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Central Bankers Confront a Strange New World

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Central Bankers Confront a Strange New World

February 16, 2016

Every generation passes along its experiences, and the lessons learned from them, to the next. For example, Americans who lived through the Great Depression teach their children about the importance of saving. 

The same is true for central bankers. Today's Federal Reserve, aware of the role it played in causing or aggravating the Great Depression, was determined to avoid a repetition when the financial system came close to collapse in 2008. In response, the Fed introduced an array of special lending facilities, slashed its benchmark rate to a range of 0 percent to 0.25 percent, and initiated a series of large-scale asset purchases that expanded its balance sheet to $4.5 trillion.

For the younger generation of economists, the stagflation of the 1970s serves as a teaching moment. For them, the cost of high inflation was a loss of central bank credibility. Low and stable inflation became both an end in itself and a means to an end: a way to achieve maximum sustainable growth. Inflation targeting, either explicit or implicit, came into vogue while anchored inflation expectations became the litmus test for assessing monetary policy success.

Back-to-back asset bubbles in the late 1990s (in technology and Internet stocks) and the following decade (housing) challenged the faith in inflation targeting. Price stability, it turns out, is a necessary but not a sufficient condition for economic stability.

Fast forward to today. It is almost inconceivable to anyone who lived through the 1970s and early 1980s that the Fed, along with central banks throughout the developed world, would be unable to hit its 2 percent inflation target - from below - after seven years of near-zero interest rates and a bloated balance sheet. It is equally mind-boggling to economists, who finally abandoned their 3-percent-growth-next-year forecast, that 2 percent real GDP growth is as good as it gets. 

The anomalies aren't limited to the U.S. Remember Japan, Inc.? In the 1980s, Japan was the envy of the world. American companies sent teams abroad to study Japanese management techniques so they could apply them in the U.S. The Harvard Business Review published long articles on Japan's business practices - for example, 1990's What Working for a Japanese Company Taught Me - including six-month budgeting, consensus decision-making and quality control. 

We haven't heard from Japan, at least as a global economic force, since the bursting of its asset bubble - in stocks and real estate - in 1989. Yes, Japan is still the world's third largest economy, behind the U.S. and China. But Japan's "lost decade" is now entering its 27th year. Last month the Bank of Japan joined monetary authorities in Switzerland, Sweden, Denmark and the Euro zone in implementing a negative deposit rate, dubbed "the new abnormal" by The Telegraph. 

Is this the future for developed nations with aging populations? Japan ranks first in the world when it comes to the proportion of people over age 60, followed by Italy, Germany and other European countries, according to a 2013 United Nations' report. The U.S. ranks 39th, but like most of the developed world, an increase in life expectancy and a decrease in fertility rates are conspiring to reduce old-age support ratios. Currently there are 2.8 working Americans for every Social Security beneficiary. By 2035, that number will fall to 2.1, according to the Social Security Administration.

Unless there's a huge influx of immigrants, which seems unlikely in the current environment, the U.S. labor force offers little hope for faster economic growth. That leaves productivity, the other determinant of potential GDP, which is painting an equally bleak picture.

Non-farm business productivity measured as output per hour has increased at an average rate of 1.3 percent since 2004, less than half the pace of the 1995-2004 period. The slowdown preceded the Great Recession and is evident across dozens of developed economies. This might support the idea that the slowdown is not a cyclical phenomenon. The claim that productivity is being understated because of a failure to capture innovations in information technology - the mismeasurment hypothesis - is increasingly suspect as the empirical evidence is not consistent with the theory. It's all rather depressing.

But cheer up. Many of the doom-and-gloom purveyors, dating back to Thomas Malthus in the 18th century, turned out to be dead wrong. Consider a few of those predictions:

--In 1798, Malthus predicted starvation through overpopulation in An Essay on the Principle of Population.

--In 1968, biologist Paul Ehrlich published The Population Bomb, predicting famine and death on an unprecedented scale, the only antidote to which was mandatory population control.  

--In 1972, the Club of Rome, one of the early environmental groups, issued a report entitled Limits to Growth, warning that the world would run out of oil and other vital commodities within decades, sending prices soaring to prohibitive heights.

--In 2005, the publication of Matthew Simmons' Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy in 2005 foretold, in a contrarian sort of way, the explosion in U.S. oil output, a result of technological innovation that enabled drillers to extract oil and natural gas from shale.

Thanks to human ingenuity, oil is now both plentiful and cheap, which I doubt will curb the fascination with peak oil.

The next burst of innovation, and there is bound to be one, will make central banks' job a bit easier. But central banks aren't the only game in town. They just happen to be the only functioning game, especially in the U.S., where hyper-partisanship in an election year has put compromise out of reach.

So what are the lessons learned from this period? What will central bankers pass on to posterity? Thirty years from now, with the benefit of hindsight, the current period of slow global economic growth, disinflation, and low or negative interest rates may make more sense. Absent that context, this strange new world remains something of a mystery to them in terms of how the economy got here and, more importantly, how to restore its former health.


Caroline Baum is a contributor to e21. You can follow her on Twitter here.

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