It’s never the central bank’s fault. Or at least that’s what I hope to show.
I will argue that there has never been an inflation or deflation that was “blamed” on central bank policy. More specifically, this is my argument:
Undesirable inflations and deflations are never blamed on central banks by the consensus of expert opinion in the country affected, during the period when prices are actually changing. Can you think of any counterexamples?
Think of this as a contest. If I am right, then it is no surprise that very few economists agree with my view that the Fed caused the recent deflation. After all, it’s never the Fed’s fault, or at least it’s never perceived to be the Fed’s fault at the time. At a later date, however, economists may be able to take a more dispassionate look at what really happened.
Here’s how I started thinking about this topic. I asked myself whether central banks were ever blamed for any inflation or deflation. One place to start is with hyperinflation, something America has never really experienced. Was the German central bank blamed for the 1920s hyperinflation? I’m not an expert here, but aren’t hyperinflations usually blamed on fiscal authorities? Isn’t it assumed that the central bank is in some sense forced to print a lot of money to pay the government’s bills? I can’t imagine why a central bank would suddenly start printing such a vast quantity of paper money for no good reason. Thus I will provisionally assume that not only the German hyperinflation, but also more recent hyperinflations in developing and former communist countries were actually a failure of fiscal policy, and that the central bank was not blamed.
What about the US? We have had two types of high inflation, wartime inflation and the Great Inflation of 1966-81. During the Civil War we had to go off gold and print money, so that was another fiscal inflation. During WWI many other countries went off gold, so the value of gold fell in world markets, and again the Fed did not seem to be at fault. The most promising case is 1966-81. Here I really think you can make a case that it was the Fed’s fault. But there is just one problem, it wasn’t perceived that way at the time. First it was the “guns and butter” fiscal policy of President Johnson. Then it was labor unions—a cost-push wage spiral; then it was crop failures in 1973, then OPEC in 1974 and again in 1979-80. One excuse after another was made for the Fed.
Now that’s not to say a few farsighted observers didn’t see the real problem at the time. Unless I am mistaken, people like Milton Friedman, Anna Schwartz, and Allan Meltzer did recognize that the Fed was to blame very early on. But it was never the Fed’s fault according to the consensus opinion. By the way, notice how all these far-sighted observers happen to have been members of a “discredited” school of thought that does not start with the letter “K.” That group was also the first to notice that the Fed was to blame for some important deflationary episodes.
If you take a close look at my original assertion, you’ll notice all sorts of hidden qualifications. One is that it has to be an undesirable inflation or deflation. I believe that there are five important deflations or disinflations since the Fed was founded. The 4 important deflations were 1920-21, 1929-33, 1937-38 and late 2008. And there was also a very important disinflation in 1981-82, when the rate of inflation fell from double digits to about 4%. The 1920-21 deflation was partly attributed to the Fed, but not really “blamed” on the Fed. In other words, it was viewed as a necessary corrective to the high prices of WWI. The 1981-82 disinflation was also partly attributed to the Fed, but once again was viewed as a painful if necessary adjustment to a lower trend rate of inflation.
I do believe that the 1929-33 and 1937-38 deflations were undesirable and are now mostly blamed on the Fed. But at the time, most observers gave the Fed a pass. First it was the effect of the stock bubble bursting. Then we had the banking panics. Then there was the international monetary crisis and the hoarding of gold. But it was never the Fed’s fault. In 1937 few observers paid any attention to the reserve requirement increases. By 1938 interest rates were very low and it was assumed that any monetary expansion would be “pushing on a string.” Again, not the Fed’s fault. Of course that is also the view of the profession toward the late 2008 deflation. It’s not the Fed’s fault, it was the greedy bankers that made bad loans. Somehow that led to a banking panic which led to a brief but important deflation in late 2008. Money? Money is always important at some other time in history, never right now. Or at least so it seems.
What about the great Japanese deflation? Don’t most economists blame that on the BOJ? I don’t know if that’s right, but I would agree that many prominent US macroeconomists blame it on the BOJ. But if you return to my original assertion, you will notice some more weasel words. It has to be blamed on the central bank by the consensus of opinion in the country in question. Did expert opinion in Japan blame the BOJ for the deflation? I don’t think so, at least not in any direct way involving “tight money.” My sense is that many in Japan blamed it on the weak banking sector and falling real estate prices. But if I am wrong, please correct me and I will admit that the theory in the post is wrong. I am not “infallible.”
So it seems like central banks are never blamed for producing undesirable inflation or deflation by expert opinion in the country, at the time the problems occur. Do I have a theory for this? Yes, a very simple one. Central banks almost invariably do what the consensus opinion suggests is a sound and reasonable policy. Obviously one wouldn’t expect most economists to blame themselves!
So it’s never “our” fault, it’s always some special factor. But here’s the problem, if it is never the central bank’s fault, then virtually all of modern macroeconomics disappears. New Keynesian models, monetarist models, even Austrian models are all predicated on the notion that nominal shocks created by poor monetary policy generate business cycles. But if it’s never the central bank’s fault, then aren’t we in an endogenous money world? Isn’t this getting close to what the post-Keynesians argue?
Those who read this blog know that I am about as far from post-Keynesianism as it is possible to be. I do blame the Fed for all the recessions and inflations for which others blame the Fed, plus the 2008 fiasco. But what does the history I just recited tell us? It says that monetary mistakes never, ever, look like monetary policy mistakes at the time. The Fed is always doing what sober sensible opinion says they should be doing. And if it doesn’t work out, that sober sensible opinion will point anywhere but at themselves; they’ll point at guns and butter spending, labor unions, market bubbles, OPEC, crop failures, banking crises, stock market crashes, or international forces. There is no end to the list of excuses.
Yes, with the benefit of hindsight the conventional wisdom does come around to blame the Fed or BOJ for undesirable inflations or deflations. Those who didn’t live through the period with all the “non-monetary shocks” constantly in the headlines, can take a calm look at the falling price level on a graph, and ask themselves “why did the Fed let that happen?” Then it becomes the Fed’s fault. In some cases they develop indicators (i.e. M2 for the Great Contraction) that were not even used when the problem actually occurred. Or they develop a better understanding of the distinction between real and nominal rates (for 1966-81.) But at the time it always looks like something else is the cause. And most often that “something else” is actually a symptom of the inept monetary policies.