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10-Year retrospective: Lesson 3

Why reform must be international

Gradually, inch by painful inch, the central bankers are losing their clothes – the comforting ideology that has enveloped them like a warm garment for more than a generation. This is the ideology, or “regime”, of central bank independence and inflation targeting (CBI+IT). Oh, how shy they are! Look how they hold onto any scraps!

I think they would cast these off  in an instant if – if only – somebody could come up with a new and better Big Idea. Then, quick as lightning, they would change their clothes, and, like a  Shakespearean spirit, appear before the audience fresh and rosy-cheeked.

Why should they care so long as they keep their self-respect? They are like other professionals in this. In fact, they are luckier than most. They have kept their place in public esteem longer than others (teachers, doctors, not to mention bankers and journalists!). They have had a darned good run.

Most of them, again like professionals in other fields, can only think of conventional wisdom : double down. We were right when we followed rules and we are going to go on being right now we don’t.

But far-sighted central bankers know this will not do

John Taylor (he of the Taylor Rule) advocates an international reform whereby each central bank would announce and agree to abide by its own rules for monetary policy – an international move to a rule-based system.

He understands, as few others do, that a fatal flaw in QE has been its adverse international repercussions.

John defends the original IT+CBI ideology while it was rules-based; and he may be right. The problem is, in my view, it led inexorably to more discretion – it was indeed always discretionary in concept – and became, as Mark Carney has admitted, a “distraction” – i.e. a focus on price stability came at a cost.

In  reality, moreover, even in its heyday, only a few central banks had the effective freedom to follow  a regime of inflation targeting focussed on their domestic economies. In effect, most had to follow the lead of dominant central banks. Volatile international capital flows and a reluctance on the part of investors (official and private) to hold the currencies of all but a few advanced countries condemned most other countries to second-class status in markets. Many tried very hard to put the ideology into practice; few succeeded.

In my view (one I guess John would not share) QE was not an aberration from this ideology: it was its logical culmination. Yet its international effects threatened world trade as surely as does Trump’s protectionist rhetoric. This was an awful situation for public servants to find themselves in.

Thoughtful central bankers know that QE  led to an era of competitive currency devaluations. At last year’s annual monetary conference in Jackson Hole, Allan Meltzer (who died earlier this year) argued that the Fed’s “quantitative easing” was in effect a monetary policy of “competitive devaluation,” and he added this stark warning:

“Other countries have now followed and been even less circumspect about the fact that they were engaging in competitive devaluation. Competitive devaluation was tried in the 1930s, and unsuccessfully, and the result was that around that time major countries agreed they would not engage in competitive devaluation ever again.”

John Taylor has now produced evidence for this effect.

Central banks are engaged in competitive devaluation

He shows balance sheet operations of the large advanced countries such as QE have “significant” exchange rate effects.  He shows also that there are similar effects even for the Swiss National Bank, as in other central banks in small open economies.

They had little choice but to react to prevent these unwanted moves in their own exchange rates.

In this sense, there was a “competitive devaluation” aspect to these actions as argued by Allan Meltzer—whether they are intentional or not.

In my view, this mechanism forced central banks into a kind of herd behaviour – the “madness of crowds” psychology which they sometimes see at work, and criticise, in money markets.

These  resulting movements in exchange rates clearly affect the flow of goods and capital and interfere with their efficient allocation.

Taylor says rightly that they also have been a source of political instability as concerns about currency manipulation are heard from many sides.

This is another reason to normalise policy and reform the international monetary system.

In Taylor’s view a rules-based international system must be the way to go.

In The Money Trap I argued, five years ago, that inflation targeting was fatally flawed – that was the main lesson of the crisis –  but that governments as well as central bankers would defend it to the last breath. Why? Because it was the best system available within the existing international monetary system.

That is why it has lasted so long! Not because it is a good system but because a decisive jump to a better system would deprive not just central banks but governments also of a large degree of so-called autonomy.  In reality, their citizens would gain much more than they would lose  from adopting such a system of global rules but governments’ own freedom of manoeuvre – and their claim to be the source of all the goodies their publics enjoy – would be reduced.

From this perspective only, central banks and governments are natural buddies (in most other respects being miles apart). On IT+CBI they sink or swim together,  grasped in a deathly embrace.

John Taylor clearly sees the connection. Knowing that the US would find it (at present) impossible to embrace a  truly rules-based reform, he goes for a half-way house: but I feel he knows that  it’s not really an ideal, or even viable, long-run solution.

The Fed’s dismantling of unconventional monetary policies leaves the essential framework intact.

We need to escape before it sinks us – again. The rest of the world should  set up an international, rules-based system and invite the US to join when it is ready.

John Taylor, who received Central Banking’s  “economist of the year” award for his work in designing global “rules of the game”, discusses these issues in his blog here, a new rules-based international system here and the new international monetary policy research  here