The last chance for fiat money

Martin Wolff writes a compelling commentary in the Financial Times about the failure of monetary policy in recent years, oddly, naming current Fed chief Ben Bernanke but not his predecessor in the process.

Central banks must target more than just inflation
Did inflation targeting fail? Central banks have mostly escaped blame for the crisis.

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

This is no small matter. Over almost three decades, policymakers and academics became ever more confident that they had found, in inflation targeting, the holy grail of fiat (or man-made) money.

At which point, many Monty Python fans will surely reflect on the 1975 classic and think to themselves, "Grrrrrail?"

The whole thing is actually worth reading, so most of it is appended below. It all boils down to the complaint that has been made here for years now - that economists don't get out enough and are so far detached from the real world that they are wholly incapable of effectively formulating any policy that won't end in disaster.

The fact that hubris seems to be another common characteristic of the dismal set doesn't help matters either, a prime example of which is Messr. Mishkin.

Frederic Mishkin of Columbia University, a former governor of the Federal Reserve and strong proponent of inflation targeting, argued, in a book published in 2007, that inflation targeting is an “information-inclusive strategy for the conduct of monetary policy”.* In other words, inflation targeting allows for all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation. Now that we are living with the implosion of the financial system, this view is no longer plausible.
No less discredited is the related view, also advanced by the Fed, that it is better to deal with the aftermath of asset price bubbles than prick them in advance. Prof Mishkin wrote that “it is highly presumptuous to think that government officials, even if they are central bankers, know better than private markets what the asset prices should be”. Today, few would mind such presumption, given the costs of the financial crises that follow asset price bubbles accompanied by big expansions in private credit.

Complacency about the Great Moderation led first to a Great Unravelling and then a Great Recession. The private sector was complacent about risk. But so, too, were policymakers.

What role then did monetary policy play? I can identify three related critiques of the central banks.

First, John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule, which relates interest rates to inflation and output.** This caused the housing boom and the subsequent destructive bust (see charts).

Prof Taylor has an additional point: by lowering rates too far, the Fed, he argues, also caused the rates offered by other central banks to be too low, thereby generating bubbles across a large part of the world. In retrospect, for example, the autonomy of the Bank of England was much smaller than most imagined: the wider the interest rate gap vis-a-vis the US, the more “hot money” flowed in. This induced a lowering of standards for granting credit and so a credit bubble.

Second, a number of critics argue that central banks ought to target asset prices because of the huge damage subsequent collapses cause. As Andrew Smithers of London-based Smithers & Co notes in a recent report (Inflation: Neither Inevitable Nor Helpful, 30 April 2009), “by allowing asset bubbles, central banks have lost control of their economies, so that the risks of both inflation and deflation have increased”.

Thus, when nominal asset prices and associated credit stocks go out of line with nominal income and prices of goods and services, one of two things is likely to happen: asset prices collapse, which threatens mass bankruptcy, depression and deflation; or prices of goods and services are pushed up to the level consistent with high asset prices, in which case there is inflation. In the short term, central banks also find themselves driven towards unconventional monetary policies that have unpredictable monetary effects (see chart).

Finally, economists in the “Austrian” tradition argue that the mistake was to set interest rates below the “natural rate”. This, argued Friedrich Hayek, also happened in the 1920s. The result is misallocation of resources. It also generates explosive growth of unsound credit. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose. As a result, we now face two challenges: clearing up the mess and designing a new approach to monetary policy.

On the former, we have three alternatives: liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard. That is why we should not have fallen into the quagmire in the first place.

On the latter, the choice, in the short term, is certainly going to be “inflation targeting plus”. “Out” is likely to be the “risk management” approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. “In” is likely to be “leaning against the wind” whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical “macro-prudential” approach to capital requirements in systemically significant financial institutions.

This unforeseen crisis is surely a disaster for monetary policy. Most of us – I was one – thought we had at last found the holy grail. Now we know it was a mirage. This may be the last chance for fiat money. If it is not made to work better than it has done, who knows what our children might decide? Perhaps, in despair, they will even embrace what I still consider to be the absurdity of gold.

It's nice to see this sort of introspection - someday there will be fundamental changes, but that probably won't happen anytime soon.