Monetary Policy is powerful, for good or ill
That´s why central banks hate money. They can´t hide their mistakes!
(Note: This post was written 12 years ago)
A link to this post by Matt Iglesias is the first salvo:
To step back to the hyperinflation [in Weimar Germany]. You might ask yourself how things could possibly have gotten that bad. And the answer really just comes down to refusal to admit that a mistake had been made.
To halt the inflation, the Reichsbank would have to stop printing money. But once the inflation had gotten too high for Reichsbank President Rudolf Havenstein to stop printing money and stop the inflation would be an implicit admission that the whole thing had been his fault in the first place and he should have done it earlier.
It was easier to say that hyperinflation was a necessary consequence of allied demands for reparations payments and that he had no choice but to print currency in the quantity demanded.
And concludes:
The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now.
Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.
So I decided to describe the process in charts. The set of charts below illustrate the path of the (log) price level in Brazil. Before inflation was finally tamed in mid 1994, several “stabilization plans” usually based on price freezes were enacted. Notice that the effect of the “policy” was longest after the first plan in 1986, becoming progressively shorter.
That satisfies the definition of “crazy”: Someone who does the same thing over and over and each time expects a different result.
In the Collor Plan they “innovated” and confiscated 80% of everyone´s liquid assets! The result was a kink in the slope of prices, meaning the rate of inflation decreased somewhat. But in 1994 when the Central Bank decided enough was enough, inflation immediately “disappeared” as if by “magic”.
The chart below graphs the rate of monthly inflation over the same period.
The charts below illustrate the same pattern for famous hyperinflation episodes (some of those are discussed by Thomas Sargent in “The End of four big inflations”). The pattern is clear: When the monetary authority sets its mind to do it, inflation stops immediately.
And this Anasthasios Orphanides article discusses a1937 “cover-up” episode by the Fed:
Though the extent of the sharp decline in activity was not immediately evident, by Fall it became fully clear to the Committee that the economy was thrown back to a severe recession, once again.
The following evaluation of the situation by (John) Williams at the November 1937 meeting is informative, both for offering a frank admission that the FOMC apparently wished for a slowdown to occur and also for outlining the case that the recession, nonetheless, had nothing to do with the monetary tightening that preceded it.
Particularly enlightening is the reasoning offered by Williams as to why a reversal of the earlier tightening action would be ill advised. We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. …
In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. …
If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn.
It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)
The chart below shows that: 1) The change in MP quickly reversed the deflation that went on from 1929 to early 1933 and, 2) The reversal in MP quickly brought deflation back in mid 1937!
So Iglesias conclusion is consistent with the data. If the Central Bank makes a mistake it will keep making it, unless you change the “actors” in the process. They are terrified of being “blamed”.