Friday, September 9, 2011

How to Make Central Banks More Accountable For Passive Tightening

Yesterday we learned that despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now.  In the Eurozone, ECB president Jean acknowledged the Eurozone economy faces "particularly high uncertainty and intensified downside risks" yet chose, along with the rest of the ECB authorities, not to further loosen monetary policy.  Across the Atlantic, Fed Chairman Ben Benarnke gave a speech where he too acknowledged the economy was surprisingly weak. He then noted that the "Federal Reserve has a range of tools that could be used to provide additional monetary stimulus" that he and other Fed offiicials "will continue to consider... at our meeting in September..."  In short, both central banks have decided to sit on the sidelines for now despite the ability and need to do more.

There is a term for this. It is called a passive tightening of monetary policy. It occurs whenever a central bank passively allows total current dollar or nominal spending to fall, either through an endogenous drop in the money supply or through an unchecked decrease in velocity.  This failure to act when aggregate demand is falling has the same impact on the stance on monetary policy as does an overt tightening of monetary policy.  Bernanke has made this point himself recently as a justification for maintaining the size of the Fed's balance sheet.  The passive tightening of monetary policy is like a school crossing guard who could have but failed to stop a student from running into traffic.  Though the guard didn't cause the student to cross into traffic, he still bears responsibility for failing to save the student.

Now the damage done by a passive tightening is no different than that of an overt tightening. The only difference is that the public is more aware of the overt form.  Consequently, the ECB and the Fed are not questioned for the harm they cause by allowing such passive tightening of monetary policy.  Thus, most people observing the economic problems in Europe and the United States never connect the dots between these central bank's inaction and what they are witnessing.  This allows the central banks to be conservative, play it safe, and not be held accountable for their passive tightening.

There is a way to change this.  Introduce a market for nominal GDP futures contracts.  It if were a deep and liquid market, it would provide real time analysis on market expectations of future nominal spending. And since the market's forecast of future nominal spending affects current dollar spending, it would provide real time analysis on how a central bank is actively and passively shaping the current stance of monetary policy.  For example, if a nominal GDP futures market existed currently for the U.S. economy it would probably indicate a sharp tightening of monetary policy.  The public would then interpret this as a dereliction of duty by the Fed.  

Such a market would instantly asses the nominal spending impact of any speech, news, action, or inaction taken by the central bank.  The Fed would not have the luxury to sit on the sidelines.   Having the Fed's performance judged in real time would make it far more accountable. This is why Scott Sumner has been arguing for it for so many years.  And this is why we need it so badly today.


  1. David
    It appears that the Fed is full of "defenders"!

  2. This comment has been removed by the author.

  3. I agree. but why not the same for a future market for inflation, and other macro variables?

  4. Well, it's already perfectly obvious that the Fed needs to do more even without a nominal GDP market. The Fed would still find excuses to be incompetent... Would they be remotely competent excuses? No. But Kocherlakota et. al. have never sounded reasonable...

    Keep up the fight though -- monetary policy in the US, Europe, and Japan is all completely crazy, and has been for years. The most interesting thing to me is the silence of most of the economics profession, and how to interpret that...

  5. T Veblen
    But there´s still hope...
    "There is a proliferation of economics blogs, with increasing numbers of economists attracting large numbers of readers, yet little is known about the impact of this new medium. Using a variety of experimental and non-experimental techniques, this study quantifies some of their effects. First, links from blogs cause a striking increase in the number of abstract views and downloads of economics papers. Second, blogging raises the profile of the blogger (and his or her institution) and boosts their reputation above economists with similar publication records. Finally, a blog can transform attitudes about some of the topics it covers".

  6. Terrific post, and entering the phrase "passive tightening" into the public debate is very valuable.

    The Fed is following a feeble, dithering path of passive tightening, as the Fed officials lack resolve--they are following in the timid footsteps of the Bank of Japan.

    This is the argument we need to put forth at every opportunity.

  7. David,

    I have always had a bit of a problem with what to think of "passive" tightening of monetary policy since reading Friedman and Schwartz "History" many years ago. Ideally most monetarist economists would basically like the central banks to "do nothing".

    Central banks however can not "do nothing" as George Selgin would tell us. Therefore, the real problem is the existence of central banks to begin with - as George also would tell.

    I think there is reason to use a bit of Selgin's arguments here. When we talk about monetary policy being "passive" as a bad thing we "sound" like interventionist keynesians: "The government should do something", "The Fed should do something".

    Therefore, in my view it would be better to argue from a welfare theoretical perspective. The benchmark for "socially optimal" monetary policy most be perfect competition Free Banking. We know that in the Selgin model the outcome is basically a fixed NGDP level. Therefore, the "socially optimal" monetary policy is not a question about doing something or not, but doing the right thing and that is to emulate the Free Banking out and the is NGDP level targeting.

    But again you are clearly right - both the Fed and the ECB is at the moment passively letting monetary conditions tighten and they should "do something" to stop it;-)