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Credibility, Commitment, and Capital

January 27, 2015

Note: The capital in the title refers to institutional capital at central banks, but I wanted alliteration more than clarity.

Imaginary conversation between two economists:
Naive Economist: Wow, what the central bank was tremendously stupid. It caused price instability, high unemployment, and financial instability.
Worldly Economist: Ahh, but the central bankers are building institutional capital.
Naive Economist: But can’t they do that by providing stability and doing what they say they are going to do?
Worldly Economist: No, they have to do stupid things that destroy the economy.
Naive Economist: Oh, that makes sense.

In any other profession, incompetence would be called incompetence. Maybe it’s because macro is so cloaked in obfuscation that everyone just assumes that what the people in charge do is right, regardless of their consequences. There is no wizard behind the curtain. People with power aren’t super smart or know things no one else does, they are just people who make mistakes like the rest of us. But if the mistakes aren’t pointed out and corrected, they will just continue.

The Swiss Franc appreciated about 20% a couple weeks ago when they went of the Euro peg. That’s an insane fluctuation for a currency in a single day. Ideally, currencies should change less than 5% in an entire year. To change in value 20% in a day is prima facie evidience that someone at the central bank screwed up. Big time. Swiss equities dropped about 10% on the news that the Swiss National Bank was going to abandon their currency peg with the Euro.

That doesn’t bother me. Central banks do stupid things all the time. The ECB has been riding the moron train for the better part of a decade now, so no big deal right? What bothers me is Tyler Cowen’s reaction to it. He posits three possible explanations, which I have excerpted below:

1. “Bureaucrats are not so much budget maximizers as hoarders of institutional capital.”

2. “They either cannot do “the right thing,” or doing that would be too costly in terms of the country’s longer-term institutional prospects.”

3. (which Tyler does not find credible) “The Swiss central bankers suddenly became stupid and forgot their macroeconomics.”

1 and 2 both rest on the assumption that bad policy is good politics. I guess that makes some sense to me. Deflation is highly popular with some Republicans these days. If they had their druthers, I can imagine them putting tremendous pressure on the central bank. I know very little about Swiss politics, so perhaps it was political pressure that forced the Swiss National Bank to abandon the peg.

But I think in those cases, it’s the central bank’s duty to at least pitch a fit. Tell people that’s why you’re doing the stupid thing. “Guys, this is a bad idea, but if that’s what you want…” No one should be wondering why things went wrong afterwards. As an added bonus, this discourages politicians from pressuring central banks.

Hindsight
It can be hard to judge central bank actions as they are happening, but are there any examples from history where a central bank deviated from price stability and was later vindicated? Maybe, but no examples spring to mind. The Great Depression looks like #3 to me, as does the period of 1970s inflation. Is the argument that #3 may be common in the past, but not anymore?

Institutional reasons
Everyone is rational, but that does not mean their actions are not stupid in the broader sense. A criminal may rob a bank which is rational, but as a society we do and should wring our hands to figure out ways to prevent that from happening. Pete Leeson has written some fascinating papers showing how a wide variety of seemingly crazy behavior is actually rational in the microeconomic sense. I suppose I could be convinced that the bureaucrat’s actions are narrowly rational, but that does not mean economists should not call them out. When a thief robs a bank, normal people understand that it is harmful to society as a whole, but if a central banker screws things up, people won’t actually know that it was bad unless other economists call them out.

Credibility and Time Consistency
Time consistency sometimes rears its head as a reason why central banks must do stupid things from time to time. Just to get it out of the way: I don’t think past central banks can bind future central banks. But I don’t think there is any sane target which requires them to do so. If you want to target inflation, just target inflation in every time period. As long as the target itself is politically popular and the economists deems it reasonable, Bob’s your uncle.

Central banks mostly spend institutional capital defending themselves in the wake of their own screw-ups. Imagine a central bank that held inflation at 2% and has done so as long as anyone can remember. What, precisely, would such a central bank need institutional capital for? It’s not until they have a year with 10% inflation that they need institutional capital to convince people they’ll get it right in the future. Is it radical to suggest that a central bank should gain institutional capital when it does good things?

Where do we go from here?
This is where the economics profession has a role to play. We must not let central bankers get away with bad decisions and say “maybe they had a secret good reason for it.” I agree with Scott Sumner (I can’t find a link) that central banks generally go with the mainstream opinion for macroeconomic policy. If 90% of macroeconomists agree with a policy, that’s what they’ll do. But if we let them get away with it, they’ll never learn.

Further reading
Cowen on why the Swiss broke the peg
Sumner calls it how he sees it
Francis Cappola on how bad breaking the peg was
Maybe it was for balance sheet reasons. Sounds like a good argument for nationalization to me. A central bank shouldn’t care what its balance sheet is.

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