PJ: Economics is complicated in today's multi-trillion dollar economies. While some politicians paint their platform as a simple task of balancing the budget by cutting government spending to build the economy, continued economic recovery is really not that simple. Because of these complexities and the simplistic approach of many political leaders many citizens misunderstand the role of the Central Bank. There are even some on the far right wing of American politics such as the Tea Party that want to see the Federal Reserve System abolished. This article from the Netherlands (printed in the Japan Times) is a quick recap of how the Central Banks actually helped western governments through the worst global economic collapse in recent history as well as looking at how they might balance their programmes for a sustainable recovery.
The Japan Times
Take away West's monetary punch bowl
By SYLVESTER EIJFFINGER and EDIN MUJAGIC
TILBURG, Netherlands — There are times to think outside the box, and there are times to return to normality. The West's major central banks — the Bank of England, the European Central Bank, and the U.S. Federal Reserve — should take this to heart.
As former Fed Chairman William McChesney Martin put it: "It's the task of the central bank to take the punch bowl away when the party is still going." Recently, however, the Fed decided not only to keep the punch bowl in place, but to refill it.
When the financial crisis erupted with full force in 2008, the world's major central banks were right to employ exceptional measures. Granted, one could argue that in some cases they overshot — for example, with the second round of so-called quantitative easing in the United States — but, roughly speaking, the response seems to have been appropriate.
More than two years later, however, the situation has changed. Economic recovery is not stellar, but it is a recovery nonetheless. Almost all developed economies have left recession far behind, and the danger of deflation has disappeared. The Swiss central bank recently adopted this position, and the ECB is worrying about higher inflation, not deflation, in the eurozone.
In emerging economies, such as Brazil, China, India and South Korea, inflation is rapidly rising and increasingly becoming an economic and social problem.
So the time has come for the West's central banks to become "normal" again. This applies especially to the Fed and the Bank of England.
Central banks in emerging-market countries like Brazil, China, India, Indonesia, Peru, Thailand and South Korea are providing good examples to follow. They have embarked on the normalization path by hiking official interest rates to nip inflation in the bud, thereby preventing price volatility from choking off future economic growth.
Faced with the economic growth in the short run, or over the medium to long term, these central banks are opting for the latter. By raising interest rates to prevent inflation from spiraling out of control, they inflict some pain on the economy now. But that pain is negligible compared to the pain that would be needed to fight runaway inflation later.
In that sense, emerging-market countries' central banks have learned the lesson of the 1970s and 1980s, when inflation ruled the world and crippled economic growth — in large part because central banks did not act in a timely fashion. Central banks like the Fed and the Bank of England seem to have forgotten that history. So, what should Western central banks do?
• (1) Put aside use of a "core inflation" indicator. There is much to say for using core inflation in conducting monetary policy and explaining decisions to the public, but only when price increases of food and energy — which core inflation strips out — are temporary in nature. That seems not to be the case anymore.
In Britain, for example, supposedly "temporary" factors have been keeping the inflation rate well above the target for almost two years. The ECB recently published a report saying that food prices will most likely increase because demand is structurally higher than supply. The same can probably be said of various commodities, including oil, demand for which has been structurally underestimated.
• (2) Start rolling back the emergency measures put in place in response to the financial and economic crisis. This applies particularly to the Fed, which in the autumn of 2010 launched a second round of quantitative easing to stimulate economic growth and employment in the short run, but also to the Bank of England, which is criticized for being too lax.
• (3) To stand a chance of preventing inflation from increasing much further, let real interest rates, at the very least, be equal to zero or slightly positive. That has not been the case for a long time, and still is not the case with headline inflation running at 2.2 percent in the eurozone and 1.5 percent in the U.S.
Even when we look at core inflation, real interest rates in the U.S. are still deep in negative territory. The picture is especially grim for the United Kingdom, with the official interest rate at 0.5 percent and inflation at 3.3 percent.
To prevent inflation from spiraling out of control, the Fed should increase the federal funds rate from almost 0 percent now to at least 3 percent within a year or so. In the same time frame, the ECB should move its official rate from 1 percent to at least 2 percent, while the Bank of England should aim for 5 percent.
Choosing a short-term boost to economic growth and employment, rather than enforcing price stability, wrecked the world economy in the 1970s and 1980s. The outcome may not be much different this time around if Western central banks maintain their current monetary policies for much longer.
Maybe the time has come for the teachers to learn from their "students" (developing and emerging-market countries).
Sylvester Eijffinger is professor of financial economics at Tilburg University, Netherlands. Edin Mujagic is a monetary economist at ECR Research and at Tilburg University.
http://search.japantimes.co.jp/cgi-bin/eo20110308a1.html
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