example, perhaps the Fed would look at new homes per capita, or the rate of housing growth compared to inflation, in order to determine its "target price" for new homes.) As people came to expect the monthly injections of cash, the Federal Housing System would become less and less able to influence events. In order to boost employment, for example, the Fed would have to inject ever higher amounts of cash, in order to catch the ever savvier home builders by surprise and make their projects more profitable than they had originally reckoned.
[glow=red,2,300]Continued...[/glow]
