#71 Liberalism And Central Banking

This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?

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- RSJ

The Chairman of US Federal Reserve, Jerome Powell, in his speech at the annual Jackson Hole symposium signalled a significant shift in its approach to tackling inflation. He had his reasons:

“The persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern. Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy….

However, inflation that is persistently too low can pose serious risks to the economy. Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.”

Fed’s Average Inflation Targeting Regime

This isn’t a surprise. An ‘ever-lower’ inflation expectation would lead to a lower interest rate. The perennial undershooting of inflation target in the US over the last quarter century has meant short-term interest rates approaching zero. Once you reach that there’s limited room for any rate cuts to boost investments, increase employment and stabilise the economy during a downturn. The experience of Japan and many EU countries that have negative interest rates is instructive here. Clearly, there is no appetite for negative rates among US lawmakers and public.

This led Powell and its policymaking body FOMC (Federal Open Market Committee) to draft the revised statement on Longer-Run Goals and Monetary Policy Strategy. The Fed will now follow the policy of ‘average inflation targeting’ with the goal set at 2 per cent. In an average targeting regime the Fed will allow inflation to run above 2 per cent for some time in order to ‘make up’ a period of inflation below 2 per cent. Powell explained:

“We have also made important changes with regard to the price-stability side of our mandate. Our longer-run goal continues to be an inflation rate of 2 percent. Our statement emphasizes that our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well anchored at 2 percent.”

“…our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Powers And Goals Of Central Banks

I was struck by a couple of different thoughts when I read his speech.

First is a political philosophy question. What is the basis for the absolute power that a central bank like the Federal Reserve has to set goals for the economy in a democracy? What are the checks and balances to this power? For instance, apart from the FOMC who else was involved in questioning or validating the change in regime? Or was it just an arbitrary consensus of some experts (elites?) who aren’t answerable to anyone?

Second, is a technical question. Isn’t the way the central banks set the inflation rate targets good old central planning at work? Instead of letting markets determine the price based on supply, demand, and labour (or factor) productivity, the central bank interferes to keep prices ‘stable’. Isn’t this a distortion of market mechanism? There are more specific questions. Where did it get the 2 per cent target from? Also, consider the scenario when actual inflation is different from 2 per cent. What’s the duration for which the Fed will wait till it acts? And how quickly will it want the average to be restored? At a theoretical level, what’s the basis for the Fed arriving at an average inflation targeting goal? What should be the goal of a central bank?

Is Central Banking A Liberal Concept?

These are compelling arguments and I thought it would be useful to use them to discuss two quite different concepts in a single edition of this newsletter. These are:

* The notion of separation of powers (or checks and balances) in a state that’s necessary to protect liberty of its citizens

* What goals should central banks pursue in a free market economy?

The separation or control of powers between various arms of the state first appeared in the works of the pioneers of political philosophy in England – Locke and Bolingbroke. However, the most compelling and specific argument for the division of powers was laid out by the French lawyer, Baron de Montesquieu, in Chapter 6 of his book De l’Esprit des Loix (The Spirit of the Laws, 1748) which is widely regarded as one of the greatest texts on political philosophy. He begins this chapter with:

“In every government there are three sorts of power, the legislative; the executive in respect to things dependent on the law of nations; and the executive in regard to matters that depend on the civil law.”  

Montesquieu has no illusions about human nature when it wields power. His view is that the only counter to power is power. This is a prerequisite for individual liberty. For him, liberty means the freedom from being harmed by others.

"Constant experience shows us that every man invested with power is apt to abuse it.

…it is necessary from the very nature of things that power should be a check to power"   

This danger of abuse of power can only be controlled through a separation of power between different institutions and people, and a system of checks and balances. That’s the only guarantee against tyranny. This was his profound insight. As he wrote:

“When the legislative and executive powers are united in the same person, or in the same body of magistrates, there can be no liberty. . . . There would be an end to everything, were the same man, or the same body, whether of the nobles or of the people, to exercise those three powers, that of enacting laws, that of executing the public resolutions, and of trying the causes of individuals.”

This wasn’t enough. Montesquieu went a step further. Apart from separating powers in hands of different bodies and people and setting them up ‘against’ one another, he also suggested each of these arms of the state should have some powers in their mandate to control other arms. That is, they have both negative and positive checks over others.

Checks And Balances

Montesquieu hadn’t contended with autonomous or regulatory institutions like central banks during his time. The notion of a central bank as a lender of last resort while being responsible for price stability and employment is only about 100-150 years old. What are the checks and balances on it?

There are two questions here? Who checks the actions of the central bank? And is there a feedback loop to its actions? The second question is easier to answer. The outcome of its actions is controlled by the market and the economy. This is what Powell meant when he mentioned the Fed has been ‘undershooting the inflation target’. The Fed aimed its actions to achieve an inflation target. The broader economy curbed its power in achieving it.

But what about the checks on its actions? Well, there are checks and balances internal to the central bank like a Board of Governors or FOMC (or its equivalent). However, these are nominated members with limited powers and there’s no external agency that has a positive check in controlling the actions of the central bank. Once the executive nominates the policy committee and the chairman (or governor) of the central bank, it hands over the keys of monetary policy to them. There’s merit to illiberal argument when it comes to actions of the central banks.  

Target Of Central Banks

We come to the question of what goals should the central bank be targeting? Over the years the central banks around the world have taken on responsibility for price stability, economic growth, and employment. But there is no shortage of people demanding more – from income equality to paying off college debts of students and ‘green new deal’. As the central banks around the world went for significant balance sheet expansion after the global financial crisis (GFC) with no corresponding rise in inflation, there has been greater clamour for monetary policy (therefore, central banks) to serve fiscal goals. This keenness to hand over more responsibility is a tad difficult to swallow when you consider the ‘illiberal’ argument.

So, how should we think of goals of a central bank? Let’s first take its role in price stability or inflation management. This is widely considered to be its primary goal. But we come back to the ‘central planning’ argument. How much sense does it make to control price when you want to manage the economy? George Selgin, currently at Cato Institute, in his book Less Than Zero: The Case for Falling Price in a Growing Economy(1998) framed this issue well:

“Using monetary policy to stabilise the price level is not at all like making the weather more predictable, as James Buchanan and Kevin Dowd have claimed. Stabilising the price level is more like making barometric readings predictable, while leaving the weather itself as uncertain as ever: price level movements allowed under a productivity norm are merely nominal indicators of underlying changes in productivity.”

Selgin instead bats for a ‘productivity norm’ which will achieve the same result as that of ‘zero inflation’ regime without interfering with the price mechanism. He writes:

“Instead, the price level should be allowed to vary to reflect changes in goods' unit costs of production. I call a pattern of general price level adjustments corresponding to such a rule for individual price changes a 'productivity norm'. Under a productivity norm, changes in velocity would be prevented (as under zero inflation) from influencing the price level through offsetting adjustments in the supply of money. But adverse 'supply shocks' like wars and harvest failures would be allowed to manifest themselves in higher output prices, while permanent improvements in productivity would be allowed to lower prices permanently.”

For Selgin rising prices during adverse supply shocks (like we are going through in a pandemic) would be better than zero inflation.

If it isn’t a target inflation rate, what should be the goal of central bank? This is a question that’s relevant for India as the term of the first monetary policy committee (MPC) ends. Should we follow the average inflation targeting regime like the Fed or should we continue with the flexible inflation target (FIT) regime (4 per cent with +/- 2 per cent range)? Or should we accept managing price isn’t feasible and look for other options?  

V. Ananta Nageswaran writing in the Mint makes two key points the goals central banks should set for themselves.

First, central banks through monetary policy have failed to raise inflation rates in developed economies by influencing short-term interest rates (a point Graeme Wheeler, the governor of Reserve Bank of NZ had argued for). Second, they don’t have the tools to influence nominal GDP growth. So, they should aim to control credit growth and through it the ‘overheating’ of the economy:

“Further, central banks’ failure to raise the inflation rate in the last ten to twelve years (US, UK and Europe) and in the last three decades (Japan) are powerful proofs against Wheeler’s claim with respect to the inflation rate. At the same time, they are powerless to influence economic growth too. So, the mitigation for the ill-effects and consequences of any inflation-targeting central bank is not to add economic growth as an objective but to hold them responsible for what they can actually control. That does not include inflation or economic growth. That is only credit growth—of both bank and non-bank varieties. They can control that through monetary and regulatory policies.”

I would tend to agree. Credit growth management isn’t distorting the signal that is price. It is also something that’s in control of the central bank through credit policy. As Nageswaran writes:

“The RBI should define overheating more broadly than only through inflation. Apart from the inflation rate, overheating manifests itself in trade deficit and in asset (financial and non-financial) price bubbles. Hence, managing credit growth through monetary policy and regulatory measures could not only rein in inflation but also other imbalances, of both real and financial variety. Thus, an ‘overheating’ mandate will also ensure financial stability.”

To conclude, the nature of the central bank as an institution gives it autonomy and powers that aren’t ‘liberal’. However, a better choice of goals for it than inflation rate targets and the feedback loop from the economy about its actions will nudge it towards a more ’liberal’ space.

HomeWork

Reading and listening recommendations on public policy matters

* [Podcast] George Selgin on Average Inflation Targeting in Macro Musings with David Beckworth.

* [Podcast] Melvyn Bragg and his guests discuss Montesquieu in the legendary BBC programme In Our Time.

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