Avoiding the next crisis: can central banks learn?

• Author: Hetzel, Robert L.

Any effort to avoid future recessions must rest on an organized way to learn from the past. However, the absence of such efforts within central banks renders such learning problematic and makes likely the recurrence of episodes of recession and financial market turmoil. Critical to learning is the use by policymakers of models to evaluate the past performance of monetary policy. These models should not be the complicated, multiequation models favored by the forecasting departments of central banks. Rather, they should be simple models that require policymakers to take a stand on the basic issues in monetary economics: the nature of the price level (monetary or real) and how well the price system works to maintain output at potential (full employment). They should serve as a safeguard to the understandable tendency of central bankers to attribute economic disturbances exclusively to real shocks rather than monetary shocks.

This article explains how learning requires that policymakers use models to disentangle causation from correlation. In that way, models can bring coherence to the diverse experiences of the past and can facilitate prediction of how well alternative policy rules would work. The quantity-theory hypothesis that recessions originate in central bank interference with the price system is summarized and used to explain the Great Recession. The article concludes with comments on learning and models.

Creating Causation Out of Correlation

An inversion of Says' law would be that demand creates its own supply. There is a demand for journalists to explain the Great Recession and subsequent slow recovery. The resulting supply of stories uses correlation to explain causation. In the boom phase of a business cycle when individuals are optimistic about the future, they bid up asset prices and take on debt. In the bust phase, they sell assets at fire sale prices and attempt to pay down debt. Correlation becomes causation through a morality tale about greed and speculative excess.

The initial occurrence of speculative excess requires a purging of the economic body. Easy money and inflation lead to tight money and deflation. To become easily comprehensible, this story anthropomorphizes impersonal market forces through the vilification of the unrestrained greed of Wall Street bankers. Finally, the story resonates by mining a deep populist vein in American culture. As a result of unrestrained speculation, paper wealth increases out of proportion to the productive capacity of the real economy. The inevitable bursting of the asset bubble disrupts financial intermediation and productive economic activity. In the form of the real-bills doctrine, this perennially popular populist narrative powered the creation of the Federal Reserve System. (1)

In contrast to the journalistic imperative to tell a compelling story, the fundamental methodological desideratum in macroeconomics is to disentangle causation from correlation. This effort requires a model, which separates the behavior of exogenous variables and shocks from the behavior of endogenous variables. Exogenous forces arise from outside the working of the price system and endogenous variables respond to them in a way dependent upon the price system. As a way of introducing the importance of bringing the discipline of economies to bear on the issue of the shocks that cause cyclical fluctuations in the economy, the following provides an example of the kind of descriptive characterization of business cycles referred to above and contrasts it with an economic characterization.

Washington Irving commented on the 1818-19 deflation and recession:

Every now and then the world is visited by one of these delusive seasons, when the "credit system" ... expands to full luxuriance: everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open..... Banks ... become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed that a vast amount of promissory capital is soon in circulation.... Nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital....

Now is the time for speculative and dreaming of designing men. They relate their dreams and projects to the ignorant and credulous, [and] dazzle them with golden visions.... The example of one stimulates another; speculation rises on speculation; bubble rises on bubble.... No "operation" is thought worthy of attention, that does not double or treble the investment.... Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant [in Fisher 2008: 4].

William Graham Sumner, in 1874, commented similarly on the same event:

In consequence.... the inclination of a large part of the people, created by past prosperity, to live by speculation and not by labor, was greatly increased. A spirit in all respects...