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 showeda 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 catthan 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 thinksome 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.