12 Special reportThe world economy The EconomistOctober 12th 2019
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morespecialreportsPreviousspecialreports,anda listofforthcomingones,
canbefoundat:Economist.com/specialreports2 non. A decade of below-target inflation suggests that “what was
previously treated as axiomatic is in fact false,” according to Larry
Summers and Anna Stansbury of Harvard University. “Central
banks cannot always set inflation rates through monetary policy.”
Central banking has also become more politicised. One of the
few ideas to unite President Donald Trump with Alexandria Oca-
sio-Cortez, a left-wing congresswoman, is the belief that the Fed
should stop worrying about inflation and gun for growth. Mr
Trump has called Jerome Powell, the Fed’s chair, an “enemy” for
failing to cut rates as much as he would like as America fights a
trade war with China. In Europe the ecb is facing fierce hostility to
its negative-interest policy among the German public.
On the left, wacky schools of thought like “modern monetary
theory” (mmt), which says, roughly, that as long as inflation re-
mains contained the government can borrow as much as it likes
and that fiscal policy should manage the
economic cycle, have influenced some
people such as Ms Ocasio-Cortez.
This environment brings risks. A his-
tory of inflation by economists at Deutsche
Bank warns that periods of high inflation
have tended to accompany transitions be-
tween monetary-policy regimes like the
abandonment of Bretton Woods. Nobody
should welcome reforms to central banks
led by populists. It would be wrong to sup-
pose that low inflation expectations are
immutable or there to be exploited, wheth-
er to boost growth or to fund more govern-
ment spending. Stimulated too much,
economies will eventually overheat. An
environment of low inflation does not jus-
tify tearing down institutions that guard
against currency debasement like that seen
in Argentina and Turkey.
Yet reform is needed to achieve three
goals. First, central banks must improve
how they fight recessions. Second, they must find ways to steer the
economy despite a flat and uncertain short-term Phillips curve,
the relationship between inflation and unemployment. Third, fis-
cal policy must act as the stimulus-of-last-resort if economies
weaken and inflation falls while interest rates can fall no further.
These needs are increasingly recognised, but the reforms that are
under consideration mostly lack ambition.Getting real
Take each aim in turn. First, recession-fighting. For several de-
cades economists have had a prescription for monetary policy
when nominal interest rates can fall no further: reduce real inter-
est rates instead, by promising more inflation in the future. At the
very least, inflation expectations should not be allowed to slip. To
that end the Fed may soon commit to targeting 2% inflation on av-
erage over the economic cycle rather than at any one point in time.
In booms, inflation would be allowed to run a little higher than
2%. In a downturn, this should brighten the economic horizon.
A more effective reform would be to target a long-run path for
the level of prices, rather than year-to-year inflation. Policymakers
would have to correct their mistakes if prices veered off course.
There could be no repeat of the persistent policy timidity seen in
the 2010s. After a long downturn and disinflation central banks
would have to push to find the limits of the economy’s capacity.
Yet this would do nothing towards the second goal: freeing cen-
tral banks from having to divine the short-term trade-off between
inflation and unemployment. To target prices they would still
have to judge whether movements in inflation were being drivenby the labour market or by supply-side factors, such as technologi-
cal change or global shocks reverberating through cross-border
supply chains. Worse, they would lose some flexibility to ignore
temporary distortions. Phenomena such as rising tariffs or oil
prices that pushed inflation up and growth down could force cen-
tral banks to tighten monetary policy to get prices back on course
even as the economy suffered.
It would be better for them to remain agnostic on economic re-
lationships that they do not understand and target a single, sim-
pler variable: the level of nominal gdp, or, loosely speaking, out-
put plus inflation. Such a target would incorporate both central
bankers’ underlying goals of stable inflation and a healthy econ-
omy. It would replace their faulty judgment about the Phillips
curve with a better, implicit test: only when growth and inflation
rose in combination—a sign of overheating at home, rather than a
shock to supply—would they need to get hawkish. There would be
no more fine-tuning of the labour market.
The third aim, reform of fiscal policy, is the hardest to achieve.
One idea is to sharpen the so-called automatic stabilisers, such as
unemployment benefits, which ensure a mini fiscal stimulus dur-
ing downturns. Governments could legislate in advance to cut,
say, payroll taxes when the unemployment rate rises sufficiently.
This would not hurt. But it would be an incremental reform that
cannot compensate for a total loss of monetary-policy firepower.
Calibrating a sufficient fiscal stimulus without knowing the eco-
nomic circumstances in which it would apply is too difficult.
In addition to beefing up automatic stabilisers, governments
should also find a way to give central banks some scope for fiscal
action that can be used at their discretion. A recent paper by Black-
rock, an asset manager, whose authors include Stanley Fischer, a
former vice-chair of the Fed, suggests central banks should have a
“standing emergency fiscal facility”. The idea is that in a deep
slump, central banks would be authorised to create money to fi-
nance new spending or a tax cut.
Technocrats cannot easily oversee a fiscal stimulus. Monetary
policy is not about building bridges or setting rates of income tax.
The redistributive effects of low rates, which some say has exacer-
bated wealth inequality by boosting asset prices, are controversial
enough without central banks deciding how society’s resources
should be spent. So politicians would need to agree on the struc-
ture of the central bank’s fiscal tools in advance. One simple option
would be a uniform handout to the public in which every adult re-
ceived an equal share of newly created money. Central banks’ role
would be what it has always been: to calibrate the size of the stimu-
lus and ensure a credible commitment not to overdo it.
It is wishful thinking to imagine that these reforms can happen
quickly, not least because they involve handing more power to
technocrats. For good reason the role of monetary policy is con-
strained by law. In Europe it is set by treaty. It may take a downturn
to create political impetus for change. But sooner or later eco-
nomic policy will have to adapt to today’s disinflationary world. 7Central
banking has
become more
politicised