Stop worshiping central banks

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR, Oct 18, 2022 (IPS) - Preoccupied with enhancing their own ‘credibility’ and reputations, central banks (CBs) are again driving the world economy into recession, financial turmoil and debt crises.

Wall Street ‘cred’

Most CB governors believe ‘credibility’ is desirable and must be achieved by fighting inflation at any cost. To justify their own more harmful policies, they warn inflation is ‘damaging’.

They argue CBs need ‘independence’ from governments to pursue ‘credible’ monetary policy. Inflation targeting to ‘anchor’ inflation expectations is supposed to generate desired ‘confidence’. But CBs have been responsible for many costly failures.

The US Fed deepened the 1930s’ Great Depression, the 1970s’ stagflation and the early 1980s’ contraction, besides contributing to the 2008-09 global financial crisis (GFC). Hence, CB notions of ‘credibility’ and ‘independence’ need to be reconsidered.

Milton Friedman – whom many central bankers revere – blamed the 1930s’ Great Depression on US Fed actions and inactions. Instead of providing liquidity support for businesses struggling with short-term cash-flow problems, it squeezed credit and economies.

But why did the Fed behave as it did? Some economic historians insist it was “to promote the interests of commercial banks, rather than economic recovery”.

Monetary policy before and during the Great Depression “was designed to cause the failure of non-member banks, which would enhance the long-run profits of the Fed’s member banks and enlarge the [Fed’s] regulatory domain”.

Others concluded, “Federal Reserve errors seem largely attributable to the continued use of flawed policies” to defend the ‘gold standard’, and its poor understanding of monetary conditions.

Central banks contractionary

Worse, few lessons were learnt. Instead of protecting the gold standard, or being counter-cyclical, fighting inflation is the new CB preoccupation. Even worse, most CBs now commit to an arbitrarily-set inflation target of 2%, first promoted by the Reserve Bank of New Zealand over three decades ago.

Major CB interventions have caused both economic booms or bubbles and busts or contractions, often without mitigating inflation. Such “go-stop” monetary policy swings have caused asset price bubbles and financial fragility besides sudden contractions.

Ben Bernanke’s research team found the major damage from the 1970s’ oil price shocks was due to the “tightening of monetary policy” response. Other research attributed the 1970s’ stagflation largely to the Fed’s “go-stop” monetary policy, worsened by policymakers’ “misperceptions” and “faulty doctrine”.

Hence, “in substantial part the Great Stagflation of the 1970s could have been avoided, had the Fed not permitted major monetary expansions in the early 1970s”.

Labour pays

Likewise, Fed chair Paul Volcker sharply raised interest rates during 1979-81 “to a crushing level of nearly 20 per cent by the middle of 1981”.

This precipitated the “ensuing recession that started in July 1981 [which] became the most severe downturn since the second world war”. US unemployment reached nearly 11% in late 1982, the highest since the Great Depression.

Volcker’s actions betrayed the Fed’s dual mandate to pursue both full employment and price stability. First in the Employment Act of 1946, it was re-codified in the 1978 ‘Humphrey-Hawkins’ Full Employment and Balanced Growth Act.

Eventually, the long-term unemployed “became invisible to both the labour market and to policymakers”. Many became deskilled as others fell victim to criminality, substance abuse, and mental illness, even suicide.

The overall health of Americans became “poorer for years as a result of the deep economic recession in 1981 and 1982”.

Sending Global South south

Volcker’s actions caused developing country debt crises, with decades lost in Latin America and Africa. A recent New York Times opinion-editorial warned, “The Powell pivot to tighter money in 2021 is the equivalent of Mr. Volcker’s 1981 move”, and “the 2020s economy could resemble the 1980s”.

Yet, invoking CB credibility, many with power and influence are urging the Fed to stick to its guns with Volcker’s “courage to take out the baseball bat to slam the economy and slay inflation”!

The World Bank warns of dire developing country debt crises following policy-induced recessions. Meanwhile, the International Monetary Fund has warned developing economies with dollar-denominated debt of imminent foreign exchange crises.

Stop-go new norm

Fed, Bank of England and European Central Bank policy approaches still justify “go-stop” monetary policy reversals. Resulting booms or bubbles and busts also feature in other recent crises, e.g., the GFC.

Following the 1997 East Asian financial crises, Mexican, Russian and post-US ‘dotcom bubble’ bust, the Fed eased monetary policy too much for too long during the ‘Great Moderation’.

CBs enabled credit expansion in the 2000s, culminating in the GFC. More worryingly, the “near-consensus view” is that independent CBs have failed to achieve – let alone protect – financial stability.

Easy credit and rising stock and housing markets have involved rapid credit and loan growth worsening asset price bubbles. Regulatory oversight became increasingly lax as investors ‘chased yield’. Leverage grew, using dodgy ‘derivative’ products, making proper risk assessment difficult.

Guy Debelle, once Deputy Governor of Australia’s CB, noted, “The goal of financial stability has generally been left vague”. Hence, CBs failed to see significant build-up of financial instability”.  Soon after, the Lehman Brothers’ collapse precipitated the GFC.

QE magic from bubble to bust

Governments withdrew fiscal ‘stimuli’ too soon. So, major CBs aggressively pursued ‘unconventional monetary policies’, especially ‘quantitative easing’, to keep economies afloat.

Extraordinary monetary expansion provided vital liquidity, but poor coordination also fuelled asset price bubbles. Thus, unviable enterprises survived, undermining productivity growth.

With less investment in the real economy, supply capacity is falling behind still growing demand. Pandemic, war and sanctions have also disrupted supplies.

Raising interest rates, CBs now race to reverse earlier monetary expansion. Credit contractions are squeezing economies, hitting poorer countries especially hard.

Reviewing historical data, the author of the ‘Taylor rule’ – whom many CBs profess to follow – concluded, “The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses – frequently monetary excesses – which lead to a boom and an inevitable bust”.

Independence for what?

CB independence (CBI) advocates often claim low inflation during the Great Moderation was due to CB credibility. But inflation in most countries declined from the mid-1990s, with or without CBI.

The alleged causation has been much exaggerated, and is certainly not as strong as argued. Claiming CBI ensures low inflation also denies other relevant variables, e.g., labour market casualization and globalization.

Debelle observed, “How much [low inflation] can be attributable to central bank independence or the inflation target is difficult to disentangle …[Favourable] assessment mostly relies on assertion, rather than empirical proof”.

Milton Friedman argued crisis responses involve inherently political decisions, best not left to the unelected. A modern CB’s “responsibilities overlap with other government functions”. So, CBs must be subject to political authority while maintaining operational independence.

CBI fetishism has also allowed central bankers to ignore distributional consequences of monetary policies. This has often enabled financial asset owners, speculators and creditors. CBI has also meant neglecting development responsibilities.

Emphasizing CBI also implies “a very narrow view of central bank functions”. This has made economies more prone to financial instability and crisis. Clearly, CBI is no harmless ‘elixir’ ensuring low inflation.

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Central bank myths drag down world economy

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR, Oct 11, 2022 (IPS). The dogmatic obsession with and focus on fighting inflation in rich countries are pushing the world economy into recession, with many dire consequences, especially for poorer countries. This phobia is due to myths shared by most central bankers.

Myth 1: Inflation chokes growth

The common narrative is that inflation hurts growth. Major central banks (CBs), the Bretton Woods institutions (BWIs) and the Bank of International Settlements (BIS) all insist inflation harms growth despite all evidence to the contrary. The myth is based on a few, very exceptional cases. 

“Once-in-a-generation inflation in the US and Europe could choke off global growth, with a global recession possible in 2023”, claimed the World Economic Forum Chief Economist’s Outlook under the headline, “Inflation Will Lead Inexorably To Recession”. 

The Atlantic recently warned, “Inflation Is Bad… raising the prospect of a period of economic stagnation or even a recession”. The Economist claims, “It hurts investment and makes most people poorer”. 

Without evidence, the narrative claims causation runs from inflation to growth, with inevitable “adverse” consequences. But serious economists have found no conclusive supporting evidence. 

World Bank chief economist Michael Bruno and William Easterly asked, “Is inflation harmful to growth?” With data from 31 countries for 1961-94, they concluded, “The ratio of fervent beliefs to tangible evidence seems unusually high on this topic, despite extensive previous research”. 

OECD evidence for 1961-2021 – Figures 1a & 1b – updates Bruno & Easterly, again contradicting the ‘standard narrative’ of major CBs, BWIs, BIS and others. The inflation-growth relationship is strongly positive when 1974-75 – severe oil spike recession years – are excluded. 

The relationship does not become negative even when 1974-75 are included. Also, the “Great Inflation” of 1965-82 did not harm growth. Hence, there is no empirical basis for setting a particular threshold, such as the now standard 2% inflation target – long acknowledged as “plucked from the air”!

Source: World Bank database

Developing countries also have a positive inflation-growth relationship if extreme cases – e.g., inflation rates in excess of 20%, or ‘excessively’ impacted by commodity price volatilities, civil strife, war – are omitted (Figures 2a & 2b). 

Figure 2a summarizes evidence for 82 developing countries during 1991-2021. Although slightly weakened, the positive relationship remained, even if the 1981-90 debt crises years are included (Figure 2b).

Source: World Bank database

Myth 2: Inflation always accelerates

Another popular myth is that once inflation begins, it has an inherent tendency to accelerate. As inflation supposedly tends to speed up, not acting decisively to nip it in the bud is deemed dangerous. So, the IMF chief economist advises, “Don’t let inflation ‘genie’ out of the bottle”. Hence, inflation has to be ‘nipped in the bud’. 

But, in fact, OECD inflation has never exceeded 16% in the past six decades, including the 1970s’ oil shock years. Inflation does not accelerate easily, even when labour has more bargaining power, or wages are indexed to consumer prices – as in some countries.

Bruno & Easterly only found a high likelihood of inflation accelerating when inflation exceeded 40%. Two MIT economists – Rüdiger Dornbusch and Stanley Fischer, later International Monetary Fund Deputy Managing Director – came to a similar conclusion, describing 15–30% inflation as “moderate”. 

Dornbusch & Fischer also stressed, “Most episodes of moderate inflation were triggered by commodity price shocks and were brief; very few ended in higher inflation”. Importantly, they warned, “such [moderate] inflations can be reduced only at a substantial … cost to growth”.

Myth 3: Hyperinflation threatens

Although extremely rare, avoiding hyperinflation has become the pretext for central bankers prioritizing inflation prevention. Hyperinflation – at rates over 50% for at least a month – is undoubtedly harmful for growth. But as IMF research shows, “Since 1947, hyperinflations in market economies have been rare”.

Many of the worst hyperinflation episodes in history were after World War Two and the Soviet demise. Bruno & Easterly also mention breakdowns of economic and political systems – as in Iran or Nicaragua, following revolutions overthrowing corrupt despotic regimes.

A White House staff blog noted, “The inflationary period after World War II is likely a better comparison for the current economic situation than the 1970s and suggests that inflation could quickly decline once supply chains are fully online and pent-up demand levels off”.

Myth 4: Evidence-based policymaking

Central bankers love to claim their policymaking is evidence-based. They cite one another and famous economists to enhance the aura of CB “credibility”. 

Unsurprisingly, the Reserve Bank of New Zealand promoted its arbitrary 2% inflation target mainly by endless repetition – not strong evidence or superior logic. They simply “devoted a huge amount of effort” to preaching the new mantra “to everybody who would listen – and some who were reluctant to listen”.

The narrative also suited those concerned about wage pressures. Fighting inflation has provided an excuse to further weaken workers’ working conditions and pay. Thus, labour’s share of income has been declining since the 1970s. 

Greater central bank independence (from the executive) has enhanced the influence and power of financial interests – largely at the expense of the real economy. Output and employment growth weakened as a result, worsening the lot of the many, especially in the global South. 

Fact: Central banks induce recessions

Inappropriate CB policies have often slowed economic growth without mitigating inflation. Hawkish CB responses to inflation can become self-fulfilling prophecies with high inflation seemingly associated with recessions or growth collapses.

Before becoming Fed chair, Ben Bernanke’s research team concluded, “an important part of the effect of oil price shocks [in the 1970s] on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy”. 

Thus, central bank interventions have caused contractions without reducing inflation. The longest US recession after the Great Depression – in the early 1980s – was due to Fed chair Paul Volcker’s 1979-81 interest rate hikes. 

A New York Times opinion-editorial recently warned, “The Powell pivot to tighter money in 2021 is the equivalent of Mr. Volcker’s 1981 move”, and “the 2020s economy could resemble the 1980s”. 

Fearing an “extremely severe” world recession, Columbia University history professor Adam Tooze has summed up the current CBs’ interest rate hike frenzy as “the single most dramatic simultaneous tightening of monetary policy ever”! 

Phobias, especially if based on unfounded beliefs, never offer good bases for sound policymaking.

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Ideology and dogma ensure policy disaster

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR, Oct 04, 2022 (IPS) - Central banks (CBs) around the world – led by the US Fed, European Central Bank and Bank of England – are raising interest rates, ostensibly to check inflation. The ensuing race to the bottom is hastening world economic recession. 

Going for broke

New UK Prime Minister Liz Truss has already revived ‘supply side economics’, long thought to have been fatally discredited. Her huge tax cuts are supposed to kick-start Britain’s stagnant economy in time for the next general election. 

But studies of past tax cuts have not found any positive link between lower taxes and economic or employment growth. Oft-cited US examples of Reagan, Bush or Trump tax cuts have been shown to be little more than economic sophistry. 

Reagan’s Council of Economic Advisers chairman, Harvard professor Martin Feldstein found most Reagan era growth due to expansionary monetary policy. Volcker’s interest rate hikes to fight inflation were reversed. This enabled the US economy to bounce back from its severe 1982 monetary policy inflicted recession. 

George W Bush’s 2001 and 2003 tax cuts also failed to spur growth. Instead, deficits and debt ballooned. “The largest benefits from the Bush tax cuts flowed to high-income taxpayers”. Likewise, Trump tax cuts failed to lift the US economy, with billionaires now paying much less than workers. 

After Boris Johnson stepped down, UK Conservative Party leadership contenders started by promising more tax cuts. But The Economist was “sceptical that such cuts will lift Britain’s growth rate”. Instead, it worried tax cuts would compound inflationary pressures, triggering ever tighter monetary policy. 

The Economist concluded, “It is hard to spot a connection between the overall level of taxation and long-term prosperity”. Unsurprisingly, The Economist sees Truss’ “largest tax cuts in half a century” as “a reckless budget, fiscally and politically”. 

While such tax cuts mainly benefit the very rich, the costs of such monetary and fiscal policies are borne by workers and other consumers. Workers are harshly punished by austerity measures, losing both jobs and incomes to interest rate hikes.

Tax cuts usually make things worse. Typically, these require cutting social protection and essential public services, ostensibly to balance the budget. So, already greater wealth and income inequalities will worsen.

Governments have to cut public investments due to ballooning budget deficits. Higher interest rates and public spending cuts will also derail efforts needed to transition to more sustainable, greener futures.

Class war

Policy fights over inflation have many dimensions, including class. Instead of helping people cope with rising living costs, increasing interest rates only makes things worse, hastening economic slowdowns. Thus, workers not only lose jobs and incomes, but also are forced to pay more for mortgages and other debts.

Unemployment, lower incomes, deteriorating health and other pains hurt workers. As workers want higher incomes to cope with rising living expenses, such austere policies are deemed necessary to prevent ‘wage-price spirals’.

As usual, workers are being blamed for the resurgence of inflation. But research by the International Monetary Fund (IMF) and others has found no evidence of such wage-price spirals in recent decades. 

Experience and evidence suggest very low likelihood of such dialectics in current circumstances, although some nominal wages have risen. Since the 1980s, labour bargaining power and collective wage determination have declined.

Policymakers should address stagnant, even declining real wages in most economies in recent decades. These have hurt “low-paid workers much more than those at the top”. Even the Organization for Economic Cooperation and Development club of rich countries has “worryingly” noted these trends. 

The IMF Deputy Managing Director has explained why wages do not have to be suppressed to avoid inflation. Letting nominal wages rise will mitigate rising inequality, plus declining labour income shares (Figure 1) and real wages.

Source: IMF, World Economic Outlook, April 2017

Profit margins had already risen, even before the Ukraine war and sanctions. US trends prompted the Bloomberg headline, “Fattest Profits Since 1950 Debunk Wage-Inflation Story of CEOs”. Aggregate profits of the largest UK non-financial companies in 2021 rose 34% over pre-pandemic levels. 

Policymakers should therefore restrain profits, not wages. Recent price increases have been due to rising profits from mark-ups. Recent trends have made it “easier for firms to put their prices up” notes the Reserve Bank of Australia Governor. 

Addressing inequality

The IMF Managing Director (MD) recently warned, “People will be on the streets if we don’t fight inflation”. But people are even more likely to protest if they lose jobs and incomes. Worse, the burden of fighting inflation has been put on them while the elite continues to enrich itself.

Raising interest rates is a blunt means to fight inflation. It worsens living costs and job losses, while tax cuts mainly benefit the rich. Instead, the rich should be taxed more to enhance revenue to increase public provisioning of essential services, such as transport, health and education. 

The IMF MD noted raising taxes on the wealthy will help close the yawning gap between rich and poor without harming growth. Public provision of childcare and labour market programmes (e.g., retraining) will improve labour supply. Easing worker shortages can thus dampen price pressures. 

The current situation requires addressing growing inequality. Redistributive fiscal measures – taxing high earners to fund expanded social protection and public provisioning – are time-tested means to address disparities.

Increasing top tax rates and tax system progressivity are also socially progressive, checking growing inequality. Meanwhile, as consumer prices spiral, rising profits and high executive remuneration have to be checked.

Supply-side policies

The World Bank and Bank of International Settlements heads have urged reducing the current focus on demand management to counter inflation. They both insist on addressing long-term supply bottlenecks, but do not offer much practical guidance. 

Poorly coordinated ‘unconventional’ monetary policies since the 2008-09 global financial crisis have created property and stock market bubbles. These damage the real economy, worsen inequality and slow labour productivity growth, with the worst spill over effects in developing counties. 

Addressing supply bottlenecks can involve tax incentives and credit policies. But discredited supply-side mantras – e.g., labour market deregulation – must be discarded. Related fiscal and monetary policies – e.g., tax cuts for the rich and inappropriate interest rate hikes – should also be abandoned.

Governments are losing chances to boost productivity, achieve low carbon transformation and cut inequalities. Instead, policymakers should pro-actively push desired economic changes by favouring less carbon-intensive and more dynamic investments. 

This may also require checking CBs’ monetary policy independence to more effectively coordinate fiscal with monetary policies. But this should not undermine CBs’ ‘operational independence’ to foster “orderly economic growth with reasonable price stability”. 

Governments must rise to the extraordinary challenges of our times with pragmatic, appropriate and progressive policy initiatives. To do this well, they must boldly reject the ideologies and dogmas responsible for our current predicament.

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