When the Governor of the Bank of Canada, Stephen Poloz, insisted in New York this week, “the idea that monetary policy just isn’t working any more [is] one myth I’d like to dispel right off the top,” he was right — to a point. Yes, exceptionally low interest rates and other unconventional monetary policies are holding off the threat of a renewed recession. But that doesn’t mean that monetary policy will continue to work in the future.
Even as central bankers’ power and responsibilities have grown since the 2008 financial crisis, they have confronted a growing dilemma — forced to govern through exceptions in an era where rule-following (particularly the holy grail of the 2% inflation target) has become the ultimate source of policy credibility. Where central bankers are supposed to stick to the rules, they have found themselves endlessly making exceptions, promising that one day things will return to “normal.”
Since early experiments with monetarism in the late 1970s and early 1980s, most central banks have moved towards an increasingly rule-based approach to monetary policy, with inflation targeting becoming the norm in many countries in recent years.
Yet today we are faced with a situation in which the rules no longer apply but are still being invoked as if they did.
A recent Buttonwood column in The Economist notes that the Bank of England has missed its inflation target “almost exactly half the time” since 2008. The European Central Bank (ECB) has effectively expanded its narrow mandate, which formally requires it to make price stability its top priority, by arguing that employment and other issues are crucial to achieving it. Yet the ECB and the Bank of England continue to act as if the old rules still apply.
Scratch an unconventional monetary policy and you will also find a kind of economic exceptionalism — an argument that the crisis we face is extreme enough that it requires a radical but temporary suspension of economic rules and norms.
Most of the unconventional monetary policies tried to date, and just about all of those proposed as future possibilities, break quite radically with existing norms. Negative interest rates weren’t even supposed to be economically possible (until they were tried), while quantitative easing (a central bank’s buying up bonds by massively increasing the size of its balance sheet) still carries a whiff of past irresponsibility as a way for governments to avoid fiscal retrenchment by “printing money.”
More recent proposals include helicoptering money into the government’s or the public’s accounts, abolishing cash to make low interest rates effective, and even introducing a reverse incomes policy — a government-enforced increase in wages (as opposed to the wage controls of the 1970s) to try to get inflation going.
All of these existing and potential policies break with current economic norms, and all are being pitched as temporary, exceptional measures that are (or may be) necessary in the face of an extreme crisis.
Ironically, rule-following was designed to avoid this problem. It came into its own as an influential approach to monetary policy in the wake of the destabilizing 1970s, with their stop-go economic policies and rampant inflation. Mainstream economists came to love rule-based monetary policy, as did politicians — not just neoconservatives like Margaret Thatcher and Ronald Reagan who first championed the approach, but eventually the more centrist politicians who followed, like Jean Chrétien, Tony Blair, and Bill Clinton, as well as today’s mixed lot.
A rule-governed approach to policy was designed to be stabilizing — to do away with the problem and even the possibility of exceptions by removing not only governments’ but even central bankers’ discretion: just stick to the rules, and everything will work out.
Yet rules only work until they don’t apply anymore. A rule that pretends it can always apply inevitably runs into serious problems when an exception becomes necessary.
Of course, as Alan Greenspan has noted, the victory of rules over discretion was never entirely true in practice. But it was a very powerful narrative — one that promised that the commitment of central banks (and governments) to low inflation was credible because they were constrained to follow the rules.
It is such an effective narrative that it has convinced markets that anything other that rule-following is likely to be destabilizing. And as central banks begin to face the limits of those rules, their earlier persuasiveness has come back to haunt them: Canadian markets, for example, have not been happy with Poloz’s attempts to break with the tradition of simple rule-based pronouncements and to communicate the real uncertainties facing the economy today.
This fixation on rule-following has put central bankers into a credibility trap. If bankers admit that the rules no longer apply, then they risk losing their credibility since market actors have come to believe the mantra that rules — particularly low inflation targets — are the only way to ensure sound policy. On the other hand, if they don’t admit the limits of the rules, continuing to lurch from exception to exception, they will eventually lose credibility as the gap between rhetoric and reality widens. Damned if they do and damned if they don’t.
Of course, the most viable solution to this trap is for governments to stop relying so heavily on central banks in the first place and start taking some responsibility for economic recovery through fiscal action (something that the Canadian government has at least started to do). Yet for that kind of fiscal action to work, governments around the world would have to convince the markets that they believed in it enough to stick to their guns — a rather unlikely scenario in today’s austerity-driven times.
As the potential for renewed economic crisis continues to grow, this credibility trap will only widen, with central bankers and governments lurching from exception to exception, refusing to question the neoliberal rules that no longer seem to apply.
An earlier version of this blog was published on the Sheffield Political Economy Research Institute’s Political Economy Blog.