What should a central bank (not) do?

• Author: Steil, Benn
• Position: Essay

The financial crisis that began unfurling in 2008 has led to the refashioning of the model central bank governor along the lines of Churchillian war leader, willing to try anything with the money he conjures to restore economic growth. This raises important questions as to what limits, if any, elected officials should impose on such aspiring great men, and what limits markets will ultimately impose on them if elected officials forbear. This article focuses on the second of these questions.

The Pitfalls of Aggregate Demand Management

It is a fundamental postulate of today's dominant paradigm of Keynesian macroeconomics that all demand is created equal. Government spending is interchangeable with consumer spending, which is itself interchangeable with business investment. Paul Krugman (2001) illustrated the paradigm impeccably.

"The driving force behind the current [2001] slowdown is a plunge in business investment," he observed. "Over the last few years businesses spent too much on equipment and software, and ... they will be cautious about further spending until their excess capacity has been worked off," he cautioned. But "to reflate the economy," he assured us, "the Fed doesn't have to restore business investment; any kind of increase in demand will do." For as "Larry Summers says, you don't have to refill a flat tire through the puncture." How would Krugman, then, have had the Fed refill the tire punctured by plunging business investment? "Housing," he said, "which is highly sensitive to interest rates, could help lead a recovery."

But surely Krugman understood that we could have too much demand for housing, even if the economy as a whole was producing less than what he believed to be its aggregate capacity? No, he did not, so in 2002 he urged the Fed to do more. The Fed, he wrote, "needs to create a housing bubble to replace the Nasdaq bubble" (Krugman 2002). We know how that turned out. Yet today he is singing from precisely the same hymn sheet--just louder.

If Krugman and Summers could be permitted a tire analogy in support of their paradigm, perhaps I can be allowed a shower analogy in rebuttal. Imagine you get into the shower, turn on the water, and nothing comes out. You call the plumber. He tells you there's a hole in the pipes, and that it will cost you $1,000 to repair it. You tell him just to turn up the water pressure instead.

Sound sensible? Well, this is the logic behind the Fed's strategy of flooding the money pipes until credit starts flowing freely again from banks to businesses. You wouldn't expect this to work in your shower...