Friday, 27 November 2009

Watson on White

William Watson highlights William R. White's critiques of modern central banking:
The argument he provides is explicitly Austrian, which will commend it to many readers of this page. He quotes Hayek in two places and relies heavily on the fundamental proposition of Austrian economics that: “It is not self evident that policies are desirable when they are effective only at the expense of creating even bigger problems in the future.”

That’s a jab at Greenspanian monetary policy, which White sees as having imparted an inflationary bias to U.S. monetary policy and sown the seeds of future disaster even as it fought against recessionary tendencies in 1987, 1998 and 2001. If the Fed rushes in with buckets of liquidity every time a financial market experiences stress, the market learns that stress is not such a fearful thing. As a result, monetary policy becomes less effective. As White writes: “The degree of monetary easing required to kick start the United States economy seems to have been rising through successive downturns as the ‘headwinds’ of debt have become stronger.” Much of the debt in question was spawned by monetary policy itself: Credit begets collateral, which begets further credit, an evolution the Fed has fostered over the last 25 years.

We may have had unusual stability in the real economy in the Greenspan-era but, White argues, we had growing “instrument instability.” Consider balancing a ping-pong ball on a ping-pong racquet. To keep the ball stable, you move the racquet. If there are shocks to either ball or racquet, you have to move the racquet more and more to keep the ball where it is. The ball never moves much but eventually the required racquet movements are too big, the system collapses and you drop the ball. White argues that’s what’s happened to monetary policy.
Watson never links to the paper, but it's almost certainly this one.

Upshot: interest rates in the boom should be higher than would be dictated by inflation targeting alone, banks should watch against "unusually rapid credit and monetary growth rates, unusually low interest rates, unusually high asset prices, unusual spending patters (say very low household saving or unusually high investment levels)" to try to resist procyclicality in the financial system.

I wonder how or whether this could be operationalised. I'd want something other than "pick a central banker with the right utility function and let him be independent" and more like our current policy targets agreement. Not sure that it can be done in a way that wouldn't wind up being worse than simple inflation targeting: it's awfully hard to distinguish a monetary asset bubble in, say, housing prices from structural problems like the combination of IRD being too lenient on LAQCs and tight zoning/RMA restrictions on new housing supply.

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