Tuesday, May 13, 2008

Catastrophes are far more likely with a weak central bank than a strong one.

My reply to Steve Waldman's May 13th post, "Capabilities, constraints, and confidence":

Steve, you write, "I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged.", and this is a very big theme in your blog. But it's important to realize that catastrophe is much more likely to happen with a very weak central bank, or essentially no central bank, as with a gold standard, or some simplistic algorithm used to manage money supply (and even a long complicated formula or computer program is simple compared to the ultra-multidimensional, flexible, high level intelligence of strong and logical human minds, using formulas and programs only as an aide. With highly complex situations, even long formulas and programs may be far too simple, relative to the analysis of smart and logical human brains, and may perform on average far worse).

Please see graph 3, on page 7 of this paper by Carreras and Tafunell. It shows U.S. GDP from 1831-2000. Look at the massive swings in GDP before the introduction of a strong basically Keynesian modern central bank towards the end of the depression. Talk about catastrophe, after catastrophe, after catastrophe. You don't need to be an econometrician to see that volatility in the economy has been vastly lower in the 50+ year era of strong (essentially Keynesian) central banks.

This not only prevents or diminishes the great human suffering of depressions and recessions, it also raises total long run GDP, because these demand crunches result in a great deal of idle human and material capital that could have been producing if a powerful central bank had countered the demand crunch, essentially by increasing money supply and circulation. As I've recommended before, I recommend again as strongly as possible that you read the great Princeton Economist Paul Krugman's book, "The Return of Depression Economics" (and "Peddling Prosperity"). It explains this with great intuition. If you can't find the time to read this book now, please at least read his 1998 article in Slate, "Baby-Sitting the Economy". In a few pages it gives great intuition on the importance of a strong fed in fighting recessions and ending them quickly.

Mark Thoma aludes to the enormous importance of recession and depression fighting in item 6 of his rejoinder to your post. You're very critical of the fed's performance and very concerned with it having a lot of power, but really; take a look at the historic GDP graph; recessions have been far less severe since we have had powerful, modern, central banks.

Another of my analogies: Costly mistakes and abuses can happen from having a powerful police force, and there should be checks and balances, but, overall, far worse things would happen if we had a weak police force.

One final note: Fiscal measures are also very important. It's much better to fight a recession by employing people in building infrastructure, clean energy research and projects, education, etc., than in making yachts, mansions, and luxury hotels, or restaurant meals and new cars. Fiscal policy has the drawback, though, of taking longer to take effect than monetary policy (increasing the money supply, lowering interest rates, etc.).