Demythologizing central
bankers By Thomas I Palley
It is often said that the winners get to
write history, which matters because the way we
tell history frames our understanding. What is
true for general history also holds for economic
history, and the way we tell economic history
affects our expectations and aspirations for the
economy.
The past 25 years have witnessed
a boom in the reputation of central bankers. This
boom is based on an account of recent economic
history that reflects the views of the winners.
Now, with the US economy entering troubled waters,
that reputation may get dented. More importantly,
there is an opportunity to tell an alternative
account of recent history.
The raised
standing of central bankers rests on a phenomenon
that economists have termed the "Great
Moderation". This
phenomenon refers to the
smoothing of the business cycle over the past two
decades, during which expansions have become
longer, recessions shorter and inflation has
fallen.
Many economists attribute this
smoothing to improved monetary policy by central
banks, hence the boom in central banker
reputations. This explanation is popular with
economists since it implicitly applauds the
economics profession by attributing improved
policy to advances in economics and increased
influence of economists within central banks. For
instance, the chairman of the US Federal Reserve
is a former academic economist, as are many of the
Fed's board of governors and many presidents of
the regional Federal Reserve banks.
That
said, there are other less celebratory accounts of
the Great Moderation that view it as a
transitional phenomenon, and one that has also
come at a high cost. One reason for the changed
business cycle is retreat from policy commitment
to full employment.
The great Polish
economist Michal Kalecki observed that full
employment would likely cause inflation because
job security would prompt workers to demand higher
wages. That is what happened in the 1960s and
1970s. However, rather than solving this political
problem, economic policy retreated from full
employment and assisted in the evisceration of
unions. That lowered inflation, but it came at the
high cost of two decades of wage stagnation and a
rupturing of the link between wage and
productivity growth.
Disinflation also
lowered interest rates, particularly during
downturns. This contributed to successive waves of
mortgage refinancing and also reduced cash
outflows on new mortgages. That improved household
finances and supported consumer spending, thereby
keeping recessions short and shallow.
With
regard to lengthened economic expansions, the
Great Moderation has been driven by asset price
inflation and financial innovation, which have
financed consumer spending. Higher asset prices
have provided collateral to borrow against, while
financial innovation has increased the volume and
ease of access to credit. Together, that created a
dynamic in which rising asset prices have
supported increased debt-financed spending,
thereby making for longer expansions. This dynamic
is exemplified by the housing bubble of the past
eight years.
The important implication is
that the Great Moderation is the result of a
retreat from full employment combined with the
transitional factors of disinflation, asset price
inflation, and increased consumer borrowing. Those
factors now appear exhausted. Further disinflation
will produce disruptive deflation. Asset prices
(particularly real estate) seem above levels
warranted by fundamentals, making for the danger
of asset price deflation. And many consumers have
exhausted their access to credit and now pose
significant default risks.
Given this, the
Great Moderation could easily come to a grinding
halt. Though high inflation is unlikely to return,
recessions are likely to deepen and linger. If
that happens, the reputations of central bankers
will sully, and the real foundation and hidden
costs of the Great Moderation may surface. That
could prompt a rewriting of history that restores
demands for a return to true full employment with
diminished income inequality. How we tell history
really does matter.
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