Thursday, December 2, 2010

More on Central Banking

I've mentioned from time to time central banking, and that next term we'll look into what Central Banks are and what they do. There's much more fuss currently in the US about their central banking system, the Federal Reserve, than there is here. This article is a reasonably good description of both the system, and the problems it is facing.

There are a lot of issues covered in the article, but something I mentioned yesterday is of note: Since the 1970s the Fed has had a "dual mandate" - maintain not just low and stable prices but also maximum employment (whatever that means). This would seem to be at the bottom of many criticisms over there, since it gives an unelected body a large say in macroeconomic policy.

We'll find out next term that monetary policy and fiscal policy can often act against each other and frequently do. They act against each other in general macroeconomic terms: If the central bank is targetting output. In the UK we appear to try to limit this potential conflict by having the Bank of England only target keeping inflation at a particular level. This may lead to it considering output when it sets interest rates (since output affects inflation) but fundamentally the Bank is judged on whether it achieves 2%.

So it may be this extra macroeconomic goal the Fed is set in the US which attracts particular criticism. It could also just be that the Tea Partiers have stirred things up there, but certainly we don't appear to be criticising the Bank of England half as much here.

The other point of interest is whether unelected bodies should have power over economic policy. The first instinct is probably to shout "no!", but on the other hand populist policies are not necessarily the best policies. The populist policy of hounding banks out of town is self-defeating since then jobs are lost, and who is going to set-up business in an environment. Populist policies also often conflict with what you'll learn during econ101ab to be the best policy - so perhaps unelected bodies may do a better job?

Wednesday, December 1, 2010

Classic Economists and Mistakes

In the UK, the Bank of England has a mono mandate, so to speak: It is charged with keeping inflation low and stable - around 2%. In the US however, the Federal Reserve (the central bank system) has a dual mandate: To also achieve maximum employment via its monetary policy decisions.

It's fair to say some people disagree with this while others agree. John B Taylor is a prominent figure in monetary policy theory in economics, as you'll learn next term. He devised what is called the Taylor Rule: That the interest rate should be set taking into account both inflation and the output gap (the difference between actual and potential GDP).

However, despite this, Taylor is now a fierce critic of the Federal Reserve and commonly makes statements like: "The Fed's decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble." He states this based on a very simple equation called the Taylor Rule: It's not even estimated. It's a very theory-orientated construction and from his he asserts monetary policy was too loose in 2002-4 and this caused the housing bubble and subsequent crash.

Now Taylor, along with a Republican politician, is suggesting that this dual mandate should be removed and replaced with a single-mandate, just price stability.

Greg Mankiw isn't convinced about this, suggesting that even if the mandate was simply price stability some of the same policies (notably quantitative easing) would have still taken place.

Furthermore, Taylor is making a really fundamentally basic error of judgement that a lot of economics (and people more generally) often make: Comparing apples and oranges.

Taylor says: QE1 (quantitative easing last year) didn't work: The economy is still in a mess. Yet how on earth does he know this? He's comparing the pre-QE1 economy with the post-QE1 economy yet these are two fundamentally different things.

He wants to compare the post-QE1 (or today's) economy with another US economy run up to today without QE1, so a without-QE1 post-QE1 economy. But he can't and the next best thing is to compare where we are now with where we were back then.

But how does John B Taylor know that the without-QE1 economy today wouldn't be in a much worse situation? The answer is: He doesn't. He asserts it would be, based on no evidence.

Next term, we'll try and cover why this kind of analysis is very dangerous indeed because it often leads to policymakers changing policy - changing policy based on little or no evidence, but simple assertions, however strongly put.