As the world debates whether Ben Bernanke has saved us from a financial crisis or whether he has pumped more air into the asset bubble, it would be useful to think about this question. How much of central banking is about computer models of the economy and how much about the insight of the man at the top?
John Maynard Keynes had a pretty low opinion of the central bankers of his time and their ability to smooth out economic fluctuations. His battles with the Bank of England are legendary. He seemed to have had more confidence in the science of monetary economics than in the good sense of its practitioners.
Keynes once said that central banking would become as boring as dentistry, where a few scientific rules and principles could be routinely put to use. Modern critics of central banking may extend the analogy to say that the masters of the monetary universe are like bad dentists. They would rather send the patient home with a painkiller (easy money) than drill through the rot in his teeth.
Milton Friedman, who rescued central banking from the dust heap of history, where Keynes’ followers had consigned it to in the 1940s, 1950s and 1960s, too, believed that the game could be played with a few fixed rules. He controversially suggested that the central banker’s job could be outsourced to a computer, which would increase money supply at a fixed rate. No role for human discretion there.
Modern central bankers, however, insist that there is a role for human judgement in setting interest rates and controlling money supply.
For instance, in the late 1990s, economists at the Federal Reserve were worried that unemployment in the US was too low. Past experience had showed that whenever US unemployment dropped below 5%, the economy would heat up. A tight labour market would push up wages and inflation. The data pointed to an interest rate hike. The US couldn’t sustain non-inflationary growth when the unemployment rate fell below 5%.
Alan Greenspan, who was chairman of the Fed at that time, was unimpressed. His business friends were telling him how the use of computers and information networks was pushing up productivity. It was up to him to choose between history and current anecdotal evidence. Greenspan believed, rightly as it turned out, that a productivity surge in the US would keep inflation under control even as unemployment continued to fall. In short, there was no reason to increase interest rates.
In his recent autobiography, The Age of Turbulence, Greenspan writes how the Fed moved away from a textbook approach to monetary policy: “Instead of putting all our energy into a single forecast and then betting everything on that, we based our policy response on a range of possible scenarios… It let us reach beyond econometric models to factor in broader, though less mathematically precise, hypotheses about how the world works.”
In a speech he gave on 21 September, Frederic S. Mishkin of the US Fed revisited the question of how much of central banking is art and how much science. He starts with a wonderful survey of what monetary economics has taught us in recent decades—the scientific advance, that is.
Mishkin identifies nine key principles of monetary economics that were developed over the past 50 years. First, inflation is always a monetary phenomenon. Second, price stability is a goal worth pursuing since it yields great long-term benefits to the economy. Third, there is no trade-off between inflation and unemployment in the long run. Fourth, expectations about inflation are very important. Fifth, real interest rates need to march in step with inflation, the so-called Taylor rule proposed by economist John B. Taylor. Sixth, monetary policy suffers from the time inconsistency problem. Seventh, independent central banks make for better monetary policy. Eighth, central banks need to target a strong nominal anchor. Ninth, financial frictions play an important role in business fluctuations.
This may sound a bit complicated to the uninitiated. What Mishkin shows is that the science of monetary policy has made great strides over the past five decades, thanks to the work of economists such as Milton Friedman, Edmund Phelps, Franco Modigliani, John B. Taylor and Edward C. Prescott, among others. Thanks to them, students and practitioners of monetary policy have a far deeper scientific understanding about the relationship between money, prices and output.
Yet, Mishkin too argues that the advance of science has not pushed back the art of monetary policy. “Monetary policy will never become as boring as dentistry. (It) will always have elements of art as well as science,” he predicts.
Like it or not: Ben Bernanke, Y.V. Reddy and the rest are not about to be replaced with computers.
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