The Risks and Rewards of Fiat Money

Central bankers are a powerful lot and so it’s 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?

Comments

[Mad Hedge F...:]

vsx With the media going gaga over the imagined economic recovery, it’s time to take another look at Ben Bernanke’s exit strategy, or the lack of one. There is no doubt that a large part of our current financial stability is owed to massive Fed support of the entire spectrum of the debt markets and the forced recapitalization of the banks. If Ben vacates too soon, we’ll descend back into the depths of Hell. If he hangs around too long, he’ll be doling out massive dollops of hyperinflation. It’s like having an annoying dinner party guest who you can’t ditch because you need him to pay the bill. Fed watchers say the dilemma is as challenging as threading a needle in the dark while wearing pruning gloves. There are also the two 800 pound gorillas swept under the carpet named Fannie Mae and Freddie Mac, which are still major sources of home loans for the catatonic housing market. I’m glad it’s his headache and not mine.

Nov 16 11:48 AM

[bob adamson:]

This article by James Picerno provides an excellent summary of a representative selection of recent observations by knowledgeable observers of the role played since 2003 by US and EU central banks. Happily the polemics between the proponents and opponents of the various sub-schools within the Austrian and Keynesian schools and calls for clear declarations of policy from the central banks are left to another day.

This article is especially timely now as both the general economy and the stock and commodities markets have reached points where their future trajectory is especially hard to assess, particularly for the near term. Following two years of dramatic rises and falls (and the dodging of imminent threats of dramatic meltdowns and ensuing chaos), we are all edgy in the face of the current appearance of surface calm (perhaps unstable and fleeting) and hidden subsurface currents that current conditions suggest to many observers.

It is therefore natural that much is expected or feared from central bankers and this gives rise to agitated debate about what they should do or not do next. A balanced and calm article like this helps gives a needed calm perspective. Arguably, it is simply too soon for an accurate assessment whether central banks currently should be staying the course with or adjusting the detail of current stimulus policy or should begin to wind down current stimulus initiatives. That being so, we should restrain our urge to see the central banks asserting that they are on top of the situation by making new declarations of future intents.

Nov 16 04:07 PM

[The Geoffster:]

Central bankers are modern day alchemists and equally effective.

Nov 16 09:42 PM

[Gedankonomist:]

"Central bankers are a powerful lot and so it’s easy to assume that they’re also prescient."

They're "prescient" in the same way the casino you play blackjack in is "prescient."

Nov 17 09:57 AM