Review: Central Banking in Theory and Practice

by Alan S. Blinder

In 1995, while I was adjusting to life at the University of Hawai`I as a transfer student, Alan Greenspan (a.k.a. "The Maestro") served as Chairman of the Federal Reserve Board. The U.S. had recovered from the 1991 Gulf War recession, and was in the early years of a long-running bull market. From 1994 to 1996, Alan Blinder was the FRB's vice-chairman.

After his departure, Blinder gave three lectures as part of the Lionel Robbins Memorial Lectures. These were published a 1998 book, which was a part of my 2005-2006 MBA curriculum. Despite working in an industry that does has nothing to do with central banking, I've held onto it through all these intervening years.

A few things changed recently. First, our move to Japan increased my motivation to clear out some of my old books. Second, COVID allowed me to work from home, and I found more time to read them. So I cracked open this short, 80-page book and decided to do a book report.

1. "Targets, Instruments, and all That" 

What are central banks responsible for? On one level – the less interesting one – they oversee the payments system and supervise banks. The more interesting thing they do is implement monetary policy by balancing inflation against employment.

What makes things difficult is that this isn't a math problem. The varying weights of the different inputs are always changing, and the future is difficult to predict. It's like driving a car by looking out the side window, on a road you've never been down before. Caution is paramount.

Yet proactive measures also have their place. "If it ain't broke, don't fix it!" is a terrible approach to both car maintenance and central banking. Rather, periodic maintenance and early problem detection help keep small problems in the economy from becoming larger.

Even so, too much proactivity is like using a thermostat in a cold room. If you turn it up shortly before going to bed, and then turn it up again just before falling asleep (thinking the first time wasn't effective), you might wake up at midnight drenched in sweat. Similarly, the effects of FRB decisions require time to take effect. 

In the event that the FRB gets things exactly right, there's another issue that comes up --- if you're too successful, the public gets the impression that the FRB's job is easy and that crises are always overblown.

To find the golden mean of economic prudence, the FRB uses multiple economic models when making its decisions, but they are not perfect. Nevertheless, they are better than nothing, and far better than relying on politicians' election results-based preferences.

2. "Choosing and using a monetary policy instrument." 

When the world operated on a gold standard, it was a far simpler time. Trade benefited from fully convertible currencies (effectively a peg to gold), governments weren't responsible for inflation, and banks didn't have to worry about "setting" official interest rates.

As the 20th century progressed, and major world currencies dropped any remaining pretense of a gold standard, monetary policy became a new thing. At that point, it became possible for governments to "fine tune" their economies for maximum performance. The question then became, "OK, but how should we do that?" 

At first, the answer was monetarism – control of the money supply within the country. If there was too much, the country experienced inflation. Too little, and it constrained growth potential. But monetarism had no answer for stagflation in the 1970s – both high inflation AND low growth.

A focus on interest rate signaling eclipsed monetarism. When inflation was a risk, the Fed raised interest rates, and this filtered down to cool the economy. When a recession hit, the Fed lowered rates to stimulate spending and investment. 

3. "Central Bank Independence." 

How responsive should a central bank be to its national government? In the past 50 years, we have seen that a central bank does its best when the goals are set by the national government, while the decisions are left to the central bank's discretion.

Due to the regular cycle of elections, politicians prefer short term gains even if it means sacrificing long-term price stability. This is why "many governments wisely try to depoliticize monetary policy by, e.g., putting it in the hands of unelected technocrats with longer terms of office and insulation from the hurly-burly of politics."

Central banks can also show over-sensitivity to financial markets. Blinder's boss, Alan "The Maestro" Greenspan, built a reputation for this over his twenty-year tenure. From the Black Tuesday of 1987 through the war on terrorism, Greenspan was quick to insulate the economic from financial shocks. Unfortunately, soon after his departure, the Great Recession would hit the U.S. economy through the one sector that Greenspan tried so hard to accommodate.

As Blinder himself put it, "Following financial markets may be a nice way to avoid unsettling financial surprises, which is a legitimate end in itself. But I fear it may produce rather poor monetary policy." (p60) And "delivering the policies the markets expect – or indeed demand – may lead to very poor policy." (p62)

Seen through the lens of spring 2020, the risks of political interference seem to be greater than in the recent past. Despite the current chairman being his own appointee, President Trump has repeatedly berated Jerome Powell publicly.

Trump has dubbed Powell no less than enemy of the state and a "fail," with "No 'guts,' no sense, no vision! A terrible communicator!" He has mused, "Where did I find this guy Jerome?" The president's main issue is that he is allergic to any increase in interest rates. [Source]

My concern with this state of affairs is that it undermines the authority of the Federal Reserve Bank for the sake of short-term populism. The credibility of the Fed is not something to be taken lightly. "Credibility means that your pronouncements are believed – even though you are bound by no rule and may even have a short-term incentive to renege…. It is painstakingly built up by a history of matching deeds to words." (p65)

4. Conclusion 

Central Banking in Theory and Practice serves as a wonderful snapshot of late 20th Century central banking "philosophy." Although Blinder had drawn from the lessons learned from the preceding twenty years, his insights could just as easily serve as a reprimand to those in the following twenty. Indeed, some of his quotes seem custom made for email signatures.

5. Quotes 

"It is foolish to make the best the enemy of the moderately useful." p8

"Unless you have thought through your expected future actions, it is impossible to make today's decisions rationally." p14

"If there are any surprises at all, the decisions that you actually carry out in the future will differ from the ones you actually planned. That's flexibility. Ignoring your own likely future actions is myopia." p15

"Ordinary rational people do not deem it wise to ignore the admittedly unknown future in order to "maintain flexibility." p15

"Skepticism about econometric estimates is one thing, and is highly appropriate. But healthy skepticism should not be allowed to devolve into econometric nihilism, which is too often an excuse for wishful thinking and an escape from the discipline of data." p23