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The public policy blog of the American Enterprise Institute
It wasn’t so long ago that the Federal Reserve and its chairman were thought to have virtually omnipotent ability to influence the course of the US economy. Policymakers were dazzled by three decades of steady economic growth and low inflation, the Great Moderation. When he was running for president back in 2000, Senator John McCain said that if then-Fed Chairman Alan Greenspan died, he would “do like they did in the movie Weekend at Bernie’s … I’d prop him up and put a pair of dark glasses on him and keep him as long as I could.”
But today it’s just the opposite. With interest rates at rock-bottom levels, the Fed is thought by some to be “out of bullets” to deal with the sluggish economy. Sure, the central bank can keep buying bonds, but some on the Federal Open Market Committee, as reflected in the recent Fed minutes, worry so-called quantitative easing is doing more harm than good right now, laying the groundwork for asset bubbles and a loosening of inflation expectations.
But has opinion of Fed policy effectiveness now swung too far in the other direction, from omnipotent to impotent? Economists Christina Romer and David Romer think so. As they argue in a new paper, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter”:
There is little doubt that an overinflated belief in the power of monetary policy has contributed to some major policy errors. Most famously, policymakers in the mid-1960s believed that they faced an exploitable long-run inflation-unemployment tradeoff, and thus that monetary policy could move the economy to a sustained path of low unemployment and low inflation.
This belief led them to pursue highly expansionary policy, starting the economy down the path to the inflation of the 1970s. The record of such errors has led many to argue that perhaps the most important attribute of a successful central banker is humility.
In this paper, we present evidence that the opposite belief—an unduly pessimistic view of what monetary policy can accomplish—has been a more important source of policy errors and poor outcomes over the history of the Federal Reserve. At various times in the 1930s, faced with the Great Depression, Federal Reserve officials believed that the power of monetary policy to combat the downturn or stimulate recovery was minimal. In both the mid- and late 1970s, faced with high inflation, policymakers believed that monetary policy could not reduce inflation at any reasonable cost.
And there is evidence that in the past few years, faced with high unemployment and a weak recovery, monetary policymakers believed that policy was relatively weak and potentially costly. In each episode, the belief that monetary policy was ineffective led to a marked passivity in policymaking.
Romer and Romer pointedly criticize Fed Chairman Ben Bernanke and other Fed board members for their public views, mildly reminiscent of the 1930s Fed, that “monetary policy tools are not very effective and potentially costly.” As such, they are encouraged by the recent Fed move to target unemployment and indefinitely continue its bond buying strategy until that target is hit as long as inflation remains anchored. (Christina Romer has advocated the Fed switch to NGDP level targeting, so this is hardly surprising.) Romer and Romer:
The view that hubris can cause central bankers to do great harm clearly has an important element of truth. A belief that monetary policy can achieve something it cannot—such as stable low inflation together with below-normal unemployment—can lead to the pursuit of reckless policies that do considerable damage.
But the hundred years of Federal Reserve history show that humility can also cause large harms. In the 1930s, excessive pessimism about the power of expansionary monetary policy and about its potential costs caused monetary policymakers to do little to combat the Great Depression or promote recovery. I … We have stressed that it is too soon to reach conclusions about recent developments. But, faced with persistent high unemployment and below-target inflation, beliefs that the benefits of expansion are small and the costs potentially large appear to have led monetary policymakers to eschew more aggressive expansionary policy in much of 2010 and 2011. In hind-sight, these beliefs may be judged too pessimistic. …
One possible conclusion is that a central banker should have a balance of humility and hubris. A central banker needs to have a sound knowledge of both the limitations and the powers of monetary policy. Thus, the most important characteristic to look for in central bankers is not their inherent optimism or pessimism about the effectiveness of monetary policy, but rather their understanding of how the economy works and the possible contribution of policy.
The Romer and Romer paper is part of the annual meeting of the American Economic Association. The duo also write another excellent paper on monetary policy, “Friedman and Schwartz’s Monetary Explanation of the Great Depression: Old Challenges and New Evidence.” In it, Romer and Romer establish a link between monetary shocks and expectations of deflation in the central years of the downturn—1930 and 1931–by examining the business press of the era:
We find evidence that these professional observers did indeed expect deflation in substantial part because of Federal Reserve behavior and monetary contraction. This suggests that monetary shocks in the Depression may have affected output and employment by raising real interest rates.
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