Friday, May 24, 2024

"Central Banks Mission Creep"

From The Milken Institute Review, April 24:

There was a time not that long ago when monetary policy was easy, at least in concept. Central banks were supposed to regulate the amount of money in circulation to ensure that it helped facilitate economic stability. Grow the money supply too fast, and inflation would follow. Grow the supply too slowly and the economy would falter like an inadequately lubricated engine.

Business cycles were generally thought to originate on the demand side of the economy. If aggregate demand exceeded the supply of goods and services, the price level increased. Central banks responded by slowing the growth of the money supply. If aggregate demand came up short, unemployment rose, and central banks intervened with more money. 

Inflation and unemployment were inversely related. This inverse relationship was embodied in the Phillips Curve, which served as a menu of sorts from which governments could choose between keeping inflation low by tolerating some unemployment and keeping unemployment low by tolerating a little inflation. This dance of monetary policy wasn’t always easy to get right in practice. But from 1945 to 1973, the basic steps were pretty straightforward.

Did Macroeconomics Die in 1973?
Then, disaster struck. The OPEC cartel sharply increased the price of oil by collectively limiting supply — first in 1973-74 and then again in 1979-81. Global business responded by reducing production or by passing on the extra costs to customers. Suddenly inflation and unemployment rose hand in hand. Was the Phillips Curve dead?

Nope. The problem was simply that the price shock imposed by OPEC on oil importers required a supply-side contraction to restore equilibrium. This was really nothing new in terms of accepted economic theory — price shocks of this magnitude just weren’t that common. But this doesn’t mean central banks were prepared to switch tactics at the drop of a commodity crunch. The Phillips Curve just wasn’t there to offer a roadmap. Indeed, decision-makers were caught between a rock and a hard place.

Under the determined leadership of Paul Volcker, the U.S. Federal Reserve knocked inflation down from 14 percent in 1980 to 2 percent in 1986 — though at the price of accepting an increase in unemployment from 6 percent in 1979 to 10 percent in 1982.

Mercifully, the global economy’s excursion into supply-side hell was relatively short. But the trauma did drive home the sense that macroeconomic policy required an understanding of the impact of shocks to supply as well as to demand. 

The lesson was reflected in the establishment of the European Economic Area in 1994, creating a free trade zone in much of Western Europe, along with the adoption of a common currency in 1999. The main aim of both projects was to facilitate cross-border trade, increasing productivity by enlarging markets, increasing competition and facilitating more specialization. This proved to be one of the most successful supply-side stimulus packages of all time.

Breaking Free
One conclusion is inescapable: because increased trade stimulates the supply of goods and services and drives down prices to competitive levels, it behooves central banks to promote trade to keep inflation low without generating unemployment. But most of the world’s central bankers remain stuck in their old ways, arguing they would be exceeding their mandates if they explicitly defended open trade. Likewise, the central banks of those European countries that have not yet adopted the euro ought to advocate currency integration as a barrier to inflation....