THE conventional story of the credit crunch is that following the dot-com boom the US Federal Reserve cut interest rates, creating an inflationary debt-fuelled boom that manifested itself in housing. But is the Fed to blame? US economists Jeffrey R. Hummel and David Henderson prompted controversy by lending support to Ben Bernanke’s theory of a “global savings glut”. In a Cato Briefing Paper they argued that Alan Greenspan effectively froze the monetary base (i.e. the part of the money supply that the Fed controls). They argue that it was foreign investors’ holdings of US Treasury bills that were putting downward pressure on short-term interest rates, and (rightly or wrongly) the Fed passively allowed it. In the 2011 Mundell-Fleming lecture, Hyun Song Shin argued that it was activity by EU central banks that was responsible for the low rates. Does it matter?
There are two separate questions that economists need to understand – the first is whether interest rates were artificially low, and the second is why. It is troubling that those who believe that the first is true seem not to care about the answer to the second. Or perhaps they do care, but they hold the Fed responsible purely because it is the monetary authority for the US. It is tempting to believe that the Fed is equally culpable regardless of whether it lowered interest rates itself, or simply failed to offset the forces being generated by other central banks. But think through the logic of this claim. Should the Fed attempt to offset all foreign purchases of Treasuries? Should it have discretion over how much foreign demand reflects genuine savings and how much is government manipulation? And indeed if we blame it now for allowing a housing bubble to emerge should we include housing in our measure of the price index? There is a lengthy academic debate on whether asset prices should be included in price indices, and I for one would be uneasy about giving central bankers the task of identifying and offsetting asset price bubbles in real time.
American economist Scott Sumner has recently argued that the Fed cannot be blamed for the inflation that led to the Wall Street Crash because the money supply measures that reveal the inflation were not publicly available at the time. As Robert Murphy has responded, the fact that doctors of the time didn’t understand bacteria does not affect the cause of deaths during the bubonic plague. Whether we “blame” central bankers or not is really a secondary consideration to our attempts to understand what happened and why. By assigning blame we suggest that the Fed should have done better. It encourages us to think “if only it did X everything would be ok”. But the problem isn’t that individuals focused on the wrong targets, and the solution isn’t to work out how they can improve. The lesson should be that the nature of central banking – the attempt to centrally plan the monetary system – imposes an epistemic burden on policymakers that they cannot possibly ever fulfil. The Fed wasn’t to blame for the crisis, because any argument for what it “should” have done is insincere. We should absolve it from culpability, and remove the shackles of expectation that we place upon it. It did the best it could be expected to do. And that wasn’t enough.
Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School. www.anthonyjevans.com