Economist based in São Paulo, Brazil, been working in financial markets for 11 years. Avid reader & writer; big fan of Belgian beer, Argentinian jazz, Ethiopian coffee and the joys of a peaceful and globalized world.
Professor Charles Goodhart was one of the participants in the GES 2012 “The Future of Central Banking: Inflation Targeting versus Financial Stability” panel. He served as a member of the Bank of England’s Monetary Policy Committee from 1997 to 2000 and became Emeritus Professor at the London School of Economics in 2002. He formulated what is widely known as “Goodhart’s law,” a description of a kind of “observer effect” typical to social sciences:
“Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”
Goodhart’s law seems to me a very smart and humbling idea, and it comes to my mind every time I hear about explicit targets for economic variables, such as inflation and the recent idea of NGDP targeting. I had the chance to ask him three questions I judged most relevant in the current debate on central banking:
Professor Charles Goodhart at the 2012 Global Economic Symposium | Photo by the author
One of the FAQs from the rules of Monopoly (the board game) goes like this:
What if the Bank runs out of money?
Some players think the Bank is bankrupt if it runs out of money. The Bank never goes bankrupt. To continue playing, use slips of paper to keep track of each player’s banking transactions — until the Bank has enough paper money to operate again. The banker may also issue “new” money on slips of ordinary paper.
In September 1998, following the financial collapse of Russia, a hedge fund went belly up. It wasn’t an ordinary hedge fund: among its board members were two economics Nobel laureates, and its failure triggered a coordinated bailout orchestrated by the Federal Reserve Bank of New York. Almost all of the major investment banks operating in the United States at that time were involved, with contributions totaling $3.6 billion.
1997 economics Nobel laureate Myron Scholes, of Black-Scholes model fame, and one of the partners of LTCM | Photo by Magnus Manske on Wikimedia Commons, CC BY 2.0
The story of Long Term Capital Management (LTCM) became, at the hands of journalist Roger Lowenstein, a best-selling book ingeniously titled When Genius Failed. Some of the several possible lessons implied from the book are: no single player is bigger than the market, extreme outcomes are incredibly hard to predict, and hubris can take a financial system down. In sum, even geniuses sometimes fail spectacularly; it’s part of the game we used to call capitalism. Capital unwisely invested is punished and changes hands to more efficient players, who are only as good as their last investment decision. Harsh as it may sound, this grand scheme of organizing society helped take mankind to levels of prosperity that were unimaginable before it emerged.
Ten years after the failure of LTCM, Lehman Brothers filed for bankruptcy, and global markets entered a destructive spiral, only interrupted after the largest injection of public money in financial institutions ever seen. In the minds of many economists and policymakers, one fact was directly linked to the other: Lehman’s failure triggered chaos in financial markets, so we should avoid large bank failures at any cost. This is one of the main pillars of what is now being called “financial stability.”
Federal Reserve Chairman Ben Bernanke responding to questions from the House Budget Committee | Photo by Peter Larson/Medill News Service on Flickr, CC BY 2.0
On August 23rd, in an interview with Fox Business Network, Republican U.S. presidential candidate Mitt Romney said if he wins the race for the White House, he will not appoint Ben Bernanke for a new term as chairman of the Federal Reserve. Bernanke’s current term, his second in a row, ends in 2014, months before the end of the period in which the current monetary policy committee announced it would leave interest rates at extraordinarily low levels.
Corn field in Canada, Photo taken by Perry McKenna on Filckr, CC BY 2.0
After an 18-month reprieve, world food prices are on the rise again. The Food Price Index from the Food and Agriculture Organization of the United Nations (FAO) went up by more than 6% in July, with the Cereals sub-index surging 17% in that month. Corn and soya recently hit all-time highs in nominal terms.
Even after nearly two decades since the inception of Plano Real and the end of the nightmare of hyperinflation combined with successive currency devaluations and redenominations, Brazil is still a country obsessed with price indexes. Rarely a day goes by without the release of a fresh inflation gauge: IPC-FIPE, IPCA, INPC, IGP-M, IGP-DI, IGP-10 . . . . The myriad of acronyms can be mind-boggling to foreign observers, but any good Brazilian economist can accurately explain the differences in terms of weights, levels of income and time frames covered.
Curiously, this obsession does not seem like it will terminate any time soon. The first reason is because it is fed by strong financial incentives. Brazilian government and corporations are large issuers of inflation-linked debt, and there’s a sophisticated (though relatively illiquid) market for interest rate swaps with one of the legs linked to a price index. Thus, several banks’ proprietary trading desks, funds and corporations spend large amounts hiring consultants and specialized teams in an attempt to acquire an edge in inflation forecasting. Not long ago, some of them used to send interns with clipboards on a daily basis to capture the slightest price changes in a basket of household goods in supermarkets.
1984 Cruzeiro notes, one of the several currencies of Brazil between 1986 and 1994. Photo taken by Kafziel on Wikemedia Commons, CC-BY-SA 3.0
Second, there are several legacies from the high inflation times in the form of indexed contracts and tariffs. The only way a country can deal with decades of large nominal price changes is by assuring real prices — of goods, wages, and services — will remain more or less stable and predictable, and Brazil did that by putting explicit or implicit indexation clauses in virtually every price agreement in the country. This prevented a total collapse of the price system during the 1980s and part of the 1990s; nevertheless, ever since the stabilization brought about by the real, it became a major source of inflationary inertia — the transmission of past inflation to future inflation. One can observe this effect in 2009 and today in periods of very weak growth and yearly inflation stubbornly above 4%.
Inflation targeting is dead. Harvard Kennedy School professor Jeffrey Frankel, a former economic advisor to Bill Clinton and leading macroeconomist, is now trying to write its obituary in an article for Project Syndicate from May 16th, later expanded for Vox. According to Professor Frankel, the system that was born in New Zealand in 1990 and exported successfully to several other countries passed away in September 2008 when most of the world’s central banks cut interest rates to record lows in an attempt to curb the effects of a major liquidity squeeze and avoid the prospects of long term deflation. Since then, the central banks that had adopted the system have not formally abandoned it, and the Federal Reserve has even released, for the first time in its history, an explicit inflation target. Yet it is clear that price stability is either taken for granted or has become less important than other economic policy goals. Inflation targeting may not make much sense in a world where inflation, to paraphrase the FOMC statements, is to remain subdued for a long period of time. On top of that, as Mr. Frankel put it, inflation targeting did not provide any response to asset market bubbles, thus failing to meet the recent commitment of central banks to financial stability.
Harvard Professor Jeffrey A. Frankel. Photo used with permission from Professor Jeffrey A. Frankel
Since inflation is no longer a problem, central banks have been using their increased discretionary power to pursue new and more ambitious goals. In a world of difficult political coordination and little consensus about what must be done to put the economy back on the growth and development track, central banks are now the ultimate instruments of economic policy implementation. Over the past few years, they have become responsible not only for price and financial stability but also for a substantial part of government funding in the developed world and much of the stimulus to avoid a depression. The consequences of this huge experiment still remain to be totally understood and felt (the latest BIS annual reportappropriately alerted: “prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on”); meanwhile, a group of countries keep relying heavily on central banks to keep their debt cost at sustainable levels and stimulate growth.
Ben Bernanke on The Atlantic magazine cover, April 2012 issue
First of all, I guess a brief introduction is in order. I’m an economist based in São Paulo, Brazil; 32; working in financial markets since months before the great Argentina default of 2001. Though I was a fairly decent undergrad student, I think I developed most of my current strengths from learning with some brillian
t bosses and colleagues with whom I was lucky to work and from my almost unstoppable urge to understand how the world works (together with the belief, held from a very early age, that, as a Brazilian journalist put it, there’s no alternative to reading). The extremely nice people from Bertelsmann Foundation found me through my blog in Portuguese, and conceded me the honor of writing about the future of central banking for Future Challenges. So, here I am. Continue reading →