A couple of weeks back, I had commented on the limitations of using mathematical/statistical models in economics. One more example of how models can be unreliable wherever homo sapiens are involved came in the result of the US Presidential election a couple of weeks back: Every poll had predicted a Clinton win, to be sure with narrowing margins. And, I am sure the pollsters had used the most sophisticated stratified sampling techniques for conducting the polls. Results obviously have a way of surprising expectations.
One of the election promises of the President-elect is to curb the independence of the US Federal Reserve. Last week, Federal Reserve chair Janet Yellen publicly stressed how “critically important” central bank independence is to the economy. And, the Governor of the Bank of England described such attacks by politicians on central banks as a “massive blame-deflection exercise” (Reuters, November 16). As I have argued earlier in this column, in a democracy, can central banks become a fourth, co-equal and independent branch of government — along with the legislative, administrative and judicial wings? As Joe Zammit-Lucia, Trustee of RADIX (a political think tank in UK) wrote in a letter to The Economist (November 12), “The vast majority of central banks across the world do not have operational independence... How does one balance the judgements made by technocrats with the political accountability that is essential if we are not to continue eroding people’s confidence in democracies?”
In recent times, central banks have rarely been held accountable, the most glaring example being the weaknesses in banking supervision, which culminated in the financial crisis of 2008. Alan Greenspan, the former chairman of the Fed and an acolyte of Ayn Rand, the market fundamentalist, confessed in testimony before the US Congress in 2009, “The whole intellectual edifice collapsed in the summer of last year... there was a flaw in the model”. More recently (Financial Times, October 25, 2013), Greenspan, in an interview with Gillian Tett, has confessed that the whole period (that is, the crisis) upset his view of how the world worked: “The models failed at a time when we needed them most.” Was he held accountable for his ideology, his erroneous beliefs and judgments, which led to the largest drop in global output since the 1930s?
Coming to monetary policy, the other prime responsibility of central banks, the record is equally questionable. The Friedmanite belief in the quantity of money in circulation determining inflation (since the speed of circulation is supposed to be constant) has proved unreliable: Today, hardly anybody talks of the various ‘M’s; the humongous increase in money supply in Japan and the Euro zone over so many years has not led to any increase in inflation. (To be sure, questions about money numbers go back at least three decades. To quote from The Trillion Dollar Meltdown by Charles Morris, “The transcripts of FOMC meetings through most of 1980 betray an air of semicomic desperation as the members try to discern which numbers they should count as the money supply.” More recently, in an article titled What is monetary policy? (Finance and Development, September 2016), an IMF economist acknowledged that “the correlation between money and prices is harder to gauge than it once was”. On the other hand, “if policymakers hike interest rates and communicate that further hikes are coming, this may convince the public that policymakers are serious about keeping inflation under control.”
Most standard macroeconomic models used by central banks are based on the assumption that all economic agents (you and I) have “rational expectations”: “The hypothesis according to which the public uses all available and useful information to predict the future, including information, concerning the policies to be carried out by the government in the future” (Gregory Mankiw’s definition). Can we form any rational expectations about the new President’s policies or the impact of Brexit on Britain’s economy — or that of demonetisation on India’s?
Perhaps only central banks can. One example: In a recent policy statement, the Bank of England pronounced that it will allow “a period of somewhat higher consumer price inflation in exchange for a more modest increase in unemployment”. As a result, the bank expects inflation will be more than two per cent, peaking at 2.8 per cent in early 2018. Any bets?
Are independent central banks more a part of neoliberalism, of a laissez-faire ideology, not a way to improve the economy? Will paper currency created by central banks be accepted as a means of exchange without the full backing of the sovereign?
The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com