Sunday, May 11, 2008

As with government in general, central banks can be flawed, but not having one at all would be far worse

In response to Steve Waldman's April 6th post, "Central banks are dangerous":

I know you're concerned that the fed chairman could be incompetent, and so if you give him a lot of power he could cause serious problems. Further, you state, "Our long-term plan, though, ought not be to canonize central banks, but to render them obsolete."

What I say to that is this: it's like saying our long term plan should be to have no U.S. government. U.S. Governments may sometimes be horribly incompetent and corrupt, relative to what we normally have, like the Bush administration and the Republican congresses of the conservative era. But having no government at all would be far worse. That would lead to far lower quality of life and wealth creation. It would mean no police, no courts, no military, no public education, and on and on.

I know you recently started a finance Ph.D. program. As you learn more and more about economics you will find out more and more the crucial importance of government in addressing pure free market problems like externalities, asymmetric information, inability to patent, large economies of scale and monopoly power, and much more.

As with government in general, likewise for the Fed. Because Greenspan, despite the mythology, was a horrible Chairman, doesn’t mean we should have no Fed, or that we should not give it strong powers. The cost of a rare terrible chairmen, like Greenspan who acted largely based on Libertarian ideology rather than what's best for the economy, is better than the immensely greater costs from having no Fed at all or a very weak one.

Keep in mind that if a fed chairman is grossly incompetent for a long period of time the economic community will speak out en masse, and congress and the president can pass a special law to remove him. There are checks and balances.

Why is the Fed so important and indispensible. You will learn this as you progress in your education, but to learn a great deal about this quickly and with great intuition, I strongly suggest you read two books by Princeton Economist and John Bates Clarke Medal winner Paul Krugman: "Peddling Prosperity" and "The Return of Depression Economics". You will really enjoy and learn from these books. Also, here's a good article on Greenspan from Barrons.

A final analogy is with modern scientific medicine. You can find terrible doctors, but that doesn't mean it's best to never use modern medicine and instead to go back to primitive herbs and folk remedies for everything. With all of the flaws in modern medicine, it's more than doubled the human lifespan compared to the days of only non-scientific medicine, given us a Polio vaccine, etc., etc.

And really, I'd say the same thing for academic economics and finance. It has a lot of flaws and inefficiencies, but it's essentially the only game in town that is largely trying to be, and succeeding in being, scientific, and that thinks long and deep about issues, well beyond simpleminded sound bite "analyses" like those used by today's conservatives (which is virtually all of today's Republican politicians and those who control the party and its machine).

Academia may have serious flaws and waste, but it's essentially the only game in town for so much of the important things it does, and the good that does come out is so valuable it's immensely worth having to pay for the waste that's hard to fight in academia's insular world of massively asymmetric information.