Central banks make an historic turn
When the economic history of the 21st century is written, September 2012 is likely to be recorded as a defining moment, almost as important as September 2008. This month‚Äôs historic events ‚Äď Ben Bernanke‚Äôs promise to buy bonds without limit until the U.S. returns to something approaching full employment, Angela Merkel‚Äôs support for the European Central Bank bond purchase plans and the Bank of Japan‚Äôs decision to accelerate greatly its easing program ‚Äď may not seem earth-shattering in the same way as the near-collapse of every major bank in the U. S. and Europe. Yet the upheavals now happening in central banking represent a tectonic shift that could transform the economic landscape as dramatically as the financial earthquake four years ago.
To see why, we must go back in history 40 years, to the early 1970s. Maintaining full employment was at that time regarded as the main objective of all economic policy, and this had been the case for roughly 40 years, since the Great Depression. But by the early 1970s, voters had enjoyed decades of more or less full employment and were starting to focus on inflation rather than depression as the main threat to their prosperity. Economists and politicians were responding to this shift. Milton Friedman led a monetarist ‚Äúcounterrevolution‚ÄĚ against the Keynesian obsession with unemployment, designing new economic models to challenge the Keynesian view that market economies were naturally prone to long-term stagnation. By restoring the pre-Keynesian assumption that market economies were automatically self-stabilizing, the monetarist models produced two powerful policy prescriptions directly opposed to the Keynesian views.
First, the monetarists insisted that price stability, rather than full employment, was the only legitimate target for monetary policy and government macroeconomic management more generally. Second, they argued that central bankers should not accept any direct responsibility for unemployment, since sustainable job creation depended solely on private enterprise ‚Äď full employment would be achieved automatically if inflation were conquered and market forces were allowed to operate freely, with the minimum of government interference or union constraints. A few years later, Margaret Thatcher and Ronald Reagan turned Friedman‚Äôs intellectual revolution into practical politics. On top of its economic impact, monetarism had huge ideological effects by absolving government macroeconomic management of any direct responsibility for jobs and instead attributing unemployment to regulations, unions, welfare policies and other market distortions.
The historic significance of this month‚Äôs central bank decisions should now be clear. The Fed has promised to keep printing money until full employment is restored ‚Äď and it has committed itself to even bolder measures if those announced last week prove inadequate. The ECB has undertaken to ‚Äúdo whatever it takes‚ÄĚ to preserve the euro and specifically to buy Spanish and Italian government bonds with newly created euros in unlimited amounts.
In making these announcements, the Fed and the ECB were not just demoting their previously inviolable inflation targets to near-irrelevance. They were breaking intellectual and political taboos that had dominated central banking for four decades. This iconoclasm has prompted an extreme reaction from the one remaining bastion of traditional monetarism in central banking, Germany‚Äôs Bundesbank. On Tuesday the Bundesbank‚Äôs president, Jens Weidmann, described the new central banking quite literally as the work of the devil; Mephistopheles, he recalled, had used just such policies to create chaos and hyperinflation in Goethe‚Äôs Faust.
And indeed, the attempts to use monetary policy to restore full employment will need to overcome the two main objections presented by monetarist theory and repeated his week by the Bundesbank. Will printing more money produce intolerable inflation? And what happens if businesses fail to respond to monetary expansion by creating more jobs ‚Äď won‚Äôt that lead to ever more desperate and risky efforts to artificially stimulate employment?
Most of the admonitions against using monetary policies to achieve full employment focus on the risk of unleashing inflation. On this score, the Fed and the ECB have a very credible response, offered most recently from Ben Bernanke and Mario Draghi last week: As long as unemployment and industrial excess capacity remain anywhere near present levels, generalized inflation is very unlikely. Even if some commodities, such as oil or food, experience inflation, this will be offset by others goods and services whose prices fall.
The more insidious danger is that the Fed will simply fail in its efforts to stimulate job creation and accelerate economic growth. Disappointment was, after all, the outcome of the last two rounds of QE. So why should this one be any different, even if the Fed keeps increasing the amount of new money printed? This is the troubling question that Bernanke has so far failed to answer or even seriously confront.
It may turn out that just injecting money into banks and bond funds is not sufficient, regardless of the amounts. A genuine economic stimulus may require newly created money to be distributed directly to businesses or households as suggested here in the past. Imagine, for example, that the extra $40 billion the Fed will pump every month into the bond market were spent instead on a $130 monthly payment to every U.S. citizen, repeated until the economy returned to full employment. With the taboo against central banks accepting responsibility for unemployment now completely broken, such truly radical monetary policies may just be a matter of time.
PHOTO: U.S. Federal Reserve Chairman Ben Bernanke addresses U.S. monetary policy with reporters at the Federal Reserve in Washington, September 13, 2012. REUTERS/Jonathan Ernst