November 16, 2009
THE BURDEN OF FIAT MONEY: REAL-TIME DECISIONS
Central bankers are a powerful lot and so it’s an easy to assume that they’re also prescient. When you’re making decisions that affect the livelihoods of millions of people—billions on a global scale—confusing people with their institutional authority can become habit forming. But central bankers are mortal, and therefore prone to mortal decisions, a.k.a. flawed decisions. Heck, it happens to the best of us at times. The only difference is that most people’s day jobs don’t cast a long shadow over a nation’s money supply.
No less an expert on central banking than Paul Volcker, the patron saint of inflation slayers everywhere, advises that “central bankers suffer from hubris like everybody else.” That’s not surprising, but it does have consequences.
The monetary policy du jour, as a result, may not be exactly what the macroeconomic gods ordered. A mismatch between the optimal monetary policy and current events is in some sense fate. Working with limited information makes it hard to know if today’s actions will suffice for the uncertainty that arrives tomorrow. As a result, we can talk of monetary policy in terms of its degree of inaccuracy or accuracy.
Intelligently dispensed or not, monetary policy steers economic activity, ranging from decisions in asset pricing to lending preferences to choices that affect the labor market. Alas, poor decisions have a habit of delivering less-than-satisfying results.
Remember all the talk of the Great Moderation? “One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility,” Ben Bernanke pronounced in early 2004 in his then-current position as a Fed governor. “Reduced macroeconomic volatility,” he went on to explain, “has numerous benefits. Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.”
It’s debatable how much the Fed was influenced by the past for setting monetary policy in 2004 and beyond, but some observers of central banking suggest that the calm history in those halcyon days led policymakers astray. Anna Schwartz of the National Bureau of Economic Research speaks for many dismal scientists when she charges in a recent essay that the Fed kept interest rates too low for too long earlier in this decade. In turn, the inappropriate interest rates distorted markets, she says, and the fallout wasn't trivial. “In the case of the housing price boom, the government played a role in stimulating demand for houses by proselytizing the benefits of home ownership for the well-being of individuals and families.” The net result, to state the obvious, was less than optimal.
Volcker has commented that the preference for low interest rates earlier in this decade was based on a “misreading of the Japan situation.” The worry that deflation threatened in 2001-2005 was simply wrong, as was the resulting prescription: low interest rates.
Economist Scott Sumner opines that another Fed mistake of some consequence was the decision in September 2008 to leave interest rates as is. “On September 16, 2008, the Fed made one of its most costly errors ever,” he recently wrote. “Immediately after the failure of Lehman Brothers, the FOMC decided to leave the target rate unchanged at 2.0 percent.” Monetary policy, in other words, should have been far more supportive given current events. It wouldn’t have prevented the financial crisis, but it might have minimized the fallout, perhaps by more than a trivial amount.
The idea that central banks have power of the ebb and flow of economies isn’t new. In 1963, Milton Friedman and Anna Schwartz reordered perceptions of the Great Depression with their the monumental A Monetary History of the United States, 1867-1960, which indicts the central bank’s monetary policy for the events of the 1930s. Friedman and Schwartz argued that the central bank’s errors in managing the money supply were the primary catalyst that turned recession into something far worse. “Prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the [economic] contraction’s severity and almost as certainly its duration,” they wrote.
Today, central bankers the world over are faced with another decision of above-average consequence. The exit strategy, as it’s called, requires that the Fed and its counterparts choose when to begin drawing back the enormous liquidity that’s been injected into the global economy.
“It is clear…that our exceptional support cannot last for too long a period of time since there are negative side effects,” Jürgen Stark, a member of the European Central Bank’s executive board, said last week. Jan F Qvigstad, deputy governor of the Central Bank of Norway, also remarked last week that the country’s current target policy rate of 1.5% “will be 2.75 per cent around the end of next year.”
Some central banks have already begun raising rates, as we noted a month ago. The Fed too must return monetary policy in the U.S. to something approaching a normal state. As always, the possibility of raising rates too early, too late or insufficiently keeps everyone guessing. Accordingly, inflation may or may not be a problem in the years ahead.
“At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard,” we wrote in March. “We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming.”
The risk tied to the timing and magnitude of the exit strategy isn’t necessary limited to inflation, as the tumultuous history of this decade reminds. We might add that we also shouldn’t kid ourselves that the Fed will make exactly the right decisions at exactly the right time.
There are many advantages to fiat money. But the main advantage is also the primary risk: flexibility. As with democracy and investing, choices matter. Rarely are those choices perfect. Sometimes they’re egregiously wrong, sometimes they’re more or less productive. The great question is what outcome will the decisions give us this time?
Posted by jp at November 16, 2009 9:45 AM
You offer an intriguing if provocative counterpoint. But with all due respect, the practical reality is that inflation exists, which is to say the purchasing power of the dollar has diminished over time. We can debate if there's a there there with the concept of fiat currencies, but the hard truth is simply this: Dollars buy less today than yesterday and I expect the trend will endure.
Posted by: JP at November 16, 2009 3:53 PM
There is no such thing as fiat money. The US dollar is backed by the gold and bonds held by the federal reserve. This means that if private banks need more paper dollars, they should be able, at their option, to bring $100 worth of stuff to the Fed and receive 100 paper dollars from the Fed in return. The Fed's assets will rise in step with its liabilities, and the value of the dollar will not change. The big advantage is that the quantity of money is determined by the public itself, rather than by government officials suffering from hubris.
Posted by: Mike Sproul at November 16, 2009 1:05 PM