25.2 Why Have Central Bankers So Often Gotten It Wrong?

If the link between money supply growth and inflation is so clear, and if nobody (except perhaps inveterate debtors) has anything but contempt for inflation, why have central bankers allowed it to occur so frequently? Central bankers might be more privately interested than publicly interested and somehow benefit personally from inflation. (They might score points with politicians for stimulating the economy just before an election or they might take out big loans and repay them after the inflationary period in nearly worthless currency.) Assuming central bankers are publicly interested but far from prescient, what might cause them to err so often? In short, lags and high-employment policies.

A lag is an amount of time that passes between a cause and its eventual effect. Lags in monetary policy, Friedman showed, were “long and variable.” Data lag is the time it takes for policymakers to get important information, like GDP (Y) and unemployment. Recognition lag is the time it takes them to become convinced that the data is accurate and indicative of a trend and not just a random perturbation. Legislative lag is the time it takes legislators to react to economic changes. (This is short for monetary policy, but it can be a year or more for fiscal policy.) Implementation lag refers to the time between policy decision and implementation. (Again, for modern central banks using open market purchases (OMPs), this lag is minimal, but for changes in taxes, it can take a long time indeed.) The most important lag of all is the so-called effectiveness lag, the period between policy implementation and real-world results. All told, lags can add up to years and add considerable complexity to monetary policy analysis because they cloud cause-effect relationships. Lags also put policymakers perpetually behind the eight-ball, constantly playing catch-up. Lags force policymakers to forecast the future with accuracy, something (as we’ve seen) that is not easily done. As noted in earlier chapters, economists don’t even know when the short run becomes the long run!

Consider a case of so-called cost-push inflation brought about by a negative supply shock or wage push. That moves the AS curve to the left, reducing output and raising prices and, in all likelihood, causing unemployment and political angst. Policymakers unable to await the long term (the rightward shift in AS because Y* has fallen below Y_nrl, causing unemployment and wages to decline) may well respond with what’s called accommodative monetary policy. In other words, they engage in expansionary monetary policies (EMPs), which shift the AD curve to the right, causing output to increase (with a lag) but prices to rise. Because prices are higher and they’ve been recently rewarded for their wage push with accommodative monetary policy, workers may well initiate another wage push, starting a vicious cycle of wage pushes followed by increases in P* and yet more wage pushes. Monetarists and other nonactivists shake their heads at this dynamic, arguing that if workers’ wage pushes were met by periods of higher unemployment, they would soon learn to stop. (After all, even 2-year-olds and rats eventually learn to stop pushing buttons if they are not rewarded for doing so. They learn even faster to stop pushing if they get a little shock.)

An episode of demand-pull inflation can also touch off accommodative monetary policy and a bout of inflation. If the government sets its full employment target too high, above the natural rate, it will always look like there is too much unemployment. That will eventually tempt policymakers into thinking that Y* is < Y_nrl, inducing them to implement an EMP. Output will rise, temporarily, but so too will prices. Prices will go up again when the AS curve shifts left, back to Y_nrl, as it will do in a hurry given the low level of unemployment. The shift, however, will again increase unemployment over the government’s unreasonably low target, inducing another round of EMP and price increases.

Another source of inflation is government budget deficits. To cover their expenditures, governments can tax, borrow at interest, or borrow for free by issuing money. (Which would you choose?) Taxation is politically costly. Borrowing at interest can be costly too, especially if the government is a default risk. Therefore, many governments pay their bills by printing money or by issuing bonds that their respective central banks then buy with money. Either way, the monetary base increases, leading to some multiple increases in the MS, which leads to inflation. Effectively a tax on money balances called a currency tax, inflation is easier to disguise and much easier to collect than other forms of taxes. Governments get as addicted to the currency tax as individuals get addicted to crack or meth. This is especially true in developing countries with weak (not independent) central banks.