“A policeman’s lot is not a happy one”

The Pirates of Penzance

    , Gilbert and Sullivan

The Bank of England has decided to increase the interest rate at which she lends money to commercial banks from a very low 0.50 percent to 0.75. Not a breath-taking rise but still a change from the policy of keeping the base rate at 0.5 or below since March 2008. The federal funds rate of the United States has been rising very slowly since the middle of 2015 and now is at 1.19; the U.S. Federal Reserve Chairman has signified his intention to keep it going up. This indicates that the various central banks are beginning to see a danger of inflation, now that the money pumped into the economies since the 2007 crash is finally beginning to enter circulation.

The reasons for raising the basic interest rate only slowly are two; that such changes must be explained and announced, so that the public adapts to the new circumstance with as little pain as possible; and that interest rates must be brought back to a level that rewards saving and allows industries such as life insurance and pensions to keep their long term engagements.

We do not really know why the financial economy of the western world failed so dismally in the three years from 2007 to 2010. Or was it to 2014? It was such a deep and long downturn that we now know it as ‘The Great Recession’. Many economists had thought central bankers and state treasuries knew by now how to manage the ups and downs of the economic cycle. After this grave recession, those wise men are under a cloud.1 During a visit to the London School of Economics, the Queen of England asked an economics professor an embarrassing question: “Why didn’t anybody see it coming?” The professor—let him stay unnamed—was left desperately looking for an answer.

“It is a feature of our modern economies that they go through repeated bouts of boom and bust. What causes this phenomenon is under dispute….”

It is a feature of our modern economies that they go through repeated bouts of boom and bust. What causes this phenomenon is under dispute, and so is the efficacy of the remedies used—especially those applied by the Governors or Presidents of central banks.

Alan Greenspan, during his long tenure as Chairman of the Fed from 1987 to 2006, was the reborn Wizard of Oz; he seemed able to iron out the business cycle of the U.S. economy by discrete interventions in the money market. Any sudden dip of activity was countered by reductions of the discount rate and expansions of the money supply. This he did with some success when the flash crash of the stock markets in 1987 and the dotcom crisis of 2000-2002. The Fed was always ready to rescue the economy from too lasting a downturn. His prestige was shored up by the tranquillity of the period that came to be known as ‘the Great Moderation’; from 1985 to 2006 real GDP grew steadily in the United States between one and five percent annually, instead of moving wildly between minus five and plus ten as in the previous decade, and this with a low average rate of inflation of around three per cent. Moderation was thought to have become permanent, so much so that Nobel laureate Robert Lucas was led to say in 2003 that “the central problem of depression-prevention has been solved”.2 Now we see, however, that reacting to all temporary dips with strong and immediate monetary countermeasures may be stoking up trouble for the future. As in the MGM film, the Wizard of Oz turned out to be a mere puppet with a loudspeaker and no powers.3

What are central banks supposed to do, suppliers of money that they are, when the economy stalls? Should central bankers try to apply direct economic measures to reduce unemployment? Should they help banks in trouble? More generally, what is the role of a central bank in an advanced economy? The answer to these difficult questions can only be found if we have a good theory about what makes an economy tick.

Keynes takes a dim view of central bankers

As I have often said in these columns, John Maynard Keynes, for good or for ill, was the most influential economist of the 20th century. His public spirit spurred him to find remedies for the sorry state of the British economy in the interwar years. Throughout the 1920s, Britain had been stuck with ten percent unemployment. With the Great Depression, the rate of unemployment doubled. The General Theory (1936) is a difficult book that has given rise to contrasting interpretations, as behoves a sacred text. In my view and whatever people say, he did not propose monetary remedies to pull the United Kingdom out of unemployment equilibrium.4 His fundamental idea was that investment was the power needed to sail the economy out of the doldrums. Private investment, however, could not be relied on, for entrepreneurs were driven by their capricious ‘animal spirits’. Merely lowering the interest rate at the Bank of England would not help revive the economy.5 Only government-funded public works would do the trick, financed by debt if necessary.6

So the neo-Keynesians of today are not following Keynes when they propose lower interest rates or an increased money supply as remedies for a recession and unemployment. These remedies are typically monetarist and would have more likely been approved by Milton Friedman, I think. The essence of the Keynesian remedies is rather debt-financed public expenditure.

The role of central banks

The best way to understand the role of a central bank is to see it as presiding over a club of commercial banks which need support and security when performing their task of funding the economy with credit. The central bank supplies them with new money that they then multiply within limits by lending it out to their clients. The business of a commercial bank is risky, since their loans are long term whereas the funds deposited with them are on sight. Even if their investments are sound, a sudden withdrawal of deposits might leave them short of liquidity and force them to a fire-sale of assets. The central bank is there as a ‘lender of last resort’. However, the commercial banks of the club will want to be sure that none of the members will free ride dishonestly or imprudently; hence the powers they grant the central bank to inspect them and regulate them.

The role of a central bank is impaired when it tries to use the function of supplying money to foster the growth of the economy or to create employment directly. Such an endeavour is understandable but in the end useless or even harmful. The task of the central bank is another: to maintain the purchasing power of the currency it issues and oversees. In other words, it must prevent inflation from eroding the value of the currency.

Now, what causes an inflation? What makes the price level rise continuously? “Inflation is always and everywhere a monetary phenomenon” as Milton Friedman famously said. If the supply of money increases more quickly than the real economy grows, then the price level starts to rise, whether there are idle resources in the economy or not. Life would be easy if the increase of the supply of money by itself brought about sustained growth and full employment.

The unreliable Phillips curve

In 1958, New Zealand economist A.W. Phillips observed an inverse relationship between unemployment and money wage rates in the United Kingdom from 1861 to 1957. The data covered a very long period and lent credence to the belief that inflation rose when unemployment fell, and vice versa. If this was the general case, it was within the power of a central bank to reduce unemployment; and further, if consumption drove the economy, then higher nominal wages were a force for growth. In that case, the central banker had a magic wand in its hand to multiply the welfare of the population.

For more on these topics, see the EconTalk podcast episodes on the Financial Crisis of 2008, and the articles “The European Central Bank Changes its Spots” by Pedro Schwartz, and “What Drove Alan Greenspan?” by Arnold Kling at the Library of Economics and Liberty.

But the Phillips correlation may have been due to the fact that during most of that century inflation was low and difficult to perceive. However, if the unemployed came to expect inflation then they would not be attracted to work more by mere increases in nominal wages. These only tend to foster employment in the short term while the information about the sleight-of-hand of the central bank has not extended through the markets. When information spreads, the public will stop confusing increases in nominal prices with higher rewards for greater productivity. 7 Real growth is not brought by monetary expansion but by increases in population, by productive investment, by technical progress, by freer trade and greater competition.

Money as a factor of production

This, of course, does not mean that money is not important, quite the contrary. Adam Smith wrote that a modicum of cash is necessary for the proper conduct of business. And again, Milton Friedman famously unfurled the banner of “money matters” in reaction to the Keynesian obsession with state expenditure. Of course, we all agree that money fulfils the role of a means of exchange and of a measure of relative prices, but it also has the function of providing liquidity for when income promised does not arrive in time. Without a store of ready money for an emergency, business becomes difficult. So, what monetarists claim is that a liquid reserve of stably valued money is necessary for a smoothly working economy.

Hence, the role of a central banker is first and foremost to keep prices on a constant and stable growth path mirroring the rate of real growth, as Milton Friedman in his time and Tim Congdon today have suggested. The discretionary use of the tools of a central banker, as did Alan Greenspan, is a recipe for ultimate instability. Rules rather than discretion is the proposal of economists of a classical bent. There are many candidates for such a rule, starting with ‘inflation targeting’ all the way to the ‘Taylor rule’. The question is still under discussion.

In today’s world of free capital movement, there is an ultimate safety net when the national bank does not play by the rules—international monetary competition. It permits individuals, firms, and investment funds of all descriptions to spread the risk by moving at least some of their assets to safer monetary zones. In this way, monetary stability, an essential element of a free society, is minimally preserved despite from the vagaries of central bankers.


[1] Well do I remember Gary Becker in 1978 sadly noting the failure of the main models used by macroeconomists to predict the evolution of economies, namely the ‘Dynamic Stochastic General Equilibrium’ models. A great deal of work is being still being carried out with these DSGE models without, to my knowledge, coming to a convincing explanation of what caused the Great Recession.

[2] Robert Lucas’ article, “Macroeconomic Priorities” American Economic Review. Feb 2003, Vol. 93, No. 1: Pages 1-14, where this assertion is to be found, is despite everything essential reading for macroeconomists, for the pointers it contains on future research.

[3] L. Frank Baum, it is said, wrote The Wonderful Wizard of Oz (1900) as an enchanting children’s tale but also as an allegory in defence of the populist case for gold and silver bimetallism. At a time of deflation, such as the 1890s, adding silver to gold in the monetary circulation of the United States could have been a relief for the agriculturists of the Midwest and the South, worried by debt and falling prices as they were. See “The ‘Wizard of Oz’ as a Monetary Allegory”, by Hugh Rockoff (Journal of Political Economy, August 1990).

[4] His main monetary proposal was to take the United Kingdom out of the gold standard.

[5] He did accept that a small amount of inflation, when not noticed by workers, could result in a reduction of the real wage and hence a limited increase in employment. But this was not the centre of his policy proposals. At bottom however, Keynes may have been more of an inflationist than is believed. Abba Lerner was reported to have elicited from Keynes agreement in principle to ‘printing’ money as a way to redress a recession. See “Was Keynes a Keynesian or a Lernerian?” David Colander JEL Dec., 1984.

[6] Allan Meltzer, in Keynes’s Monetary Theory: A Different Interpretation (CUP 2005) explains that Keynes held scant belief in the effectiveness of interest rate reductions to bring the economy to full employment. Ignorance, uncertainty, and risk inevitably added a large risk premium to long projects: this made the equilibrium rate of interest too high even if the authorities pressed it down. When it reached the bottom, the liquidity trap would kick in.

[7] Another way of expressing this delayed effect is that workers temporarily suffer from a ‘money illusion’. This is how Milton Friedman put it in his acceptance speech of the Nobel Prize in 1976. Edmund Phelps (another Nobel Laureate) did not accept that rational individuals suffered from the money illusion: for him it was the oligopolistic character of modern business, with monopolies, monopsonies and labor unions that explained the temporary Phillips effect. For Phelps this evanescent Phillips effect could lead to a wage and inflation spiral, which would only continue if the central bank financed it with money creation.

*Pedro Schwartz is “Rafael del Pino” Research Professor of economics at Universidad Camilo José in Madrid. A member of the Royal Academy of Moral and Political Sciences in Madrid, he is a frequent contributor to the European media on the current financial and social scene. He currently serves as President of the Mont Pelerin Society.

For more articles by Pedro Schwartz, see the Archive.