During the 1990s the concept of an “independent central bank” became much more fashionable. We were all trying to insulate central banks from political pressure, so that we could achieve German-style inflation. In one sense it worked. The Fed, BOJ and ECB have delivered German-style inflation. But nonetheless the experiment has been a failure. It failed in Japan, and is now failing in America. It’s useful to consider why.
The Achilles heel of independent central banks is that the fiscal authority believes, rightly or wrongly, that fiscal policy also affects the inflation rate. Thus when you have a disagreement between the fiscal and monetary authorities as to the appropriate rate of inflation, the two will end up pulling in opposite directions, producing massive economic waste in the form of higher than necessary marginal tax rates to pay for wasteful deficit spending.
We all saw this (two mules) problem in Japan during the 1990s and early 2000s, but somehow assumed (or at least I did, Krugman didn’t) that our policymakers were more sensible. I also think most economists missed this problem because they don’t think of the fiscal authority as influencing the inflation rate. For some reason even those economists who look at stabilization policy in the old-fashioned two-pronged way (use of both fiscal and monetary stimulus) tend to think that monetary policy affects inflation whereas fiscal stimulus affects real growth. I have talked about this issue quite a bit, but still haven’t heard any good explanations for the ubiquity of this strange way of framing stabilization policy. After all, both fiscal and monetary stimulus impact AD, and hence both influence output and prices.
So we go into a severe recession. The central bank decides “inflation is not a problem” and thus keeps monetary policy unchanged. The fiscal authority decides “real growth is too low” and thus adopts fiscal stimulus. Yet few people see the inconsistency here. I’ll bet you could find plenty of Congressman in Washington who support fiscal stimulus, and who favor more aggregate demand, but would oppose any Fed attempts to raise inflation. It makes no sense, but that’s the crazy world we live in. The mules in Congress don’t even know that someone else in pulling in the opposite direction.
My suggestion is that we end the independence of central banks, but replace it with something else–an explicit, legal, central bank target. Let’s suppose the Congress instructed the Fed to target 2% inflation. Now assume Congress wants more growth because we are in a recession, but because inflation is currently 2% the Fed doesn’t want to ease. The fiscal authorities could instruct the central bank to aim for 2% inflation in the long run, but allow a bit more inflation during the current recession, at the expense of a bit less that 2% inflation during the subsequent years. In other words the Fed would still have some discretion, even though their long-run mandate would be 2% inflation. They would have the legal authority to tell the fiscal authorities “OK, we’ll provide a bit more inflation right now, as long as you understand that it is being “borrowed” from future inflation. We intend to run below 2% inflation during the next boom.” This would allow for some fruitful policy coordination, while still protecting the central bank from pressure to alter its long run inflation target.
You might be thinking; “Lower than average inflation during booms and higher than average inflation during recessions. What a great idea for macroeconomic stabilization. How can we formulate that into a simple and easy to understand nominal target?”
Seriously, Congress needs to decide on some sort of explicit policy goal for aggregate demand. Whether it be inflation, the price level, or NGDP, the point is to have clearly spelled out goals so that they and the Fed are pulling in the same direction. Indeed if the goals are spelled out, there is no reason why Congress should ever have to do any pulling.
And that brings me to the final point. Even if this doesn’t improve monetary policy at all, at least I will be spared from annoying arguments with Keynesians who say; “Well yes, monetary policy could work in theory, but since the Fed is being so conservative we have to rely on fiscal stimulus. With the Fed no longer independent, there would no longer be any excuses for policy failures. The voters already blame Bush and Obama for the high unemployment; wouldn’t it be nice if the voters were correct?