Sunday, June 20, 2010

Central Banks and Objectives

In the last fifteen years the role of monetary policy has converged to be a matter of rules. In particular, rules on inflation and this has the name of Inflation Targeting (IT). While successful in keeping inflation low through a clear mechanism that aims to control expectations, IT has been blamed to cause an excess of liquidity in the world. I think criticism overstates the weaknesses of IT. In particular let me discuss the mindset rather than the IT per se that drives the criticism. A disclaimer is in order, I think IT has its days counted as the sole objective of a Central Bank. This however, does not make its achievements irrelevant.

The mindset of the critics bluntly blames IT for an excess of liquidity before and during the current financial crisis. They forgo in the process that inflation is at least as painful as unemployment. In their mindset they still have a negative-sloped-Phillips-Curve. Moreover, they disregard any important role of expectations (and thus the vertical-Phillips-Curve). There are many opinions around this subject and the consensus of the forward-looking Phillips Curve is facing a real challenge.

Behind any criticism is the underlying notion of a non-taken path that would have yielded a better outcome. Interestingly this is just an assumption. Is there any guarantee whatsoever that taking the non-IT path back in early 90's would have delivered a lower unemployment rate and avoided the financial crisis? I think the best answer is: we will never know. Counterfactual outcomes (the path non-taken) are as fictitious as any army that Quijote fought. They are based in a number of assumptions. Many of this assumptions are based, in turn, in the path taken, thus violating the counterfactual nature.

It is my believe that economist should take more seriously the optimality principle: any policy decision made today must be optimal taken as given the state of affairs. To argue that the non-taken path was better and flawless hardly helps a better understanding of reality. Furthermore, our training as economists has not helped us to acknowledge that some policies are inherently finitely lived. That is, maybe IT's was the best policy to follow and now is not. That does not mean that we were wrong all along in following IT prescription.

This is not to say that history should be neglected. If a policy yields bad results it should be replaced, but, at the same time, it should be evaluated against itself and according to its reality.

Having said this, I think that IT contributed to a low inflation level that is remarkable. Sadly it is not enough to help the economy grow. Central Banks should put a lot more attention to developments in financial markets. In particular, market concentration and excessive trading should be closely observed and corrected. By excessive trading I mean a large number of intermediaries in the financial market. It is clear now that there are at least two ways to make money in the financial market 1) the traditional one where resources are lent to profitable investments and gains are shared by investors. 2) By intermediating. This second form has been criticized for not creating wealth, but only redistribute it.

This is part true. Think of a corn producer. In order to put the corn in the hands of the final consumer, the producer has to go in to the city and spend valuable time selling the corn. If there exist an intermediary who can work full time selling corn there are gains for the three individuals (producer, intermediary and final consumer). What happens if I add a fourth individual, a second intermediary? If this individual is identical (in its functions) to the other intermediary then profits for the producer go up along with consumer surplus, and the identica intermediaries see how their profits go down. Now, further assume that the second intermediary is not identical to the other, but he is between the latter and the final consumer, now profits of the producer and consumer surplus are lower. What is going on is a redistribution of wealth from consumers and producer to intermediaries.

This is a key question financial markets cant regulate by themselves. The number of heterogenous traders (intermediaries) grows ever larger, diminishing savings returns and available funding for investment. Here lies an important role for the central bank as the vigilant of the well functioning of the payment system. This kind of objective should be added to IT. And if it represents a conflict with it, society preferences should decide which is more important.


sada said...


Anonymous said...


Juan Ramon Hernandez said...

I'll try to keep up. Thanks.

leo.g.08 said...

Dear Juan Ramon,
I hope I will have time to discuss these issue of IT more properly later (right know I´m just overwhelmed), because I certainly believe modern mainstream macro (with IT included) is "spectacularly irrelevant in the best of the cases and harmful in the worst", as Krugman says.
In any case, I do want to say something about your opinions now. It is that it is often believed the only way to establish a downward sloping Phillips curve is denying rational expectations. However, it is actually not the case. It is straightforward to get a downward sloping Phillips curve in the presence of unions which care about inflation (like in the European context) and are also totally rational and forward looking. Check it out Skott, Peter (1997) "Stagfaltionary consecuences of prudent monetary policy in a unionized economy", Oxford Economic Papers.
Bests. Leopoldo Gomez Ramirez.