In a 2013 book (The Great Recession: Lessons for Central Bankers), Huw Pill and Frank Smets argue for preserving the status quo: “… the conduct of monetary policy should neither be changed fundamentally nor overburdened with additional objectives. Rather, it should remain focused on maintaining price stability over the medium term.” The authors do take a small step toward acknowledging the huge welfare cost of the 2008-09 acute instability by adding an addendum to their no-change approach: “Nonetheless, we recognize the need for some refinement of the existing policy framework in order to avoid and reduce the costs of large financial crises.”
The Pill-Smets (P-S) conclusion goes way beyond being wrong. It seeks to perpetuate the single most foolish stabilization-policy advice to come from the New Neoclassical Synthesis (NNS), which established the rules of engagement for the micro-coherent, market-centric modeling that has dominated the macroeconomics mainstream for a generation. Think about it. Why, in the aftermath of 6 million involuntarily lost jobs incurred during the U.S. Great Recession, would the Fed abandon its coequal full-employment objective? This post briefly considers five reasons, pretty much exhausting the possibilities.
First, the welfare costs of inflation so exceed the damage caused by high joblessness and low capacity utilization to make policymaker attention to real-side stabilization relatively unimportant. As the Great Recession vividly demonstrated, however, assigning exclusive importance to the costs of inflation is utter nonsense. Everybody who pays at least casual attention to the 2008-09 real-side losses, measured in the trillions of dollars, must reject the hapless first reason for an inflation-only monetary target.
Second, monetary interventions are relatively ineffective in pursuit of a policy-relevant real-side objective. This reason is an improvement on the first, making a tiny bit of sense in mainstream micro-coherent, market-centric general-equilibrium modeling that cannot microfound the suppression of wage recontracting and the consequent causality from adverse nominal demand disturbances to involuntary job loss and recognizable same-direction cyclical movements in employment, output, and profits. In micro-coherent generalized-exchange macroeconomics, however, central-bank intervention in total spending powerfully influences real-side behavior. Ben Bernanke’s virtuoso management of collapsing demand during the Great Recession overwhelmingly supports the GEM Project’s analysis of the inherent cyclicality of modern, highly-specialized economies. Real-side monetary-policy ineffectiveness is no more than an artifact of badly designed macro theory.
Third, inflation control may be thought to be so generally powerful that close attention to real-side determinants is rendered unnecessary. Once again, the reason appears plausible in the context of mainstream micro-coherent, market-centric general-equilibrium modeling. But the badly flawed nature of consensus thinking requires it to be rejected in favor of generalized-exchange macroeconomics and its much enriched relationship between excess capacity, especially that associated with weakening nominal demand, and rational product pricing. (Chapter 6) Consistent with the available evidence, the direct links from inflation to real-side cyclical behavior are shown to be too weak to exercise effective control over the length and depth of recessions. That central banks already know this is reflected in the range of real-side evidence that they closely monitor, in addition to inflation, over business cycles. Surely no reputable economist really believes, despite what they say in defense of mainstream modeling, that the Fed should have confined its attention to inflation in its management of the 2008-09 extreme instability. Nobody is that senseless.
Fourth, central banks are operationally limited to a single objective. Multiple objectives are inherently in conflict, implying that one must be chosen. The problem is real but dealt with relatively easily. René Lalonde and Nicolas Parent (2006) have, for example, provided a useful dual-mandate modeling framework in which the effective weights on various economic indicators vary over time, as monetary-authority priorities shift between inflation and employment. In the GEM Project, the central employment-stabilization role assigned to the management of nominal demand must be supported by state-of-the-art modeling of the operational natural rate (UN) as well as the various components of Okun’s law and nonstationary productivity growth. Such oversight must be a core competency of a responsible central bank, joining the careful monitoring of the behavior of inflation relative to its established regime. The skill set associated with the real-side demand management is deemphasized in today’s mainstream thinking to the detriment of central-bank effectiveness. Indeed, emphasizing a single goal generally distorts the efficient allocation of central-bank research resources. The problem is symmetrical. In the early postwar period, the dominance of the Keynesian Neoclassical Synthesis and its inherent emphasis of employment control diverted attention from adequately understanding the causes and consequences of inflation.
Fifth, limitations of the mainstream micro-coherent, market-centric DSGE macro model make it impossible for modern theorists to adequately accommodate a full-employment monetary objective. At last, we have the real reason for the embarrassing clinging to the single-objective nominal mandate. From the perspective of mainstream general-market-equilibrium theory, accepting a coequal real-side objective is not possible absent rejection of today’s consensus rules of how to properly do macroeconomics. The real reason for a single (low-inflation) objective is Ptolemaic, in which the overriding objective of mainstream theorists is the defense of the established model class whatever the collateral costs.
In closing, it is instructive to reread the P-S quote in the first paragraph above. Given the huge cost of the 2008-09 extreme instability, those macroeconomists who are not offended by the assertion that the consensus single-objective message for the design of monetary policymaking need not change have simply given up on ever constructing micro-coherent, stabilization-relevant macro theory. They have effectively excused themselves from the active debate on stabilization-relevance.
Blog Type: Policy/Topical San Miguel de Allende, Mexico