avoiding the next crisis

8/13/2019 Avoiding the Next Crisis

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AVOIDING THE NEXT CRISIS:CAN CENTRAL BANKS LEARN?

Robert L HetzelAny effort to avoid future recessions must rest on an organizedway to leam from the past. However, the absence of such effortswithin central banks renders such learning problematic and makeslikely the recurrence of episodes of recession and financial markettumio. Gritical to learning is die use by policymakers of models to

evaluate the past performance of monetary policy. These modelsshould not be the complicated, multiequation models favored by tlieforecasting departments of central banks. Rather, they should besimple m odels diat req uire policymakers to take a stand on the basicissues in monetary economics: the nature of the price level (mone-tary or real) and howwe tlie price system works to maintain outputat potential (fuU employment). They should serve as a safeguard totlie understandable tendency of central bankers to attribute eco-nomic disturbances exclusively to real shocks rather than monetaryshocks.Tliis article explains how learning requires that policymakers usemodels to disentangle causation from correlation. In that way, mod-els can bring coherence to the diverse experiences of the past and canfacilitate prediction of how well alternative policy rules would work.The quantity-dieory hypothesis that recessions originate in central

bank interference witli die price system is summarized and used to

to Journal Vol. 33, No. 3 (Fall 2013). Copyright Cato Institijte. All rightsreserved.


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CATO JOURNALexplain the Creat Recession. The article concludes with commentson learning and models.Creating Causation Out of Correlation

An inversion of Says' law would be that demand creates its ownsupply. There is a demand for joumalists to explain the GreatRecession and subsequent slowrecovery.The resulting supply ofsto-ries uses correlation to explain causation. In die boom phase of abusiness cycle when individuals are optimistic about the future, theybid up asset prices and take on debt. In the bust phase, tliey sellassets at fire sale prices and attempt to pay down debt. Correlationbecomes causation through a morality tale about greed and specula-tiveexcess.The initial occurrence of speculative excess requires a purging ofdie economic body. Easy money and inflation lead to tight moneyand deflation. To become easycomprehensible this story anthropo-

morphizes impersonal market forces through the vilification of tlieunrestrained gi'eed of Wall Street bankers. Finally, the story res-onates by mining a deep populist vein in American culture. As aresult of unrestrained speculation, paper wealth increases out ofpro-portion to the productive capacity of the real economy. Theinevitable bursting of the asset bubble dismpts financial intermedia-tion and productive economic activity. In the form of the real-billsdoctrine this perennially popular populist narrative powered thecreation of the Federal Reserve System.'In contrast to the journalistic imperative to tell a compellingstory, the fundamental mediodological desideratum in macroeco-nomics is to disentangle causation from correlation. This effortrequires a model, which separates die behavior of exogenous

'The original Federal Reserve Act mandated that only short-term, selfliquidating debt instruments used to finance inventories of goods in tlie processof production were eligible for discounting vvitli the Reserve banks. By limitingdiscount window lending to real biUs, the founders of the Fed intended to pre-vent the speculative use of credit and tlie formation of asset bubbles. The Fed hasalways characterized itself as n institution that influences conditions in creditmarkets ratlier than asthe institution that controls money creation. The former


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C A N C E N T R A L B A N K S L E A R N ?

var iables and shocks f rom f l ie behavior of endogenous var iables.Ex og eno us forces arise from ou tside flie w ork ing of f lie pric e sy stemand endo gen ous var iables respond to them in a way d ep en de ntupon f l ie pr ice system. As a way of introducing the importance ofbringing the discipline of economics to bear on the issue of f lieshocks that cause cyclical fluctuations in the economy, the followingprovides an example of f lie kind of descriptive characterization ofbusiness cycles referred to above and contrasts i t wifli an economicchai^acterization,

Wasl i ington I rv ing commented on the 1818-19 def la t ion andrecession:Every now and the n t he w orld is visited by one of these delu-sive seasons, when flie credit system ,, , expands to full lux-uriance: everybody trusts everybody; a bad debt is a fliingunheard of; the broad way to certain and sudden wealtli liesplain and open B an ks , , bec om e so many mints to coinwords into cash; and as the supply of words is inexhaustible,it may readily be supposed that a vast amount of promissorycapital is soon in circulation, , , , Nothing is heard but gigan-tic operation s in trade; great purch ases and sales of real prop -erty, and immense sums made at every transfer. All, to besure,as yet exists in promise ; but the believer in prom ises cal-culates the aggregate as solid capital, , , ,Now is tlie time for speculative and dream ing of designingmen. They relate tlieir dreams and projects to the ignorantand credulous, [and] dazzle them witli golden vis io n s,, , , T heexample of one stimulates another; speculation rises on spec-ulation; bubble r ises on b u b b le , , , , No operation is thoughtwortliy of attention , that does not do uble o r treble tlie invest-ment, , , , Could this delusion always last, die life of a mer-chant would indeed be a golden dream; but it is as short as itis brilliant [in Fisher 2008: 4],

Wil l iam Gral iam Sumner , in 1874, commented similar ly on thesame event :

In consequence, , , , the inclination of a large part of die peo-ple, created by past prosperity, to live by speculation and not


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C A T O J O U R N A Lconsent, and llefforts to restoresociety to itsnatural conditionwere treated with undisguised contempt [in Wood2006:4].

Thomas Jefferson, who had heavy debts at the time of liis death,frequently expressed tlie American populist view that banks encour-aged speculation and subsequent financial bust through their abilityto create paper money (bank notes).^ He especially distmsted theBank of die United States:Everything predicted by the enemies of banks, in the begin-ning, is now coming to pass. We are to be ruined by the del-uge of bank paper. It is cruel tliat such revolutions in privatefortunes should be at the mercy of avaricious adventurers,who, instead of employing their capital, if any they have, inmanufactures, commerce, and oier useful pursuits, make itan instrument to burden all the interchanges of property withtlieir swindling profits, profits which are the price of no use-ful industr)' of theirs [Letter to Thomas Cooper 1814].

A s p i r i t . . . of gambling in our public paper has seized ontoo many of our citizens, and we fear it will check our com-merce, arts, manufactures, and agriculture, unless stopped[Letter to William Carmichael 1791].The Bank of tlie United States is one of tlie most deadlyhostilities existing [Letter to Albert Gallan 1803].^

In contrast, Richard Timberlake (1993:chap . 2), who was an orig-inal mem ber of M ilton Friedm an's Money and Banking W orkshop inthe early 1950s, used a quantity-theoretic framework to analyze the1818-19 deflation and recession. The char ter of the F irst Bank of theUnited States lapsed inopportunely in 1811 given the advent of warwith Britain in 1812. Given its limited ability to tax, the federal gov-emment financed wartime deficits by issuing smaU-denominationTreasury notes, which the govemment made legal tender and func-tioned as a medium of exchange. The resulting expansion in bankreserves promoted an expansion of bank note issue. This expansionof die money stock created inflation.^Jefferson died in deb t to a great extent b ecau se h e had to sell his main incom e-producing property. Poplar Forest, in 1819 to pay debts. Because of die deflation


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C A N C E N T R A L B A N K S L E A R N ?As the comm odity value of a paper dollar fell relative to th e com-

modity value of a gold dollar, given the fixed par value of gold interm s of a dollar set by die gold standard, individuals took paper dol-lars to banks and asked for gold dollars. Faced with die loss of goldreserves, banks suspended convertibility and inflation proceededwithout tlie constraint imposed by the gold standard. In 1816,Treasury Secretary Crawford decided to retum the country to thegold standard. In order to again bring the purchasing power ofdepreciated paper dollars back into line with tliat of a gold dollar, theUnited States began to retire its note issue by running fiscal sur-pluses. Th e resulting contraction in tlie monetary base and in moneyled to deflation and recession.

In tlie bursting b ubble explanation of recession, shifts in investorsentimentoverwhelm the working of the p rice system. In th e m on-etary explanation, monetary disturbances isrupt the working of theprice system. In the bubble explanation, investor mood swings arean irrational manifestation of human faUibity: unpredictable swingsbetween greed and fear. In the monetary story, stable monetaryarrangem ents a mle) can shape constmctively the expectations ofthe public because they are fonned rationally.

A corollary of the bubb le explanation is that pessimism overwhelmsdie ability of a central bank to m aintain the nom inal expenditure of thepublic even if it were to have a policy of expanding the money stock.A Kquidity trap frustrates monetary policy. In contrast, the monetaryexplanation holds that because of stability in the velocity of money acentral bank can create money in order to maintain nominal expendi-ture. Witli the bubble explanation, the sharp declines in nominalexpenditure that accompany the declines in output in recession are aninevitable concomitant of hard-wired PhiUips Curve relationship run-ning from real output and unemployment) to nominal variables infla-tion). With the monetary explanation, the associated declines innominal and real output are a sign of misguided monetary policy tliatforces a decline in nominal expenditure and, as a result, real output.

Recessions: Eaure of the Price Systemor Interference with It?


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C A T O J O U R N A Loptimism to pessimism do not arise capriciously from irrational shiftsin speculative mania or animal spirits bu t from the disruption to eco-nomic activit) caused by monetary disturbances. The dismption tothe price system from monetary shocks originates in the way thatsuch shocks confront firms with problems of coordination that onlyan omniscient central planner could solve. Firms are forced to makestrategic decisions whose solution is not amenable to the decentral-ized decisionmaking o fth e price system. That is, firms can no longerpredict changes in the demand for their product based on a smallnumber of relative prices, but must also predict the behavior of allthe firms setting prices in the economy.

Confronted with monetary shocks that force an unpredictableevolution of the price level, firms lack a way of coordinating changesin the doUar prices they set in order to discover the evolving pricelevel that undoes the shock. That is, they lack a way of searching forthe average of tlieir doUar prices (the price level) required In orderto make nominal money correspond to the purchasing powerdem anded by money holders whe at the same time preserving th erelative prices that clear markets. Moreover, a discrete increase inthe pessimism of the public about the future requires a rearrange-ment of consumption witli a new set of relative prices. Although thewelfare theorems of economics provide assurance that this new allo-cation of resources and configuration of relative prices exist, econom -ics has nothing to say about the amount of time required for thetrial-and-error process of discovering them.As an empirical matter, significant dism ption to econom ic activitynecessitates a monetary shock. Nothing endemic to the working ofthe price system produces it. A low real interest rate does not Indi-cate a faure o fth e price system butisa symptom of a negative m on-etary shock. When once agabi the public becomes optimistic aboutthe future, the real rate of interestwi rise.

The contrasting explanations of the 1818-19 deflation and reces-sion illustrate the need for identifying restrictions to disentangle thena ture of tlie shocks that cause cyclical fluctuations. In order to iden-tify monetary shocks, quantity theorists m ake two assumptions. Thefirst highlights the intrinsic worthlessness of fiat money and the sec-ond emphasizes the efficacy of the price system in the absence of


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CANCENTRALBANKS LEARN

nominal anchor) and diat respects the working of the price system(allows market forces to deteniiine real variables Kke the real inter-est rate and the unemployment rate).

In order to give fiat money value given its intrinsic wordilessness,the central bank must limit its quantity. Given that central banks ordi-narily operate with an interest-rate instrument, they must limit thequantity of money indirecdy by imposing discipline on the public sdemand for nominal money. In order to impose that discipline, theymust operate with a rule that conditions tlie expectations of the pub-li Such a rule possesses two facets. First, because individualst kepiece of paper (money) today in exchange for goods tliat satisfy realwants, tliey must believe that money will possess value in exchangetomorrow. Practically, the central bank must keep the inflationaryexpectations of tliepubKcin line widi its inflation target (Hetzel 2008).

Second, in order to avoid the price fixing diat creates an excessdemand for bonds produced by unsustainably liigh interest rates andthe resulting open-market sales required to maintain tlie rate pegthat lead to monetary contraction and deflation, the central bankmust have a procedure diat allows die market to detennine the realinterest rate. Symmetrically, it must avoid an excess supply of bondscreated by unsustainably low interest rates and the open-market pur-chases that lead to monetary expansion and inflation. Luce any cen-tral planner, the central bank lacks the dispersed knowledge ofmarket participants. It does not know the value of tlie sustainable(natural) rate of interest.The real interest rate acts to counter fluctuations in the degreeof optimism (pessimism) of individuals about their future job andincome prospects. By lowering the price of current resources interms of forgone future resources, a low real interest rate stimu-lates the demand for current resources and thus stabizes fluctua-tions in aggregate demand when individuals are pessimistic aboutthe future. Gonversely, a high real interest rate restrains thedemand for current resources when individuals are optimisticabout the future. When central banks fail to foUow procedures thatallow market forces to determine the real interest rate, through thecreation and destmction of money, they circumvent this operationof the price system and as a consequence engender the boom and


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C A T O J O U R N A Lcounterpart of the resulting surpluses in the bond market is moneycreation and of the shortages in the bond market money destruc-tion. In individual markets, the consequences of govemment pricefbdng are obvious. One sees imm ediately th e resulting shortages andsurpluses. As explained by Milton Friedm an (1960), however, longand variable lags from money destmction and creation obscure fliemacroeconomic counterpart of central bank price fixing.

The Creat Recession of 2008-09Economists did not predict the severe world recession thatunfolded in 2008 nor did they predict the lack of a strong recovery.For this reason, m any economists are working on extending the pro -fession's workhorse New Keynesian model. Much of this work hastaken flie form of the introduction of financial frictions in credit mar-kets. Work combining finance and macroeconomics is importantregardless of the validity of the intuition that the shock that causedflie Great Recession originated in financial markets. A characteristicof recession is the persistence of high real interest rates long afferexpected consumption would have dechned (Hetzel 2012a:Table7.1,Figures 8.4 and 8.5). That fact points to a financial friction(Hetze l 2012a: 123),However, whue financial frictions could play a role in propagatingshocks, they are unlikely candidates for the shock that prec ipitated the

Great Recession, Both in the United States and in other advancedeconomies, mild recession tum ed into major recession in 2008Q2 and2008Q3 before the turmoil infin nci lmarkets set off by flie Lehm ancrisis, which started September 15, 2008. Despite flie losses banksincurred when they took the mortgage-backed securities held in off-balance-sheet entities on to flieir balance sheets, credit markets wereworkingw llbefore the Lehm an bankruptcy (Hetzel2012a:chap, 12).In contrast, the centi^al bank behavior Milton Friedman (1960)identified with recessions manifested itself in spring and summer2008. In his long-and-variable-Iags argument, Friedman pointed tothe destabiHzation of economic activity attendant upon the directresponse of central banks to realized inflation. As a result of the verylong lags between contractionary monetary policy and disinflation,


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CAN CENTRAL BANKS LEARN

AH major central banks behaved the same way in 2008-09 . Theargumentfor a monetary shock wouldbe less persuasiveiftheirmonetary policies had been divergent. Starting in sum mer 2004 andcoming to a head in 2007 and the first half of2008,an inflation shockpropelled by rising energy, commodity, and food prices pushed upheadline inflation. Even though core inflation remained significandylower at somewhat above 2 percent, central banks were concemedabout losing credibility andhaving high headline inflation passthrough to core inflation.

Atthesame time, theinflation shock caused real disposableincome to stop growing. Consumers became more pessimistic abouttheir future income prospects. That increased pessimism requiredadecline in diereal interest rate inorder tomaintain aggregatedemand equal to potential output. However, because of the persist-ence of high inflation, despite the weakening of economic activity,central banks m aintained high real interest rates. The resulting con-tractionary monetary policy turned a moderate recession due to theinflation shock into a major recession.

Ou t of a belief tha t die prob lem was not contractionary m onetarypolicy butrather a dismption to financial intermeciiation,theFO M C lowered the funds rate only slowly to a value near zero at theDecember 15, 2008, meeting.Aflow of funds out of institutionalmoney funds into the large, too-big-fa banks as well as an increaseddemand for liquidity caused the monetary aggregate M2 to surge infall 2008. After accommodating this surge, starting in January 2009,the FOMC allowed M2togrowat ahistorically low rate for eco-nomic recoveries. Focused on programs to restart financial interm e-diation in markets like the asset-backed commercial paper marketand convinced thatanear-zero interest rate implied expansionarymonetary policy, the FOMC allowed the growth rateofnominalGDP to decline drastically through a failure to promote the growthrate in the monetary base required to maintain strong M2 growth.See Hetzel (2012a: 236 and 347)for adiscussion ofthe low M2 growth afterDecember 2008. For two reasons, this low M2 growdi understates the restrainingeffect of monetary policy on nominal GDP growth. When interest rates decline, theijiterest-sensitvity of M 2 de mand causes M2 velocity to decline. Th at is, weakeningeconom ic activity and d ie associated reduction in interest rates, by causing an outflow


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C A T O J O U R N A LLearning Requires the Language of Economics

Based on FOMC documents available through 2006, the staff ofthe Board of Covem ors uses models solely to forecast the future. Thedesire to forecast the evolution of the economy creates a bias for com-plex models with very large numbers of equations. Unfortunately, theability of economists to forecast the future evolution of the economyis negligible.^ resulting characteristic of such models is their contin-ual reestimation to make them fit the data. Moreover, the FOMCdoes not provide the staff with a policy rule summarizing its behaviorto use in the simulations. In contrast to tlie effort placed on forecast-ing the future, there is no effori to use models to evaluate the efficacyor mistakes of past monetary policy. There is no organized, continu-ing effori to leam from the past.

It appears as though central bankers believe that their legitimacycomes from the pub lic percep tion that they understan d th e behaviorof economic activity and how their actions interact with economicactivity. Th at percep tion appears to derive from the belief on the pariof the public that an ability to talk about the economy in a descrip-tive way implies an understanding of the structure of the economy.An encyclopedic knowledge of facts about the economy is evidenceof a reliable grasp of a model of the economy. C entral bankers under-stand what macroeconomic variables they con trol and how they exer-cise that control.A more reliable way of achieving and maintaining legitimacywould be to engage in an ongoing, large-scale effori to leam from thepast. Theoreticians and historians would work together to use themodels of economics to understand the history of central banking(Hetzel 2012b). Determination of which policies have worked andwhich have not worked would constitute an apolitical, scientificprogram.

ReferencesFisher, R. W . (2008) Financial Market Trem ors: Causes andResponses. Federa l Reserve Bank of Dallas conomic Letter 3

(April): 1-8.


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C A N C E N T R A L B AN K S L E A R N ?Friedm an, M. (1960) A Frogramfor Monetary Stability New York:

Fordham University Press.Hetzel, R. L. (2008) The Monetary Folicy of the F ederal R eserve:A History Cam bridge: Cam bridge University Press.(2012a) The Great Recession:Market ailureor olicyFailure?G ambridge: Gambridge University Press.

(2012b) Gen tral Bank Accoun tability andIndependence: Are They Inconsistent? Journal ofMacroeconomics 34 (M arch): 616-25 .W ood, J. H . (2006) The Stabity of Monetary Policy: Th e F edera lReserve, 1914-2006. Working Paper, W ake Forest University.Timberlake, R. H. (1993) Monetary Policy in the United States:An Inteectual and Institutional History. Ghicago: University ofGhicago Press.


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C o p y r i g h t o f C A T O J o u r n a l i s t h e p r o p e r t y o f C a t o I n s t i t u t e a n d i t s c o n t e n t m a y n o t b e c o p i e d

o r e m a i l e d t o m u l t i p l e s i t e s o r p o s t e d t o a l i s t s e r v w i t h o u t t h e c o p y r i g h t h o l d e r ' s e x p r e s s

w r i t t e n p e r m i s s i o n . H o w e v e r , u s e r s m a y p r i n t , d o w n l o a d , o r e m a i l a r t i c l e s f o r i n d i v i d u a l u s e .

avoiding the next crisis

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