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Central Banking in Theory and Practice
Lecture II: Credibility, Discretion, and Independence
Alan S. Blinder
Vice Chairman
Board of Governors of the Federal Reserve System
Washington, D.C.
Marshall Lecture
Presented at
University of Cambridge
Cambridge, England
May 5, 1995
I am grateful to my Federal Reserve colleagues Janet Yellen, Jon Faust, Richard Freeman,
Dale Henderson, Karen Johnson, Ruth Judson, David Lindsey, Athanasios Orphanides,
Vincent Reinhart, Peter Tinsley and, especially, David Lebow for extensive assistance and
useful discussions. The insularity of this list does not reflect any belief that all wisdom
resides inside the Fed, but merely the fact that time and my calendar precluded any further
circulation of this draft.
Yesterday, I somewhat arbitrarily divided the subject matter
for these two lectures into "old-fashioned" and "new-fangled"
portions, taking up the former first and saving the latter for
today. My dividing line corresponds—very roughly—to issues
that, respectively, do not and do depend critically on
expectational and game theoretic considerations. Today's lecture
begins with a fairly extensive examination of an issue that is at
once very old and very new, and which therefore neatly bridges
the two camps: the debate over rules versus discretion.
1. The Rules vs. Discretion Debate: Then and Now
Economists have argued for a long time about whether or not
society would be better off if discretionary monetary policy were
replaced by a mechanical rule. To my knowledge, practical central
bankers have not joined this debate—presumably because they
think they know the answer. I, of course, agree with this
assessment. But before proceeding further, let me clarify what I
mean by a monetary policy rule, so that we at least know what we
are arguing about.
What is a rule?
The Tinbergen-Theil program that was discussed in
yesterday's lecture will, if carried out, lead to a policy
reaction function relating the central bank's instrument to a
variety of independent variables—most prominently, the
deviations of target variables from their desired levels. For
example, the equation might have the overnight bank rate on the
left and such items as inflation, unemployment, and the exchange
rate or current account deficit on the right. That is not what I
mean by a rule. Rather, such an equation is, to me, a
mathematical—and somewhat allegorical
representation of
discretionary policy. It is the way an economist theorizing in
the Tinbergen-Theil tradition imagines monetary policy to be
made. To qualify as a rule, in my parlance, the "equation" for
monetary policy must be simple and non-reactive, or nearly so.
Friedman's famous k-percent rule is the clearest example. Pegging
the exchange rate is another.
There is, however, a third case that has gained prominence
in the theoretical literature: assigning the central bank a rule
based on outcomes. rather than one (like Friedman's) based on
instruments. The two most obvious such rules are targeting
inflation or targeting nominal GDP growth. There is indeed an
intellectual case for a rule of this sort. In fact, such rules
come fairly close to—and in some cases duplicate—the legal
mandates of central banks. The problem is they are not really
rules at all, but rather objectives that may require a great deal
of discretion to accomplish. A government that wants to, say,
stabilize the inflation rate at 2% cannot replace its central
bank by a computer and go home. Hitting that target and staying
there is sure to require human judgment and adaptation to
changing circumstances—to wit, discretion. The harsh but simple
fact is that no central bank directly controls inflation,
unemployment, or nominal GDP—much as economic theorists pretend
otherwise.
2
So, to me, the operational question is: Would it be better
to replace central bank discretion with a simple rule based on
instruments the bank can actually control, not on outcomes which
it cannot control? Two very different lines of reasoning nave
been used to answer this question in the affirmative.
The old debate and the new debate
The old-fashioned approach is intimately linked to the name
of Milton Friedman. Friedman and others argue that the automatic
servo-mechanism of an unregulated economy will produce tolerably
good, though certainly not perfect, results. While activist
stabilization policy might be able to improve upon these results
in principle, they doubt it will prove efficacious in practice
because policymakers lack the knowledge, competence, and perhaps
even the good will necessary to carry out the task. Faced with a
choice between an imperfect economy and an imperfect government,
Friedman and his followers dash without hesitation for the
former. They share the worries of Lord Acton more than those of
Lord Keynes.
The arguments on each side of this old debate have been
hashed over numerous times, so I will not repeat them here.
Suffice it to say that, while I myself find the Friedmanite
arguments for rules less than persuasive, they cannot be
summarily dismissed. Our knowledge is indeed not quite up to the
task, and many monetary authorities have failed to acquit
themselves with distinction. In all honesty, we must admit that
there is at least an outside chance that Friedman could be right.
3
However, I mention this older debate not to take sides but rather
to contrast it with the newer version of the rules-versusdiscretion debate.
The new arguments for rules take an entirely different tack.
They are based neither on the ignorance nor the knavery of public
officials and, in fact, assume that e v e r y o n e — e v e n the
government!
knows how the economy operates. Moreover, the
government's objectives are assumed to coincide with the people's
objectives, and everyone has rational expectations. Despite these
seemingly ideal circumstances, modern critics argue that a
central bank left with discretion wil] err systematically in the
direction of excessive inflation. To remedy this distortion, they
advocate a fixed rule.
Kydland and Prescott. (1977) initiated this new round of
discourse by observing that the expectational Phillips curve
poses a temptation to the monetary authorities. Specifically, by
stimulating aggregate demand and surprising the private sector
with more inflation than anticipated, the central bank can reduce
unemployment temporarily. Lower unemployment is a worthy goal, to
both the public and the central bank. The problem is that you can
go to this well only so often and, under rational expectations,
not very often at all. If expectations are rational, people
understand the central bank's behavior and monetary policy cannot
produce systematic gaps between actual and expected inflation. So
a central bank that reaches for short-term gains will, on
4
average, produce more inflation but no more employment than a
central bank that is more resolute. Kydland and Prescott dubbed
this (an example of) the problem of time inconsistency and
suggested that the way to solve it was to adopt a rule.
Barro and Gordon (1983a, 1983b) and Barro (1986) clarified
this message and extended it in a variety of ways, noting among
other things that the rule could be reactive and exploring the
role of reputation as a way to produce less inflationary policies
in repeated games. Their analyses spawned a small growth industry
that spins theories of central bank behavior and offers remedies
for the alleged inflationary bias of discretionary monetary
policy. Even before I became a central banker, I found this
analysis unpersuasive, 1 and nothing I have learned since has
altered my view. Let me try to explain why.
Three major objections
First, an historic point is worth making. With some
variations in timing, the period from the late 1960s to the early
1980s was one of accelerating inflation in the industrial
countries. Barro and Gordon ignored the obvious practical
explanations for the observed upsurge in inflation—the Vietnam
War, the end of the Bretton-Woods system, two OPEC shocks, e t c . —
and sought instead a theoretical explanation for what they
'See, for example, Blinder (1987) .
5
believed to be a systematic inflationary bias in the behavior of
central banks. 2 They found it in Kydland and Prescott's analysis. 3
But that was then and this is now. Recent history has not
been kind to the view that central banks have an inflationary
bias. In fact, the history of much of the industrial world since
roughly 1980 has been one of disinflation--sometimes sharp
disinflation, and soiTiex.iit.es at high social cost. Furthermore, the
monetary authorities of many countries have displayed a
willingness to maintain their tough anti-inflation stances
despite persistently high unemployment. Whether or not you
applaud these policies, they hardly look like grabbing for shortterm employment gains at the expense of inflation.
How are we to reconcile the disinflation history of 19801995 with a theory that says that central banks systematically
produce too much inflation? My view is that we cannot. Nor can we
dismiss the 1980-1995 period as a brief interlude of history,
insufficiently long to belie the Barro-Gordon analysis, for the
1965-1980 period used as "evidence" of inflationary bias lasted
no longer.
I am tempted to conclude that Barro and Gordon and their
followers have been theorizing about the last war just as realworld central bankers were fighting the next one. In addition, it
2
0f course, some might interpret the fact that central banks
allowed these shocks to pass through into higher inflation as
evidence for inflationary bias.
3
Notice, by the way, that the theory predicts stable
inflation that is too high, not accelerating inflation.
6
is worth noting that the cure to the "inflation bias" problem did
not come from adopting rigid precommitment ("rules"), as KydlandPrescott and Barro-Gordon suggested. It came from determined but
discretionary application of tight money. Rather than seeking
short-term gains, central banks paid the price to disinflate. As
in the Nike commercial, they just did it.
My second objection is simple and practical: Most of the
literature presumes that the central bank controls either the
inflation rate or the unemployment rate perfectly on a period-bvperiod basis. Obviously, this is not so in reality. Now, a
theorist may argue that this is an inessential point; after all,
no theory is meant to be literally true. But I think that retort
dismisses the objection too cavalierly. When the literature comes
to discussing solutions to the inflationary-bias problem, as I
will shortly, the arguments for simple rules based on outcomes
(like "keep inflation at zero") or for certain incentive-based
contracts seem to hinge sensitively on the notion that either the
central bank controls inflation perfectly or that shocks are
perfectly verifiable ex post. Trust me; the real world is not
that simple.
My third objection appears to be a narrow technical detail
but is not. The literature derived from Barro and Gordon (1983a)
posits a loss function in inflation and unemployment that looks
something like the following:
L = a(pt- pt.,)2 + (u, - ku*)2,
where p is the log of the price level, u is the unemployment
7
rate, u* is the natural rate, a is a "taste" (or inflationaversion) parameter, and k is a constant less than one indicating
that the optimal unemployment rate is below the natural rate.4
This last parameter turns out to be essential to the argument for
inflationary bias. In fact, in most models the inflationary bias
of discretionary policy disappears if k=l. I can assure you that
it would not surprise my central banker friends to learn that
economic theories that assume they seek to drive unemployment
below the natural rate imply that their policies are too
.inflationary. Furthermore, if this is the source of the problem,
there is a disarmingly simple solution: direct the central bank
to shoot for u* rather than ku*.
Three proposed solutions
Let me now examine three "solutions" to the inflationarybias problem found in the theoretical literature. My purpose in
each case is to match theory up against reality.
1. Reputation: The first solution hinges on notions of
reputation—a concept, I can assure you, that is near and dear to
the hearts of central bankers. Here theorists have been barking
up the right tree. Nonetheless, theoretical models of reputation
have some peculiar features.
Consider, for example, Barro's (19.->6) model, in which the
central banker is either a "tough guy," who will always opt for
4
To be clear, ku* is the optimal unemployment rate if there
were no worry about inflaton. So it is reasonable to assume k<l
in the loss function.
8
low inflation, or a "wet," who is willing to deviate in order to
boost employment. The public does not know which kind of central
banker it has, and is therefore forced into statistical
inference. If the central bank keeps playing the low-inflation
strategy, its reputation
that is, the subjective probability
that it is t o u g h — w i l l rise. This part rings true. For example,
the Federal Reserve probably had relatively little anti-inflation
credibility in the late 1970s but has quite a lot now. Closer to
this location, I believe the monetary authorities of both the
U.K. and France have built up substantial anti-inflation capital
during the 1990s.
But in the model, as soon as the bank allows high inflation,
even once, the public concludes—with certainty—that it is a
hopeless "wet." This is the part that strikes me as eccentric,
for there are many types of central banker, not just two, and
many random shocks cloud the mapping from outcomes back to types.
For these reasons, reputation is not like pregnancy: You can have
either a little or a lot. For example, the Bundesbank's entire
reputation did not collapse when German inflation rose from about
zero in 1986 to about 4% in 1992. Nor should it have. In central
banking circles, it is viewed as obvious that the accumulation
and destruction of reputational capital behaves more like
adaptive than rational expectations. Here, I think, the central
bankers are closer to the truth than the theorists.
2. Principal-agent contracts: A second proposed cure for the
alleged inflationary bias of monetary policy that has attracted
9
the recent attention of theorists is drawing up a contract
between the central bank as agent and the political authorities
(which I shall parochially call "Congress" rather than
"parliament") as principal. The genesis of the idea is simple.
The Kydland-Prescott analysis suggests that decisionmaking is
distorted toward excessive inflation. Say the word "distortion"
and economists reflexively think of taxes and subsidies. So Walsh
(1993) and Persson and Tabellini (1993) have proposed making the
central banker's salary decline in proportion to inflation. 5 They
show that this particular incentive scheme induces the central
banker to behave optimally in the context of a model like that of
Barro and Gordon (1983a).
What's wrong with this idea? Well, to start with, a small
decrease in salary is probably not much of a motivator for
central bankers who are already voluntarily giving up a large
portion of their potential earnings to do public service. Let me
put it bluntly and personally: I currently suffer a 1% real wage
loss for each point of U.S. inflation. But that meagre $1231 has
never once entered my thinking about monetary policy.
Second, we must face up to the embarrassing fact that
virtually no central bank explicitly ties its salaries to
economic performance—not even New Zealand, where there really is
a formal contract between the governor of the Reserve Bank and
5
Actually, many people had proposed such a scheme before.
Walsh and Persson-Tabellini proved its optimality in a formal
model.
10
the minister of finance. The governor may be dismissed
(and thus
suffer a huge pay increase!) if inflation comes in too high. But
he does not have his salary docked.
Third, and finally, there is a severe problem with the party
on the other side of the contract. In practice, "the public"
cannot serve as the principal in the contemplated contract, so
Congress must play this role as surrogate. But Congress is really
an agent, not a principal. Do not members of C o n g r e s s — w h o must
stand for reelection—face even stronger incentives to go for
short-term gains than central bankers? If so, why should Congress
propose a contract with the central bank that would eliminate the
inflationary bias? And why would it enforce such a contract if
the central bank deviated and thereby caused a little boom?
Critics of government everywhere complain that elected officials
often fail to deliver what is in the best interests of the
public. The notion that highly disciplined politicians can
cure the wayward ways of profligate central bankers seems to get
the sign wrong.
3. Conservative central bankers: This brings me to the third
proposed theoretical solution to the conundrum posed by Barro and
G o r d o n — t h e one with the most practical appeal. Rogoff (1985)
cleverly suggested that, if there is an inflationary bias in
monetary policy, the cure may lie in the appointment of more
"conservative" central bankers. Now that really does have the
ring of truth! Indeed, in the real world the noun "central
banker" practically cries out for the modifier "conservative." To
11
Rogoff, conservatism has a very specific meaning. The taste
parameter, a, indicating the relative disutilities of inflation
and unemployment is presumed to be common to the central bank and
the public. Rogoff suggested that politicians should deliberately
select central bankers who are more inflation averse than society
as a whole. That way, one bias (the unrepresentative preferences
of the central bank) can cancel out the other (dynamic
inconsistency).
Rogoff's model is a splendid illustration of the humorous
definition of an economist as someone who sees that something
works in practice and asks whether it can also work in theory. Is
there any doubt that central banks in general, and successful
inflation-fighting central banks in particular, have been run by
quite conservative people? Rogoff's model argues that this common
practice is wise. Nonetheless, a few points about his proposed
solution are worth making.
First, the enhanced vigilance against inflation produced by
conservative central bankers comes at a cost: real output and
employment are more variable than in the dynamically inconsistent
solution. That is fine because it presumably moves society closer
to the optimum. My point is just that the gains on the inflation
front come at some cost. Appointing conservatives to the central
bank board does not buy society a free lunch.6
6
It may be possible to fix this problem by combining the
conservative banker and contract approaches.
12
Second, you can have too much of a good thing. In Rogoff's
model
and, I believe, in r e a l i t y — i t is possible to appoint a
central banker who is too conservative, that is, whose value of
the parameter a is so high that he does not deliver the
combination of inflation and output variability that society
really wants. Specifically, such a central bank will fight
inflation too vigorously and be insufficiently mindful of the
short-run employment costs. This too rings true; it suggests that
there is an optimal type of person best suited to a central bank
board.
Third, Lohmann (1992) suggested an interesting amendment to
the Rogoff approach which improves upon the s o l u t i o n — b u t one
which, frankly, makes me uncomfortable. There may be times when
it is optimal for the government to overrule the decision of the
conservative central b a n k e r — f o r example, following a large
supply shock. Lohmann suggests that such actions should be
allowed, but only if the government pays a cost. In reality, the
cost might be, e.g., the political heat the minister of finance
would take if she overruled an important decision of the central
bank governor. For example, the governor might resign in a huff.
Lohmann's idea is correct in theory. In a democracy there
do, after all, have to be some checks on the behavior of an overzealous central bank. But here, I suspect, we have an instance in
which the theoretical best may be the enemy of the practical
good. One of the hallmarks of a truly independent central bank is
that its monetary policy decisions cannot be reversed except
13
under truly extraordinary circumstances. Indeed, I do not know
how a central bank can claim to be independent without this
provision. So any real-world government that adopts the Lohmann
amendment must ensure that elected politicians overrule the
central bank extremely r a r e l y — f o r example, by making central
bankers removable only for gross negligence. In the U.S., Federal
Reserve governors are removable by the President only for cause.
And, of course, Congress can abolish the Federal Reserve at any
time. But these are grave steps. In practice, Fed decisions are
never overruled.
The bottom line?
Where does this extended discussion of rules versus
discretion leave us in the real, as opposed to the theoretical,
world?
While Kydland and Prescott's insight points to a genuine
difficulty for monetary policy, and some of the subsequent
literature has been enlightening, there is less there than meets
the eye. If there is strong agreement on both the positive
aspects (e.g., the Phillips curve) and the normative aspects
(e.g., the social welfare function) of a time-inconsistency
problem, as Barro and Gordon assume for the inflation problem,
societies should have little difficulty in "solving" it, albeit
imperfectly. For example, I just suggested one simple solution:
directing the central bank to prefer u* rather than ku*.
In fact, nations and households seem to have found simple,
practical ways to cope with a wide variety of potential dynamic
14
inconsistencies—ways that bear little resemblance to the
solutions suggested by theorists (except for Rogoff). Some common
examples are dealing with flood plains, avoiding capital levies,
punishing your children when they misbehave, and giving final
examinations in courses. In each case, society copes with a
potential time-inconsistency problem, by creating—and usually
following—norms of behavior, by building reputations, and by
remembering that there are many tomorrows. Rarely does society
solve the problem by rigid precommitment or by creating
incentive-compatible compensation schemes for decisionmakers.
Enlightened discretion is the rule.7
Similarly, the revealed preferences of many democratic
societies are to deal with the problem of dynamic inconsistency
in monetary policy by legislating a long-term goal (e.g., price
stability), giving discretion to nonpolitical central bankers
with long time horizons and an aversion to inflation, and then
hoping for the best. This is not obviously a bad solution.
2. Central Bank Independence
Everything, it seems, runs in fads. Lately, it appears,
fashion has been running increasingly in the direction of
central bank independence—a salutory development in my view. But
since the term "central bank independence" is somewhat vague and
has occasionally been abused, it may be useful, once again, to
begin with a definition. To me, the term means two things: first,
7
0ne prominent exception is patents, where a rigid rule is
generally inscribed in law to protect patents.
15
that the central bank has freedom to decide how to pursue its
goals and, second, that its decisions are very hard for any other
branch of government to reverse. A few words on each are in
order.
When I say that an independent central bank has considerable
latitude to decide how to pursue its goals, that does not mean
that the bank gets to select the goals by itself. On the
contrary, in a democracy it seems entirely appropriate for the
political authorities to set the goals and then instruct the
central bank to pursue them. If it is to be independent, the bank
must have a great deal of discretion over how to use its
instruments to pursue its legislated objectives. But it need not
have authority to set the goals and, indeed, I would argue that
giving the bank such authority would be an inappropriately broad
grant of power. The elected representatives of the voters should
make such decisions. The central bank should then serve the
public will.
So, for example, the Bundesbank is directed by law to
"safeguard the currency" and the Federal Reserve is instructed to
pursue "maximum employment" and "stable prices." 8 In each case,
the goals of monetary policy are set forth in legislation but are
sufficiently imprecise that they require considerable
interpretation by the central bank. Taking the Federal Reserve as
^Actually, there is a third goal: "moderate long-term
interest rates." But most of us believe that comes for free if
you succeed in achieving price stability.
16
an example, our dual mandate requires u s — t a c i t l y or e x p l i c i t l y —
to give content to the vague phrases "maximum employment" and
"stable prices" and then to decide how to deal with the short-run
tradeoff between the two. This interpretative role enhances the
de facto power of the Fed. But I think it is quite possible to
have a highly independent central bank with more preciselydefined goals; the numerical inflation target of the Reserve Bank
of New Zealand is a case in point.
The s e c o n d — a n d critical—hallmark of independence is near
irreversibility. In the American system of government, for
example, neither the President nor the Supreme Court can
countermand the decisions of the Federal Open Market Committee
(FOMC). Congress can, but only by passing a law that the
President signs (or by overriding his veto). This makes our
decisions, for all practical purposes, immune from reversal.
Without this immunity, the Fed would not really be independent,
for our decisions would hold only so long as they did not
displease someone more powerful.
Having defined independence, let me now pose a naive
question: Why should the central bank be independent? My answer
is disarmingly simple. Monetary policy, by its very nature,
requires
a
long time horizon. One reason is that the effects of
monetary policy on output and inflation come with long lags, so
decisionmakers do not see results of their actions for quite some
time. But the other, and far more important, reason is that
17
disinflation is an investment activity: it costs something up
front and pays back only gradually over time.
But politicians in democratic—and even u n d e m o c r a t i c —
countries are not known for either their patience or their long
time horizons. Neither is the mass media nor public opinion. And
none of these constituencies have much understanding of the long
lags in monetary policy. So, if politicians made monetary policy
on a day-to-day basis, the temptation to go for short-term gains
at the expense of the future (that is, to inflate too much) would
be hard to resist. Knowing this, many governments wisely try to
depoliticize monetary policy by, e.g., putting it in the hands of
unelected technocrats with long terms of office and insulation
from the hurly-burly of politics. The reasoning is the same as
that which led Ulysses to tie himself to the mast: He knew he
would get better long-run results even though he wouldn't feel so
good in the short run!
Empirical evidence bears out this hypothesis, at least in a
crude way. Researchers have employed a variety of creative ways
to measure central bank independence, including a number of legal
provisions, turnover of the central bank governor, the nature of
the bank's mandate (e.g., is it directed to pursue price
stability?), and answers to a questionnaire. A common, but not
universal, finding is that countries with more independent
18
central banks have enjoyed lower average inflation rates without
suffering lower average growth rates.9
So far, I have been speaking about independence from the
rest of the government and therefore, by inference, from both
partisan politics and public opinion. This sort of independence
seems to be what people have in mind when they talk about
independent central banks, and it is certainly the concept of
independence on which both the academic literature and the
Maastricht Treaty focus. To be independent, the central bank must
have the freedom to do the politically unpopular thing. But there
is another type of independence that, in my view, is just as
important but is rarely discussed: independence from the
financial markets.
Now, in a literal sense, independence from the financial
markets is both unattainable and undesirable. Monetary policy
works through markets, so perceptions of likely market reactions
must be relevant to policy formulation and actual market
reactions must be relevant to the timing and magnitude of
monetary policy effects.
When I speak of making the central bank "independent" of the
markets, I mean something quite different. Central bankers are
often tempted to "follow the markets," that is, to deliver, say,
the interest rate path that the markets have embedded in asset
9
See, for example, Alesina and Summers (1993), Cuckierman et
al. (1992), and Fischer (1994). Posen (1993) questions whether
the relationship is causal.
19
prices. It is easy to understand how such a temptation arises;
after all, the markets are like a giant biofeedback machine that
constantly monitors and evaluates the central bank's performance.
Central bankers are only human and want to earn high marks—from
whoever is handing out the grades. Since it can be agonizing to
wait years for the verdict of history, which is the only verdit
that really matters, central bankers naturally turn to the
markets for instant evaluation.
Following the 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, for several
reasons. One is that speculative markets tend to run in herds10
and overreact to almost everything.11 Central banks need to be
more cautious and prudent. Another is that financial markets seem
extremely susceptible to fads and speculative bubbles which
sometimes stray far from fundamentals.12 Central bankers must
innoculate themselves against whimsy and keep their eyes on the
fundamentals.
Finally, traders in financial markets—even those for longterm instruments—often behave as if they have ludicrously short
10
For a theoretical explanation based on short-time horizons,
see Froot, Scharfstein, and Stein (1992).
n
The literature on financial market overreaction, begun by
Shiller (1979), is by now voluminous. For a survey, see Gilles
and LeRoy (1991) .
12
Regarding fads, see Shiller (1984) . Regarding bubbles, see
Flood and Garber (1980) and West (1987).
20
time horizons. By contrast, maintaining a long time horizon is
the essence of proper central banking. Here's an example of what
I mean. You can use the term structure of yields on U.S. Treasury
debt to compute implied forward rates up to 30 years into the
future. During 1994, the observed correlation between changes in
the current one-year rate and changes in the implied one-year
forward rate 29 years in the future was 0.54 on daily data!13 I
have a hard time believing that the daily flow of news really has
that much durable significance. Rather, I believe, the 30-year
bond behaves altogether too much like a one-year instrument.
Notice the extreme irony here. Perhaps the principal reason
why central banks are given independence from elected politicians
is that the political process is apt to be too short-sighted.
Knowing this, politicians willingly and wisely cede their day-today authority over monetary policy to a group of independent
central bankers who are told to keep inflation in check. But if
the central bank follows the markets too closely, and strives too
hard to please them, it is likely to tacitly adopt the markets'
extremely short time horizons as its own.
Do not get me wrong. I do not believe that a central banker
can afford to ignore markets. Nor should he want to, for markets
convey valuable information—including information about expected
future monetary policy. I myself look at and appraise the
information in stock, bond, foreign exchange, and other markets
13
The correlation moves around quite a bit over time. It was
generally lower in 1988-93, but higher in 1979-87.
21
constantly. My point is simply that delivering the policies that
markets expect—or indeed demand—may lead to very poor policy.
3. Credibility and Accountability
In discussing the arguments for central bank independence, I
did not mention a rationale that is often offered by central
bankers and academics alike: the notion that more independent
central banks are more credible inflation fighters and,
therefore, can disinflate at lower social cost. Indeed, extreme
versions of the credibility hypothesis, which have appeared in
the academic literature, claim that costless disinflation is
possible if central bank policy is completely credible.14 The
reason is simple. The essence of an expectational Phillips curve
is that inflation depends on expected (not lagged) inflation plus
a function of unemployment plus other variables and random
shocks:
P. " Pt-i = t-|Ep«- PM
+ f(uj + •••
If expectations are rational and the monetary authority has total
credibility, the mere announcement of a disinflation campaign
will make t.,Ep, fall abruptly, bringing inflation down with no
transitional unemployment cost.
Omitting the credibility hypothesis was not an oversight.
Much fascinating theory to the contrary, I do not know a shred of
evidence that supports it. It seems to be one of those
hypotheses—like the interest elasticity of saving—that sounds
l4
See, for example, Taylor (1983) or Ball (1994) .
22
plausible but turns out to be untrue. The available evidence does
not suggest that more independent central banks are rewarded with
more favorable short-run tradeoffs. 15 Nor does the recent
experience of OECD countries suggest that central banks that
posted inflation targets were able to disinflate at lower cost
than central banks without such targets. Nonetheless, these
claims continue to be made. As Julius Caesar observed: "Men are
nearly always willing to believe what they wish."
Whether or not it is an important determinant of the costs
of disinflation, I can tell you from personal experience that
central bankers prize credibility and view it as a precious asset
not to be squandered. And I agree. But not because it makes
disinflation easier. Then why? A central bank is a repository of
enormous—and, if it is independent, virtually u n c h e c k e d — p o w e r
over the economy. This power is a public trust assigned to the
bank by the body politic. In return, the citizenry has a right to
e x p e c t — n o , to demand
that the bank's actions match its words.
That, to me, is the hallmark of credibility: matching deeds to
words.
Academic economists often employ a different definition. In
a game-theoretic setting, credibility is identified with dynamic
consistency or incentive compatibility. The notion is that, if
the central bank announces a policy and private decisionmakers
take actions predicated on belief in the announcement, the
15
See Fischer (1994) and Posen (1995) .
23
central bank must either be bound by rule to follow through on
its promise or have a clear incentive to do so. If there is
neither precommitment nor incentive, policy may be time
inconsistent and policy pronouncements will therefore be
noncredible. As I noted in Section 1, this is the logic behind
modern arguments for rules that tie the central bank's hands or
for compensation schemes that give it a pecuniary incentive to
behave. Each mechanism is viewed as a way to produce credibility.
But when practical central bankers talk about credibility,
they have a simpler definition in mind. In their view and mine,
credibility means that your pronouncements are believed—even
though you are bound by no rule and may even have a short-run
incentive to renege. In the real world, such credibility is not
normally created by incentive-compatible compensation schemes nor
by rigid precommitment. Rather it is painstakingly built up by a
history of matching deeds to words. A central bank that
consistently does what it says will acquire credibility by this
definition almost regardless of the institutional structure.
Thus, for example, the Bundesbank is believed when it says
it is determined to reduce inflation, even though it follows no
rule and its council members have no financial stake in
disinflation. Furthermore, this concept of credibility is not a
zero-one variable but a continuous variable; you can have more
credibility or less. As I stated earlier, I believe the Federal
Reserve now has much more anti-inflation credibility than it had,
24
say, 15 years ago. And it did not acquire this credibility
through institutional change.
Here is an interesting question to ponder. The academic
literature posits that central banks invest in credibility in
order to improve the short-run tradeoff. But there seems to be no
such credibility bonus. Why, then, are central bankers so
concerned with credibility? (Trust me, they are.)
Three answers suggest themselves, and I believe there is
something to each. First, many central bankers probably believe
the credibility hypothesis despite the evidence against it, just
as many policymakers believe that tax incentives raise personal
saving. Second, central bankers are only human; we want to be
believed and t r u s t e d — n o t thought to be duplicitous liars. Third,
central bankers may want the latitude to change short-run tactics
(e.g., abandon a money growth target) without being thought to
have changed their long-run strategy (e.g., fighting inflation).
To pull off such a feat without spooking markets, it helps to
have a reputation for keeping your word.16
This last possibility leads me to the next topic:
accountabi1itv. When it wants to change policy or procedures, a
central bank may find it helpful to bring society along by
explaining what it is doing and why. By explaining its actions
reasonably fully and coherently, a central bank can remove much
16
An example came in the spring of 1983 when the Fed under
Paul Volcker abandoned monetarism without creating fears that it
was abandoning the fight against inflation.
25
of the mystery that surrounds monetary policy, give the public a
chance to appraise its policy decisions contemporaneously, and
t h e n — i m p o r t a n t l y — e n a b l e outside observers to judge its success
or failure after the fact.
This educational role of the central bank is, in my view, an
important aspect of accountability. But not everyone sees it that
way. It is alleged, for example, that being more accountable in
this sense threatens the independence of the central bank.
Mystery, according to this view, is necessary to preserve
independence.
I could not disagree more. In fact, I view public
accountability as a logical corollary of central bank
independence in a democratic society. Our freedom to act, it
seems to me, implies a moral obligation to explain ourselves to
the public. Nor will doing so harm the central bank. If the
Federal Reserve makes good decisions, we should have no trouble
explaining and defending them in public. (Remember, we do not
have to put them to a vote!) If we cannot do this, maybe our
decisions are not so good. In this respect, I find the Reserve
Bank of Australia a model central bank. When it changes shortterm interest rates, the governor issues a lengthy statement
explaining in detail the reasoning behind the decision and what
the bank hopes to achieve by it.17
17
These statements are printed in the Reserve Bank of
Australia Bulletin: see, for example, the September 1994 issue,
pp. 23-24.
26
A second aspect, or perhaps definition, of accountability is
related to something I dealt with earlier: rewards and
punishments. In business organizations, the concept of
accountability often entails bonuses for success and punishments
for failure. Such incentives make people personally responsible
for their actions and help align the employee's interests with
those of the firm. This type of accountability takes a rather
different form in central banking. Unless the central bank is a
superb obfuscator, people will know that it is largely
responsible for macroeconomic management. It will therefore
automatically get credit (grudgingly, of course!) when things go
well and blame when things turn sour. So, for example, the
central bank governor may be rewarded with kudos and
reappointment for success and punished with scorn and dismissal
for failure. That's pretty fair accountability, it seems to me.
Finally, we can interpret accountability in the quite
literal sense of accounting for your actions. In the monetary
policy context, this means, e.g., periodic reporting of monetary
policy actions and their consequences to the legislature, press,
and public. Central banks vary a great deal in how much of this
they do. At one end of the spectrum, there may be little beyond a
formal annual report with no public questioning. Such a document
is almost bound to be self-serving, much like a corporation's
annual report. At the other end, we can imagine a central bank
governor who is constantly subjected to public questioning by the
legislature—which strikes roe as altogether too much hectoring.
27
The Federal Reserve is somewhere in the middle of this
spectrum. Since early 1994 the FOMC has announced its monetary
policy decisions immediately, abandoning a long tradition of
letting the market guess what we are up to. This small step, by
the way, was once controversial and viewed as potentially
dangerous; now it is universally accepted. However, we still do
very little in the way of explaining FOMC decisions; I believe we
could and should do more. In addition, our Chairman testifies
periodically before Congressional committees, and the FOMC
reports officially on monetary policy twice a year. Most
obviously, of course, our policy is analyzed and dissected in the
financial press on a d a i l y — i f not m i n u t e l y — b a s i s .
4. Central Banking by Committee
This has been a long journey, but there is one last stop in
the practical world. In some countries, including my own,
monetary policy is made not by a single individual but by a
committee. Few theorists have ever made anything of this fact.18
Rather, central banks are normally modeled as if they have a
well-defined preference function, just like an individual.
From my current vantage point, this theoretical lacuna looks
to be significant. I am keenly aware that committees routinely
aggregate individual preferences, need to be led, tend to adopt
compromise positions on difficult questions, a n d — p e r h a p s because
l8
An interesting exception is Faust (1993) .
28
of all of the a b o v e — t e n d to be inertial. This last point has
both advantages and disadvantages.
On the minus side, the nature of decisionmaking by committee
may have something to do with the observed tendency of central
banks to overstay their stance—remaining tight for too long,
thereby causing recessions, or remaining easy for too long,
thereby allowing inflation to take root.19 Had Newton served on
many faculty committees at Cambridge, the first law of motion
might have read: A decisionmaking body at rest or in motion tends
to stay at rest or in motion in the same direction unless acted
upon by an outside force.
Inertial behavior has its virtues, as I will remark shortly.
But it does lead to systematic policy errors. I wish I could
claim that the Federal Open Market Committee has been immune to
this ailment over the years, but I cannot. However, there is at
least one tradition at the Federal Reserve that tends to minimize
it: that of the strong chairman. The law says that each of the 12
voting members of the FOMC has one vote. But no one has ever
doubted that Alan Greenspan, or Paul Volcker, or Arthur Burns
were "more equal" than the others. The Chairman of the Federal
Reserve Board is virtually never on the losing side of a monetary
policy vote. So, to a significant extent, FOMC decisions are the
chairman's decisions, as tempered by the opinions of the other
members. Nonetheless, a chairman that needs to build consensus in
19
This is not the only reason. I observed in the first
lecture that underestimation of lags may play a significant role.
29
his committee may have to move more slowly than if he was acting
alone.
Now for the positive side. I come, as you know, from the
land of checks and balances. American traditions harbor great
fears of unbridled, centralized power. It is an anti-government
form of g o v e r n m e n t — t h e little government that couldn't because
it was too tied up in knots. Yet the Federal Open Market
Committee has great freedom to do as it will with monetary
p o l i c y — w i t h o u t asking permission from any other branch of
government and with little fear of being countermanded. So long
as our decisions on open-market policy are done by the book and
remain within our legal authority, we are neither checked nor
balanced. At least not externally.
But the group-nature of FOMC decisions creates what amounts
to an internal system of checks and balances. No Chairman can get
too far out in front of his committee. Decisionmaking by
committee, especially when there is a strong tradition of
consensus, 20 makes it very difficult for idiosyncratic views to
prevail. So monetary policy decisions tend to regress toward the
mean and to be inertial—and hence biased in just the same sense
that adaptive expectations are biased. But errors like that will
generally be small and tend to shrink over time. And, in return,
20
Curiously, there is no such tradition of consensus
decisionmaking on the U.S. Supreme Court, where 5-4 votes occur
about 20% of the time. But over the last 20 years there has been
only one 7-5 vote and one 6-4 vote on the FOMC, and there have
been only seven other votes with four dissents.
30
the system builds in natural safeguards against truly horrendous
mistakes. I leave it to some clever Cambridge don to prove that
this is optimal institutional design.
5. In Conclusion
I am afraid I have worn my central-banker hat rather more
prominently than my professor hat in today's leccure. It can
hardly be considered startling to hear a central banker favoring
discretion over rules, extolling the independence of central
banks, and stating that credibility and accountability are
important. But I hope at least to have given these concepts
sharper definition and to have brought to bear on them some
interesting real-world perspectives.
As I warned yesterday, I have been somewhat critical of some
recent theoretical research on normative aspects of monetary
policy
especially that pertaining to time inconsistency and
rules and to costless disinflation via credibility. On the other
hand, recent empirical research on some positive aspects of
central bank independence has been both imaginative and
instructive. And I hope my criticisms of the theory are at least
not uninformed. Some modern theorizing could, I believe, benefit
from a healthy dose of reality.
As Marshall, that most practical of theorists, wrote of
Edgeworth, "It will be interesting... to see how far he succeeds
31
in preventing his mathematics from running away with him, and
carrying him out of sight of the actual facts of economics." 21
21
Quoted in Keynes', Essays in Biography, p. 159.
32
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2
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3
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4
@FedFRASER