In my last post I argued that using monetary policy to lean against asset price bubbles would only tend to hurt the real economy in the long-run if for some reason the central banks target is constructed in an asymmetric way, i.e. it reacts to asset price deviations to the upside but ignores them to the downside. If its asset price target, however defined, is correctly chosen and designed in a similar way as its inflation and/or output targets in e.g. a classic Taylor rule, then on average there will be as much leaning against asset prices as there will be propping up asset price. But what effects would such a policy have on the business cycle in general? More precisely, would a central bank that targets asset prices tend to have a stabilizing or destabilizing effect on the overall system?
Once upon a time there were a number of Asian countries. They had scarce natural resources, hardly any notable capital accumulation, were heavily overpopulated and most of their people lived in extreme poverty. In fact, the situation of these Asian countries was so miserable, that development economists were betting on South America and Africa for rapid development. But then, one day, came the economic growth fairy and blessed the Asian countries with decade-long, (close to) double-digit growth rates and all was good and everyone was happy – except for the development economists, who didn’t know how this could possibly have happened. And after decades of research, … we still don’t really know. However, there are some new interesting approaches at the frontier of development economics. Justin Yifu Lin’s idea of the new structural economics is one of the ground-breaking ideas that shed some light on how economies develop. In this blog I will outline the main ideas and some personal points of criticism, but if you’re interested in more, you can look at the following paper or, if you need a more integrated perspective, at his newest book: Demystifying the Chinese Economy. Both are highly recommended readings.
A democratic market economy theoretically achieves the highest possible level of freedom and wealth. Focussing on our country, this concept indeed worked out not too badly. However, we are still far away from the perfect world stated by the theory. Furthermore, for a few years we seem to be stuck in an economic as well as a democratic crisis. Though, when the theoretical conclusions are derived by the compelling logic of mathematics, how can they fail?
The answer is pretty simple: They don’t. The differences between theoretical and empirical outcomes are caused by the differences between the models’ underlying assumptions and real social and political conditions. In this regard, one important assumption for efficient democratic as well as economic behaviour is sovereignty. It can be understood as the power and possibility to make a rational choice and force its proportional consideration by others.
Among others, in the real world sovereignty therefore requests sufficiently informed and well educated people as consumers, voters and all kinds of democratic and economic agents. Therefore, it is not just about merit goods and external effects when a government establishes compulsory education. It rather is an essential foundation for the successful operation of a democratic market economy.
In the younger past the quality and effectiveness, or at least the average outcome of our educational system seems to be decreasing. Simultaneously, our youth possesses more and more self-determination. To this effect, teenagers have to make decisions about their path-dependent future, while they just do not know how strong the latter will depend on their capability to acquire and use knowledge. For knowledge itself is power. A certain proportional amount of power definitely is a necessary condition for sovereignty. Finally, sovereignty determines individual and aggregate outcomes in a democratic market economy.
Therefore, besides several other arguments from labour market and institutional economics, already the basic theory of democracy and the market economy justifies an extension of compulsory education. The empiricism finally recommends it for today. Of course, there will be costs in the short run, financially as well as politically. However, the alternative upcoming social costs arising in the long run would be many times higher. So be paternalistic today, in order to save democratic and economic freedom in the future!
A lot has been written on the so-called lean vs. clean debate in monetary policy that tries to resolve whether central banks should actively try to counter asset price bubbles during their build or just make sure they do everything they can in order to clean up in the aftermath of these bubbles bursting. To recap, there’s decent arguments for both sides of the debate: the clean camp, applying the “Greenspan principle”, generally cites the difficulties in spotting bubbles, often due to efficient market hypothesis concerns, as the main reason for not using the particularly blunt instrument of interest rate policy to deflate potential bubbles – after all, can we ever really know it is one until it bursts? The clean camp, while generally acknowledging the problems involved in bubble-spotting, tend to stress the damage to the real economy that financial asset bubbles can cause, highlight the potential inability of central banks to “clean up” under certain circumstances, such as when the zero lower bound on nominal interest rates is reached, as well as the inconsistency of asymmetrically responding to asset prices – not at all during the build-up of a bubble, yet strongly to its bursting. There are models that supposedly show that both the clean as well as the lean approach is the optimal one (e.g. Bernanke and Gertler on the clean side and Filardo on the lean side, just to name two – both .pdfs).
A large part of the success of central banks all around the world during what became known as the Great Moderation is often attributed to the successful anchoring of inflation expectations to the levels that central banks would like to see – generally defined as 2% in most of the industrialized world. In basic theory this is awesome: if the inflation rate, through some kind of phillips curve or any other structural relationship you prefer, is linked to the aggregate level of economic activity in a stable way, than a stable inflation rate also leads to a stable level of economic activity.
In comes Charles Goodhart, former member of the Bank of England’s Monetary Policy Committee, who stated something as profound as at the same time similar to the famous Lucas Critique: Goodhart’s Law. In it’s most common version it says that “when a measure becomes a target, it ceases to be a good measure”. In other words, once a central bank (or in theory indeed any institution with enough clout to consistently affect the economy) states that it will do whatever it needs to in order to keep a given indicator at a level it so desires, the market structure will be affected by this, expectations of market agents will adapt, and the target will be achieved, even if the central bank does not really even do much – it just has to credibly promise that it would.
First of all, and on a very deep level, this of course could be seen as qualifying the very success of central banks in “anchoring” inflation rates. Has inflation in the past two decades been so tame because central banks have become better, or simply because they somehow managed to credibly make everyone believe that they have become better? In the end, the answer doesn’t matter much – it is outcomes that we want, who cares about how we get there. However, while the upside to this stable inflation anchoring in good times is enormous, it seems to have come back to haunt us at a time when we most need our monetary authorities to act. Even though inflation both in the US as well as in the Eurozone is considerably below target, inflation expectations are awkwardly close to those targets over the near-term (e.g. here for the Eurozone). Given most central banks nowadays target the forecast, they might interpret this as signalling that there is no real big need to act, and thus not act in the first place. I personally find this to be one of the most compelling explanations as to why the ECB continues to fail to do its job. As Draghi stated, “inflation expectations are firmly anchored in line with price stability“. Exactly. That’s the problem.
The Fed is in a somewhat better position since it does not only target inflation but also full employment – even if inflation sticks to 2%, as long as unemployment is above target it will (or should) ease monetary policy. The ECB, on the other hand, focuses essentially solely on inflation, and at the moment there are great doubts as to whether inflation (particularly inflation expectations) are of any use at all as a signal for what it should be doing. This monthly bulletin by the ECB (dating back to 2011, .pdf), for example, states that “well anchored expectations have contributed to enhancing the effectiveness of monetary policy and will assist the ongoing economic recovery”. Sure, stable inflation expectations also prevent us from falling into outright deflation in a scneario were we assume the central bank to be asleep. Further, as Clarida states (.pdf), “inflation inertia is the enemy of reflation once deflation set in”. However, I would state that somewhat differently: inflation inertia (in the context of this post in terms of expectations) is the enemy of reflation – period. At the moment it mostly provides a convenient excuse for central banks to do less than they should. Currently, it would seem that those well-anchored inflation expectations are part of what’s preventing effective monetary policy in the first place.