Central Banks Are the Fall Guys

For decades, the freedom of monetary policymakers to make difficult decisions without having to worry about political blowback has proven indispensable to macroeconomic stability. But now, central bankers must ease monetary policies in response to populist mistakes for which they themselves will be blamed.

CHICAGO – Central-bank independence is back in the news. In the United States, President Donald Trump has been  the Federal Reserve for keeping interest rates too high, and has reportedly explored the possibility of forcing out Fed Chair Jerome Powell. In Turkey, President Recep Tayyip Erdoğan has fired the central-bank governor. The new governor is now pursuing sharp rate cuts. And these are hardly the only examples of populist governments setting their sights on central banks in recent months.

In theory, central-bank independence means that monetary policymakers have the freedom to make unpopular but necessary decisions, particularly when it comes to combating inflation and financial excesses, because they do not have to stand for election. When faced with such decisions, elected officials will always be tempted to adopt a softer response, regardless of the longer-term costs. To avoid this, they have handed over the task of intervening directly in monetary and financial matters to central bankers, who have the discretion to meet goals set by the political establishment however they choose.

This arrangement gives investors more confidence in a country’s monetary and financial stability, and they will reward it (and its political establishment) by accepting lower interest rates for its debt. In theory, the country thus will live happily ever after, with low inflation and financial-sector stability.

Having proved effective in many countries starting in the 1980s, central-bank independence became a mantra for policymakers in the 1990s. Central bankers were held in high esteem, and their utterances, though often elliptical or even incomprehensible, were treated with deep reverence. Fearing a recurrence of the high inflation of the early 1980s, politicians gave monetary policymakers wide leeway, and scarcely ever talked about their actions publicly.

But now, three developments seem to have shattered this entente in developed countries. The first development was the 2008 global financial crisis, which suggested that central banks had been asleep at the wheel. Although central bankers managed to create an even more powerful aura around themselves by marshaling a forceful response to the crisis, politicians have since come to resent sharing the stage with these unelected saviors.

Second, since the crisis, central banks have repeatedly fallen short of their inflation targets. While this may suggest that they could have done more to boost growth, in reality they don’t have the means to pursue much additional monetary easing, even using unconventional tools. Any hint of further easing seems to encourage financial risk-taking more than real investment. Central bankers have thus become hostages of the aura they helped to conjure. When the public believes that monetary policymakers have superpowers, politicians will ask why those powers aren’t being used to fulfill their mandates.

Third, in recent years many central banks changed their communication approach, shifting from Delphic utterances to a policy of full transparency. But since the crisis, many of their public forecasts of growth and inflation have missed the mark. That these might have been the best estimates at the time convinces no one. That they were wrong is all that matters. This has left them triply damned in the eyes of politicians: they

  1. failed to prevent the financial crisis and paid no price; they are
  2. failing now to meet their mandate; and they
  3. seem to know no more than the rest of us about the economy.

It is no surprise that populist leaders would be among the most incensed at central banks. Populists believe they have a mandate from “the people” to wrest control of institutions from the “elites,” and there is nothing more elite than pointy-headed PhD economists speaking in jargon and meeting periodically behind closed doors in places like Basel, Switzerland. For a populist leader who fears that a recession might derail his agenda and tarnish his own image of infallibility, the central bank is the perfect scapegoat.

Markets seem curiously benign in the face of these attacks. In the past, they would have reacted by pushing up interest rates. But investors seem to have concluded that the deflationary consequences of the policy uncertainty created by the unorthodox and unpredictable actions of populist administrations far outweigh any damage done to central bank independence. So they want central banks to respond as the populist leader desires, not to support their “awesome” policies, but to offset their adverse consequences.

A central bank’s mandate requires it to ease monetary policy when growth is flagging, even when the government’s own policies are the problem. Though the central bank is still autonomous, it effectively becomes a dependent follower. In such cases, it may even encourage the government to undertake riskier policies on the assumption that the central bank will bail out the economy as needed. Worse, populist leaders may mistakenly believe the central bank can do more to rescue the economy from their policy mistakes than it actually can deliver. Such misunderstandings could be deeply problematic for the economy.

Furthermore, central bankers are not immune to public attack. They know that an adverse image hurts central bank credibility as well as its ability to recruit and act in the future. Knowing that they are being set up to take the fall in case the economy falters, it would be only human for central bankers to buy extra insurance against that eventuality. In the past, the cost would have been higher inflation over the medium term; today, it is more likely that the cost will be more future financial instability. This possibility, of course, will tend to depress market interest rates further rather than elevating them.

What can central bankers do? Above all, they need to explain their role to the public and why it is about more than simply moving interest rates up or down on a whim. Powell has been transparent in his press conferences and speeches, as well as honest about central bankers’ own uncertainties regarding the economy. Shattering the mystique surrounding central banking could open it to attack in the short run, but will pay off in the long run. The sooner the public understands that central bankers are ordinary people doing a difficult job with limited tools under trying circumstances, the less it will expect monetary policy magically to correct elected politicians’ errors. Under current conditions, that may be the best form of independence central bankers can hope for.

Why We Should Fear Easy Money

Cutting interest rates now could set the stage for a collapse in the financial markets.

To widespread applause in the markets and the news media, from conservatives and liberals alike, the Federal Reserve appears poised to cut interest rates for the first time since the global financial crisis a decade ago. Adjusted for inflation, the Fed’s benchmark rate is now just half a percent and the cost of borrowing has rarely been closer to free, but the clamor for more easy money keeps growing.

Everyone wants the recovery to last and more easy money seems like the obvious way to achieve that goal. With trade wars threatening the global economy, Federal Reserve officials say rate cuts are needed to keep the slowdown from spilling into the United States, and to prevent doggedly low inflation from sliding into outright deflation.

Few words are more dreaded among economists than “deflation.” For centuries, deflation was a common and mostly benign phenomenon, with prices falling because of technological innovations that lowered the cost of producing and distributing goods. But the widespread deflation of the 1930s and the more recent experience of Japan have given the word a uniquely bad name.

After Japan’s housing and stock market bubbles burst in the early 1990s, demand fell and prices started to decline, as heavily indebted consumers began to delay purchases of everything from TV sets to cars, waiting for prices to fall further. The economy slowed to a crawl. Hoping to jar consumers into spending again, the central bank pumped money into the economy, but to no avail. Critics said Japan took action too gradually, and so its economy remained stuck in a deflationary trap for years.

Yet, in this expansion, the United States economy has grown at half the pace of the postwar recoveries. Inflation has failed to rise to the Fed’s target of a sustained 2 percent. Meanwhile, every new hint of easy money inspires fresh optimism in the financial markets, which have swollen to three times the size of the real economy.

In this environment, cutting rates could hasten exactly the outcome that the Fed is trying to avoid. By further driving up the prices of stocks, bonds and real estate, and encouraging risky borrowing, more easy money could set the stage for a collapse in the financial markets. And that could be followed by an economic downturn and falling prices — much as in Japan in the 1990s. The more expensive these financial assets become, the more precarious the situation, and the more difficult it will be to defuse without setting off a downturn.

The key lesson from Japan was that central banks can print all the money they want, but can’t dictate where it will go. Easy credit could not force over-indebted Japanese consumers to borrow and spend, and much of it ended up going to wastefinancing “bridges to nowhere” and the rise of debt-laden “zombie companies that still weigh on the economy.

Today, politicians on the right and left have come to embrace easy money, each camp for its own reasons, both ignoring the risks. President Trump has been pushing the Fed for a large rate cut to help him bring back the postwar miracle growth rates of 3 percent to 4 percent.

At the same time, liberals like Bernie Sanders and Alexandria Ocasio-Cortez are turning to unconventional easy money theories as a way to pay for ambitious social programs. But they might want to take a closer look at who has benefited most after a decade of easy money: the wealthy, monopolies, corporate debtors. Not exactly liberal causes.

By fueling a record bull run in the financial markets, easy money is increasing inequality, since the wealthy own the bulk of stocks and bonds. Research also shows that very low interest rates have helped large corporations increase their dominance across United States industries, squeezing out small companies and start-ups. Once seen as a threat only in Japan, zombie firms — which don’t earn enough profit to cover their interest payments — have been rising in the United States, where they account for one in six publicly traded companies.

All these creatures of easy credit erode the economy’s long-term growth potential by undermining productivity, and raise the risk of a global recession emanating from debt-soaked financial and housing markets. A 2015 study of 17 major economies showed that before World War II, about one in four recessions followed a collapse in stock or home prices (or both). Since the war, that number has jumped to roughly two out of three, including the economic meltdowns in Japan after 1990, Asia after 1998 and the world after 2008.

Recessions tend to be longer and deeper when the preceding boom was fueled by borrowing, because after the boom goes bust, flattened debtors struggle for years to dig out from under their loans. And lately, easy money has been enabling debt binges all over the world, particularly in corporate sectors.

As the Fed prepares to announce a decision this week, growing bipartisan support for a rate cut is fraught with irony. Slashing rates to avoid deflation made sense in the crisis atmosphere of 2008, and cutting again may seem like a logical response to weakening global growth now. But with the price of borrowing already so low, more easy money will raise a more serious threat.

By further lifting stock and bond prices and encouraging people to take on more debt, lowering rates could set the stage for the kind of debt-fueled market collapse that has preceded the economic downturns of recent decades. Our economy is hooked on easy money — and it is a dangerous addiction.

The Fed’s New Message: The Economy Can Get a Lot Better for Workers

A rejection of what had been a consensus view of the relationship between the jobless rate and inflation.

Sometimes, ideas can bounce around the intellectual fringes for years before eventually being embraced by the powerful. On Wednesday you could watch it happen in real time, on cable television.

In congressional testimony, the Federal Reserve chair, Jerome Powell, argued that despite the low unemployment rate, the job market was not yet in an all-out boom and that there was room for further improvement without worrying too much about inflation. He even hinted that American workers were due for some catch-up growth in their compensation — after years in which their pay fell as a share of the economy.

It was implicitly a rejection of what had been a consensus view among leaders of the central bank as recently as last year: that the economy had already achieved, or was quite near to, full employment, and therefore that the Fed needed to raise interest rates to prevent inflation.

Consider some of his remarks during his appearance Wednesday before the House Financial Services Committee.

We don’t have any basis or any evidence for calling this a hot labor market,” Mr. Powell said. “We haven’t seen wages moving up as sharply as they have in the past.”

“To call something hot, you need to see some heat,” he added, as pithy a statement of economic conditions as you’ll hear from a Fed chief.

Representative Alexandria Ocasio-Cortez, Democrat of New York, later asked, “Do you think it’s possible that the Fed’s estimates of the lowest sustainable unemployment rate may have been too high?”

“Absolutely,” Mr. Powell replied, adding that the Phillips curve, the statistical relationship between low joblessness and higher inflation that has been central to Fed policymaking for decades, is showing itself as but a “faint heartbeat.”

He repeatedly noted evidence that the low jobless rate had led employers to be more willing to hire less qualified workers and spend money training them — a phenomenon with big potential longer-term benefits for both those people and the economy as a whole.

Perhaps most revealing, he seemed open to the possibility that workers should reclaim a higher share of the nation’s economic output.

Representative Denny Heck, Democrat of Washington, said, “Why hasn’t the Fed called out more than a generation of lack of wage growth?”

“Go back to the turn of the century: What you saw was a decline in the labor share, and that has not been reversed,” Mr. Powell said, using a term for the share of national income that goes to workers in the form of pay and benefits.

“We’re missing 10 years of growth,” he continued. “I think that’s really the underlying problem. We’re getting reasonable wage growth, but we missed all of those years beginning at the beginning of the century. It’s a very serious problem, and we should do a better job of calling it out.”

By contrast, not long ago, Mr. Powell and other leaders of the central bank were proceeding on the assumption that the job market did not have room to get much better without setting off an inflationary spiral.

In a 2017 speech, for example, when he was a Fed governor, Mr. Powell said that estimates of the long-term rate of unemployment indicated that “the unemployment rate gap has essentially been closed” and that “a variety of other measures also suggest that we are close to maximum employment.”

The unemployment rate was 4.7 percent that month, and it has fallen a full percentage point since, with no evident rise in inflation.

So what has changed? The simplest answer is: the data.

It may have been plausible two or three years ago to think it was only a matter of time before a tight job market translated into more rapidly rising compensation for workers, and, in turn, broader inflation. But it hasn’t happened, or at least not remotely to the degree that those models predicted.

It probably also helps that the Fed is now under pressure, from both conservatives and liberals, to increase economic growth. That gives Mr. Powell room to speak of improving conditions for workers without coming across as partisan.

Trump administration officials, particularly the National Economic Council chief, Larry Kudlow, have argued that there is no reason to think a stronger job market will stoke inflation. And the president has criticized Mr. Powell and the Fed for last year’s interest rate increases.

The shift also comes after years in which a handful of voices in the relative wilderness, both inside and outside the central bank, have been building the intellectual case for the view that Mr. Powell embraced Wednesday.

Internally, the Minneapolis Fed president, Neel Kashkari, has made arguments along these lines for years.

Outside the central bank, the activist group Fed Up has contended since its formation in 2014 that the economy was not as close to health as many Fed officials assumed, and that the Fed should forestall interest rate increases until there was more widespread prosperity.

A range of economists has also made these arguments, though often not the boldface names of the profession, but younger academics less tethered to an orthodoxy that dates back decades.

“I wouldn’t say we have won yet, but we are definitely making progress,” said J.W. Mason, an assistant professor at John Jay College at City University of New York who has written on these ideas. “Compared with a few years ago, the debate has definitely shifted in favor of those of us who have been saying that there is much more slack in the economy than conventional measures suggest, and that macroeconomic policy has been systematically too conservative — too worried about inflation and not worried enough about unemployment.”

This hasn’t been an overnight shift. You can see in comments from a range of top Fed officials over the last couple of years that they have grappled with the possibility that they have been overly confident in their assessment that the economy was closing in on full health.

But Mr. Powell’s appearance before Congress on Wednesday should leave little doubt of where the intellectual currents are flowing.

Goldbugs for Trump

They sold their principles a long time ago.

Before going to the White House, Donald Trump demanded that the Fed raise interest rates despite high unemployment and low inflation. Now he’s demanding rate cuts, even though the unemployment rate is much lower and inflation at least a bit higher. To be fair, there is a real economic argument for rate cuts as insurance against a possible slowdown. But it’s clear that Trump’s motives are and always have been purely political: he wanted the Fed to hurt President Obama, and now he wants it to boost his own reelection chances.

It’s not surprising, then, that Trump is also trying to stuff the Federal Reserve Board with political allies. What may seem surprising is that many of his would-be appointees, like Stephen Moore and now Judy Shelton, have long records of supporting the gold standard or something like it. This should put them at odds with his efforts to politicize the Fed. After all, one of the supposed points of a gold standard is to remove any hint of politics from monetary policy. And with gold prices rising lately, gold standard advocates should be calling for the Fed to raise rates, not lower them.

But of course both Moore and Shelton have endorsed Trump’s demand for rate cuts. This creates a dual puzzle: Why does Trump want these people, and why are they so willing to cater to his wishes?

Well, I think there’s a simple answer to both sides of the puzzle, which involves the reason some economic commentators (not sure if they deserve to be called “economists”) become goldbugs in the first place. What I’d suggest is that it usually has less to do with conviction than with cynical careerism. And this in turn means that goldbugs are, in general, the kind of people who can be counted on to do Trump’s bidding, never mind what they may have said in the past.

Let me start with what might seem like a trivial question, but which is, I believe, crucial: What does it take to build a successful career as a mainstream economist?

The truth is that it’s not at all easy. Parroting orthodox views definitely won’t do it; you have to be technically proficient, and to have a really good career you must be seen as making important new contributions — innovative ways to think about economic issues and/or innovative ways to bring data to bear on those issues. And the truth is that not many people can pull this off: it requires a combination of deep knowledge of previous research and the ability to think differently. You have to both understand the box and be able to think outside it.

I don’t want to romanticize the mainstream economics profession, which suffers from multiple sins. Male economists like me are only beginning to comprehend the depths of the profession’s sexism. There’s far too much dominance by an old-boy network of economists with PhDs from a handful of elite institutions. (And yes, I’ve been a beneficiary of these sins.) Many good ideas have been effectively blocked by ideology — even now, for example, it’s hard to publish anything with a Keynesian flavor in top journals. And there’s still an overvaluation of mathematical razzle-dazzle relative to real insight.

But even for people who can check off all the right identity boxes, climbing the ladder of success in mainstream economics is tough. And here’s the thing: for those who can’t or won’t make that climb, there are other ladders. Heterodoxy can itself be a careerist move, as long as it’s an approved, orthodox sort of heterodoxy.

Everyone loves the idea of brave, independent thinkers whose brilliant insights are rejected by a hidebound establishment, only to be vindicated in the end. And such people do exist, in economics as in other fields. Someone like Hyman Minsky, with his theory of financial instability, was, in fact, ignored by almost everyone in the mainstream until the 2008 crisis sent everyone scurrying off to read his work.

But the sad truth is that the great majority of people who reject mainstream economics do so because they don’t understand it; and a fair number of these people don’t understand it because their salary depends on their not understanding it.

Which brings me to the gold standard.

There is overwhelming consensus among professional economists that a return to the gold standard would be a bad idea. That’s not supposition: Chicago’s Booth School, which surveys a broad bipartisan group of economists on various topics, found literally zero support for the gold standard.

The events of the past dozen years have only reinforced that consensus. After all, the price of gold soared from 2007 to 2011; if gold-standard ideology had any truth to it, that would have been a harbinger of runaway inflation, and the Fed should have been raising interest rates to keep the dollar’s gold value constant. In fact, inflation never materialized, and an interest rate hike in the face of surging unemployment would have been a disaster.

Thank God we weren’t on the gold standardCreditFederal Reserve of St. Louis

 

ImageThank God we weren’t on the gold standard
CreditFederal Reserve of St. Louis

So why did gold soar? The main answer seems to be plunging returns on other assets, especially bonds, which were the product of a depressed world economy. What this means is that in practice pegging the dollar to gold would mean systematically raising interest rates when the economy slumps. Not exactly a recipe for stability.

Why, then, does goldbuggery persist? Well, some billionaires — such as Robert Mercer, also a big Trump supporter — have a thing about gold. I’m not entirely sure why, although I suspect that it’s just a plutocratic version of the Fox News syndrome — the angry old white guy ranting about big-government types inflating away his hard-earned wealth to give it away to Those People. And these billionaires give a lot of money to libertarianish think tanks that peddle gold standard derp.

Now imagine yourself as a conservative who writes about economics, but who doesn’t have the technical proficiency and originality needed to get a good job in academia, an economic policy institution like the Fed, or a serious think tank. Well, becoming a vocal gold-standard advocate opens a whole different set of doors. You’ll have a much fancier and more lucrative career, get invited to a lot more stuff, than you would if you stayed with the professional consensus.

What I’m suggesting, in other words, is that gold-standard advocacy is a lot like climate change denial: There are big personal and financial rewards for an “expert” willing to say what a few billionaires want to hear, precisely because no serious expert agrees. In the climate arena, we know that essentially all climate deniers are on the fossil-fuel take. There may be some true believers in the monetary magic of gold, but it’s hard to tell; what we do know is that prominent goldbugs do very well relative to where their careers would be if they didn’t buy into this particular area of derp.

And that, in turn, brings us back to Trump.

Why would Trump expect goldbugs to abandon their principles and back his demands to fire up the printing presses? Why is he, in fact, apparently finding it easy to get goldbugs willing to turn their backs on everything they claimed to believe?

The answer, I’d submit, is that it was never about principles in the first place. Many, perhaps most prominent goldbugs advocate a gold standard not out of conviction but out of ambition; they sold their principles a long time ago. So selling those pretend principles yet again in order to get a nice Trump-sponsored job is no big deal.

It’s cynicism and careerism all the way down.