Central banks do not deserve our respect
By Scott Sumner
Nor (in my view) do they deserve our contempt. They should be viewed skeptically. They are trying to do a good job, but often fall well short. One such occasion occurred in 2011 when the ECB tightened monetary policy. Prior to 2011 the US and eurozone had similar unemployment rates, just under 10%. Now we have 6.7% unemployment and they have 12%. The result of the ECB’s tight money policy in 2011 was utterly predictable from any basic EC101 textbook. Falling NGDP growth tends to reduce RGDP and raise unemployment. And unlike with 2008, no unconventional “market monetarist” assumptions are needed. They were not at the zero bound. The target rate was 1.0% when 2011 started, and they increased their target several times, up to 1.5%. In this case mainstream New Keynesian models predict exactly the same outcome as market monetarist models. Fiscal austerity was actually slightly more intense in America (since 2011) than in the eurozone, so that can’t explain the difference. It’s about as well established a fact as we have in macroeconomics; tight money by the ECB caused the double-dip recession.
The ECB has now woken up to their error, and even the Germans are talking about the possible need for QE. But I don’t believe that the press, or economists as a group, have yet acknowledged that the ECB caused the double-dip recession. And I think that might be because pundits show too much deference to central banks. Here’s an example:
This sort of mini-tempest isn’t unique. Investors, traders, financial writers, and policymakers have developed a startling dependency on what the head of the Federal Reserve does or does not say. Europeans have their own version of it surrounding the declarations of the head of the European Central Bank, but the syndrome is particularly acute for the Fed and Americans.
What Yellen said was fairly innocuous, and should have been taken as such. That it was not speaks to an unhealthy infantilization of finance-land that treats the Fed as some sort of in loco parentis. Yellen becomes the all-powerful mother, whose casual utterances and observations assume oracular weight.
So the central bank is the serious parent, and the markets are spoiled babies. And yet if the ECB is going to be creating catastrophic recessions for no good reason at all, why shouldn’t markets hang on their every word? If I lived in a confined space with a rogue elephant, I might watch every little twitch of the elephant’s body with great interest, alert for future movements of the beast.
The real problem is that the author (like most other pundits and economists) confuses firefighters with arsonists. The central bank is viewed as a hero, which rescues the economy from unstable markets:
The very notion that Fed policy–or any central bank policy–is the primary determinant of the global financial system should be questioned. Yes, central banks have a played a vital role in staving off crises in 2008-09 and again in the fall of 2011 surrounding the possible departure of Greece from the eurozone.
With all due respect, the suggestion that the ECB’s behavior in 2011 was somehow heroic actually boggles the mind. But I do think this is the conventional wisdom among the VSP. And the reference to the Fed in 2008 is equally indefensible. In September and October 2008 the markets were screaming about the risk of deflation and plunging NGDP, even as the Fed seemed more worried about inflation. Only in late October did the Fed finally acknowledge that the markets were right and that deflation was the real risk.
If we are forced to use silly parent/infant metaphors, the markets are the parents and the central banks are the infants, who would be wise to listen closely and learn from the parents.
PS. I admit that it’s possible I am wrong about the ECB’s role in the recession. But if I am wrong then we should rewrite all our textbooks. After the microeconomic section we should have a single page saying; “economists know nothing about macroeconomics.” And that’s because if I’m wrong then all our AS/AD and Ms/Md models are completely wrong, and we basically know nothing at all about this recession or the Great Depression.
HT: Ramesh Ponnuru