As someone who has taught introductory economics over the years, I always appreciate some educational help from the news media. Stories about macroeconomics filled the media this past week. Let me show you how I would use recent stories to teach some important principles.
Lesson One: An Associated Press story last Monday carried the headline, “Lawmakers push for Fed to cut interest rates.” A Democratic senator said it would be “outrageous” if the Fed did not lower interest rates. A Republican senator said he wanted a rate cut of at least three-quarters of a percent and added, “I hope we can get some cooperation.” A Democratic senator agreed with the need for a three-fourths point cut.
This story illustrates the need for an independent central bank, insulated from political pressures. Why, you ask? Didn’t these members of congress just echo what some economists were saying?
They did, but the point is that senators and representatives never call for raising interest rates.
I repeatedly have offered $20 to the first student who can find documentary evidence of any member of Congress calling for the Fed to tighten monetary policy. I offer an additional $5 if they can find a Democrat and yet another $10 if that person represents Minneapolis, St. Paul or North Dakota. In 15 years, I have never paid out a red cent.
One might justify this asymmetric congressional enthusiasm for rate cuts but not increases if there were evidence that the Fed always keeps money too tight. But the historical record is quite the contrary. From 1967 to 1982, consumer prices increased 400 percent. Since 1982 they have climbed another 70 percent.
The great inflation of the 1970s hurt poor people more than the wealthy, and it probably hurt North Dakota more than some other states, but no Democratic member of Congress and no one from Minnesota or North Dakota ever called for the tighter money that would have been necessary to avoid inflation.
Lesson Two: The Bank of Japan announced last week that it would loosen monetary policy, in effect returning to interest rates of zero. A Reuters story on Monday cited a Japanese market analyst who said that the Bank was “not really lowering interest rates, but that it would do things like increase the money supply or buy government bonds that would accomplish the same thing.”
What is the lesson? Central banks do not have two distinct tools: changing interest rates or changing the money supply. Rather, they can move interest rates by changing the money supply. And they change the money supply by buying or selling bonds. This fundamental misunderstanding of the link between money supply and interest rates may be the reason why so many members of Congress want low interest rates and low inflation and are dumbfounded when told that they cannot always have both.
Lesson Three: Last Wednesday, wire services and Internet sources passed the word that Argentina had its third finance minister in three weeks. University of Chicago-trained Minister Lopez Murphy, named just two weeks ago, was out. Domingo Cavallo, the old war horse who tied the country’s currency to the U.S. dollar a decade ago, was back in.
In Brazil, commentators noted approvingly that a move to give that country’s Banco Central more independence through a constitutional amendment was likely to be defeated. One columnist noted that the bank had acted independently and had failed to avoid a devaluation in the 1998-99 financial crisis. Therefore, Brazil should keep the current constitutional wording which specifies that the head of the Banco Central acts at the direction of the president.
What can we learn from these problems in Latin America? Simply that competent central banking cannot overcome the effects of other economic policies that are misguided and ultimately self-destructive.
Brazil and Argentina both suffered from hyperinflation in the 1980s or early 1990s. Both successfully ended inflation, Argentina with a currency board and one-to-one tie to the dollar that removed any trace of discretion from monetary policy. Brazil introduced a new, initially undervalued, currency the value of which it defended with tight money growth and resulting high interest rates.
When the two plans were introduced, officials in each country stressed that these were stop-gap measures that would only be sustainable if more fundamental taxing and spending reforms were made. Both countries failed to break decades-old habits of large government deficits. Both are now up to their necks in economic woes.
Brazil, which has let the value of its currency depreciate by some 10 percent since the New Year, has large, but manageable problems. Argentina’s plight is much deeper.
The lesson from both countries is that good monetary policy cannot make up for bad policies elsewhere except in the short-term.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.