The (not so boring) economics of central banking

Livio Stracca 13 June 2018

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Textbook models of central banking often feature forward looking agents who can form rational expectations about central bank behaviour and have at least a basic understanding of the functioning of the economic system. For example, models used to study ‘forward guidance’ assume that agents are able to evaluate the central bank commitment to keep interest rates low, which implies, for example, that they understand that it is central bank who sets the short term interest rate in the first place, and that inflation and other macroeconomic outcomes depend on that interest rate. Based on casual observation and the existing survey evidence, this assumption should not be taken for granted at all.

Indeed, the limited available empirical evidence strongly suggests that little is known about central banks in the main street. Jost (2017), for example, reports evidence based on the Bank of England’s Inflation Attitudes Survey, which points to some worrying gaps in understanding by a majority of respondents. Moreover, knowledge is not spread evenly – gender (men would appear to be more informed), age, employment status, income and other variables all influence the amount of knowledge of central banks. For instance, only 38% of respondents correctly answer the question “A rise in interest rates would make prices in the high street rise more slowly in the medium term” – a core belief by central banks worldwide. Limited knowledge of central banks is not only found in British households, it has been reported also for US (Binder 2016) and Dutch households (van der Cruijsen et al. 2015). The latter survey asked households to rate eleven relatively simple statements about the objectives of the ECB, out of which on average get less than five were rated correctly. Dräger et al. (2016) find that only half of US consumers have expectations that are consistent, for example, with the Fisher equation, and only a third with the Phillips curve.

Limited public knowledge can be a problem for central banks

Limited knowledge of central banks can have significant negative repercussions for their credibility and accountability. Economic agents who lack a basic understanding of the key elements of central banking may also impair the transmission mechanism of monetary policy (which at this stage, however, is only a conjecture) and do not trust the central bank as much as they would do otherwise (for which there is instead direct empirical evidence). Indeed, Jost (2017) finds that satisfaction with the Bank of England’s policy depends on the respondents’ knowledge of it, consistent with previous findings on trust in the ECB in Ehrmann et al. (2013). Even more importantly, citizens’ representatives in parliament will not be able to exercise their prerogatives and make central banks truly accountable if they do not have enough knowledge of them. 

In a recently released book (Stracca 2018), I set out to explain central banking, and in particular its many open and unresolved questions, in plain English that is hopefully understandable for the lay reader beyond the policy and research community. I endeavour to show that central banking can be understandable and even (perhaps mildly) entertaining, and that on some of the key questions the general public is perfectly able to form an opinion, once we strip them from the usual technical scaffolding and jargon. 

The book is conceptually organised in two parts, the first more didactic in the first two chapters, and then the rest (Chapters 3 to 8) is dedicated to unresolved puzzles or questions. The first two chapters deal with the foundations of monetary economics and the transition from commodity monies, such as the Gold Standard, to central bank money; and with the mainstream New Keynesian model which underpins central bank action worldwide and the consensus around inflation targeting. For example, it offers a non-technical description of the New Keynesian model that can be used to understand what central banks routinely do, for example why the Taylor principle is so important to maintain price stability.

Central banking puzzles

As mentioned, the following six chapters are dedicated to specific open questions and puzzles. Chapter 3 drills some holes in the mainstream New Keynesian model, and discusses where that model has been criticised, for example by looking at fiscal and monetary policy interactions and at the actual implementation of monetary policy, which has often little in common with the textbook model. Chapter 4 looks at the many problems created by the zero lower bound (ZLB) on interest rates – another matter where, anecdotally at least, the general public appears to have very little knowledge – and the several, all imperfect, solutions to it proposed or implemented by central banks thus far. Chapter 5 deals with the financial stability mandate of central banks and their lender of last resort function, which has received greater emphasis since the global financial crisis. Although maintaining financial stability has often been one key reason central banks were created (for example, the US Federal Reserve), there are many open questions regarding their role in today’s financial systems. Chapter 6 turns to the question of whether paper currency, the quintessential central bank (fiat) money, will disappear and whether this will complicate the implementation of monetary policy. Chapter 7 deals with the open economy dimension of central banking, by addressing the question of whether we will, or should, aim to have a world central bank or a world currency in the future. Finally, Chapter 8 addresses the question of whether central banks will eventually disappear and be replaced by other actors, possibly the private sector, in the provision of monetary services to the economy. 

The book concludes that we are not at the ‘end of history’ for central banks – their current configuration is not a steady state and will almost certainly evolve in the future. It also concludes that the three top items in the ‘to do list’ of the next generation of central bankers are (i) getting rid of the ZLB for good, beyond the only partial solutions offered so far; (ii) getting a firmer grip on booms and busts in credit and house prices, including a consensus on the central bank’s role in them; and (iii) maintaining a high degree of innovation and openness, notably to new ideas, and preventing excessive conservatism and groupthink.

Will central banks disappear after all?

As an example of the view that some central banking questions are both understandable and interesting for a wider audience beyond the experts, consider the question of whether central banks will (or indeed should) disappear. We should keep in mind that central banks have not been a constant feature of the modern economy, and that important countries such as the US and Canada did not have a central bank until the early 20thcentury. Taking a bit of distance and for the sake of reasoning, there is nothing natural or unavoidable about central banks, as they came, they could also go, perhaps faster than we can imagine.

Whether central banks, or more generally public entities, are best placed to issue money is an old question indeed, going back at least to Friedrich Hayek’s 1976 book, The Denationalisation of Money, where the Austrian economist and Nobel Prize winner claimed that market competition would lead to better money than government-produced fiat money issued by the central bank. Hayek’s proposals have been largely rebutted and long forgotten in the current debate on central banking, although the arguments in his Nobel lecture, The Presence of Knowledge, resonate very strongly with anybody who has had practical experience with policy making. But the old debate is slowly coming back, for two reasons. 

First, most advanced countries have experienced the strictures of running policy at the ZLB, and as the ZLB is a direct consequence of using paper currency as a medium of exchange, this may reinforce the push towards eliminating paper currency, even though this is not likely in the near future. An important consequence of the possible disappearance or downsizing of paper currency is that it becomes much easier to implement monetary policy as an autopilot, for example by defining the unit of account in real terms, hence guaranteeing price stability by default. Although this is not exactly what Hayek had in mind, it nevertheless has a Hayekian flavour, because it may imply the disappearance of discretionary monetary policy and greatly diminish the role of central bankers as central planners for the economy. 

Second, crypto-assets have gained more prominence in the current debate, although they do not yet represent a credible alternative to central bank-issued fiat money. Crypto-assets are probably the closest incarnation, at least that we have seen so far, to the privately issued money that Hayek had in mind. 

It is a development and a debate to be watched, but the odds for a sudden shift in our monetary system and an abrupt disappearance of central banks are low. One key characteristic of monetary standards is their staying power even in the face of apparent failure, such as high inflation. It cannot be denied that the performance of the fiat money regime in place since the early 1970s, managed by central banks, has been satisfactory, as testified by the low and stable inflation rate seen since the early 1980s, the period known as the Great Moderation. (Of course, this statement has to be qualified if it is believed that central bank policies contributed to the onset of the global financial crisis, a question that is also dealt with in the book.) As the chart below shows, the last 30 years have been the period of most stable US inflation since when data exist, and that also covers the Gold Standard. It would probably take a very significant collective failure of central banks to unsettle the current monetary standard and tilt the odds towards currency competition with privately issued money, although we can never be sure of what the future holds. 

Author’s note: The views expressed belong solely to the author and are not necessarily shared by the institution to which he is affiliated.

References

Binder, C. (2016), “Fed speak on the main street: Central bank communication and household expectation”, Journal of Macroeconomics 52: 238-251.

Dräger, L., Lamla, M. and D. Pfajfar (2016), “Are survey expectations theory-consistent? The role of central bank communication and news”, European Economic Review 85(C): 84-111.

Ehrmann, M., Soudan, M. and L. Stracca (2013), “Explaining European Union Citizens’ Trust in the European Central Bank in Normal and Crisis Times”, Scandinavian Journal of Economics 115(3): 781-807.

Jost, A. (2017): “Is monetary policy too complex for the public? Evidence from the UK”, SNB Working Paper 15/2017.

Stracca, L. (2018), The Economics of Central Banking, London: Routledge.

van der Cruijsen, C., Jansen, D.-J. and J. de Haan (2015), "How Much Does the Public Know about the ECB’s Monetary Policy? Evidence from a Survey of Dutch Households," International Journal of Central Banking 11(4): 169-218.

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Topics:  Monetary policy

Tags:  Central Banks, monetary policy, central banking

Head of the International Policy Analysis Division, Directorate General International and European Relations, ECB

CEPR Policy Research