《货币经济学》课程文献阅读：Central Banking in a Democratic Society（Stiglitz,1998）

DE ECONOMIST 146. NO. 2. 1998 CENTRAL BANKING IN A DEMOCRATIC SOCIETY** JOSEPH STIGLITZ Key words: monetary policy, central bank independend I INTRODUCTION AND MAIN CONCLUSIONS It is a special pleasure for me to be here to give this lecture to honor Professor Tinbergen, because his many interests coincide so closely with my own. He spent much of his later life working on the economics of income distribution, a subject with which I began my professional life in my doctoral dissertation, and which has continued to be a focus of my concern. Tinbergen's thesis that the relative wages of skilled and unskilled workers depend on both supply and demand fac- tors resonates throughout my work on optimal taxation. Its importance has been borne out dramatically in wage movements in the United States and elsewhere during the past two decades. From my present vantage point, I am especially appreciative of his devotion to the economics of development, which became the focus of his concern in the mid-1950s, in order, as Tinbergen(1988)explained in retrospect, to contribute to what seemed to me the highest priority from a humanitarian standpoint But today, I want to focus on other aspects of his work: his contribution to economic policy, particularly the problems of controlling the economy, the rela tionship between instruments and objectives, and the scope for decentralization, which absorbed him and earned him international recognition in his early days. I have reflected a great deal upon these issues during the past four years, during which I served as economic adviser to the president of the United States. and especially the last two years, when I served as Chairman of the Council of Eco- nomic advisers 4 The author is on leave from Stanford University. The views express not necessarily those of any institution with which I am or have been affiliated. I acknowl edge the assistance of Jason Furman. Much of the research and ideas reported here ar work with him s Eleventh Tinbergen Lecture delivered on October 10, 1997 at De Nederlandsche Bank, Amster- dam for the Royal Netherlands Economic Association I See, for instance, Stiglitz(1986, 1998) De Economist 146.. 1998 1998 Klwwer Academic Publishers. Printed in the netherlands

CENTRAL BANKING IN A DEMOCRATIC SOCIETY** BY JOSEPH STIGLITZ* Key words: monetary policy, central bank independence 1 INTRODUCTION AND MAIN CONCLUSIONS It is a special pleasure for me to be here to give this lecture to honor Professor Tinbergen, because his many interests coincide so closely with my own. He spent much of his later life working on the economics of income distribution, a subject with which I began my professional life in my doctoral dissertation, and which has continued to be a focus of my concern. Tinbergen’s thesis that the relative wages of skilled and unskilled workers depend on both supply and demand fac￾tors resonates throughout my work on optimal taxation.1 Its importance has been borne out dramatically in wage movements in the United States and elsewhere during the past two decades. From my present vantage point, I am especially appreciative of his devotion to the economics of development, which became the focus of his concern in the mid-1950s, in order, as Tinbergen ~1988! explained in retrospect, ‘to contribute to what seemed to me the highest priority from a humanitarian standpoint.’ But today, I want to focus on other aspects of his work: his contribution to economic policy, particularly the problems of controlling the economy, the rela￾tionship between instruments and objectives, and the scope for decentralization, which absorbed him and earned him international recognition in his early days. I have reflected a great deal upon these issues during the past four years, during which I served as economic adviser to the President of the United States, and especially the last two years, when I served as Chairman of the Council of Eco￾nomic Advisers. * The author is on leave from Stanford University. The views expressed here are solely mine, and not necessarily those of any institution with which I am or have been affiliated. I wish to acknowl￾edge the assistance of Jason Furman. Much of the research and ideas reported here are based on joint work with him. ** Eleventh Tinbergen Lecture delivered on October 10, 1997 at De Nederlandsche Bank, Amster￾dam for the Royal Netherlands Economic Association. 1 See, for instance, Stiglitz ~1986, 1998!. DE ECONOMIST 146, NO. 2, 1998 De Economist 146, 199–226, 1998. © 1998 Kluwer Academic Publishers. Printed in the Netherlands

JE STIGLITZ I had the good luck to serve at a time of rising prosperity - and even im- oved income distribution, lowered poverty, and increased inclusion in our so- ciety of previously marginalized groups, such as minorities. The President took much credit for these achievements, and I often quipped that if some of the glory of what was, at least in some dimensions, the strongest economy in three decades should rub off on the President, should not at least some of that rub off on his economic adviser? After all, as my staff jokingly pointed out, while I was Chair- man of the Council the misery index -the sum of the inflation rate and the un- employment rate was half of what it was when Alan Greenspan was Chairman of the Council. Others suggested that it was not the administration which should get the credit, but the Federal Reserve Board To Tinbergen, this debate might have seemed strange indeed. Macroeconomic success depended on coordination of the monetary and fiscal instruments. It was Curiously enough, economic policymaking in United States- and in many other countries- is designed to inhibit this coordi- nation and cooperation. We have created independent central banks, who may and indeed are instructed to, pursue policies independently of the wishes of the elected officials. In the United States, the deliberations of the open market com- mittee which sets interest rates is kept secret -even from the President of the United States. To be sure, in the past, presidents have not been shy about ex- pressing to the Fed what they think it should do, but the Fed has not been shy about ignoring these messages. Early on in the Clinton Administration, we adopted a policy of not commenting on Fed policy, not because we did not have strong views -at certain critical stages, many in the Administration thought their policies were seriously misguided but because we thought a public debate would be counterproductive. We thought the Fed would not listen, the newspapers would love the controversy, and the markets, worried by the uncertainty that such con troversy generates, would add a risk premium to long-term rates, thereby incre ing those rates, which was precisely what we did not want to happen There is an irony in all of this. The President is held accountable for how the economy performs whether or not he has much control. Indeed, econometric models suggest that an infallible predictor of the outcome of presidential elec tions is the state of the economy; just as the weaknesses of the economy were largely responsible for Clinton's election in 1992, the strength of the economy was largely responsible for his re-election in 1996. The Council's own economet ric models in 1995 and 1996 corroborated the findings of others predicting an electoral outcome close to that which emerged suggesting that President Clin- ton really did not need to do all that campaigning 2 Interestingly, the perception of the state of the economy seems to be a more accurate electoral outcomes than the actual state of the economy. The incumbent party has won eve in which the University of Michigan's consumer sentiment index in the month before was above 92

I had the good luck to serve at a time of rising prosperity – and even im￾proved income distribution, lowered poverty, and increased inclusion in our so￾ciety of previously marginalized groups, such as minorities. The President took much credit for these achievements, and I often quipped that if some of the glory of what was, at least in some dimensions, the strongest economy in three decades should rub off on the President, should not at least some of that rub off on his economic adviser? After all, as my staff jokingly pointed out, while I was Chair￾man of the Council the misery index – the sum of the inflation rate and the un￾employment rate – was half of what it was when Alan Greenspan was Chairman of the Council. Others suggested that it was not the Administration which should get the credit, but the Federal Reserve Board. To Tinbergen, this debate might have seemed strange indeed. Macroeconomic success depended on coordination of the monetary and fiscal instruments. It was the two working together. Curiously enough, economic policymaking in the United States – and in many other countries – is designed to inhibit this coordi￾nation and cooperation. We have created independent central banks, who may, and indeed are instructed to, pursue policies independently of the wishes of the elected officials. In the United States, the deliberations of the open market com￾mittee which sets interest rates is kept secret – even from the President of the United States. To be sure, in the past, presidents have not been shy about ex￾pressing to the Fed what they think it should do, but the Fed has not been shy about ignoring these messages. Early on in the Clinton Administration, we adopted a policy of not commenting on Fed policy, not because we did not have strong views – at certain critical stages, many in the Administration thought their policies were seriously misguided – but because we thought a public debate would be counterproductive. We thought the Fed would not listen, the newspapers would love the controversy, and the markets, worried by the uncertainty that such con￾troversy generates, would add a risk premium to long-term rates, thereby increas￾ing those rates, which was precisely what we did not want to happen. There is an irony in all of this. The President is held accountable for how the economy performs – whether or not he has much control. Indeed, econometric models suggest that an infallible predictor of the outcome of presidential elec￾tions is the state of the economy;2 just as the weaknesses of the economy were largely responsible for Clinton’s election in 1992, the strength of the economy was largely responsible for his re-election in 1996. The Council’s own economet￾ric models in 1995 and 1996 corroborated the findings of others predicting an electoral outcome close to that which emerged – suggesting that President Clin￾ton really did not need to do all that campaigning. 2 Interestingly, the perception of the state of the economy seems to be a more accurate predictor of electoral outcomes than the actual state of the economy. The incumbent party has won every election in which the University of Michigan’s consumer sentiment index in the month before the election was above 92. 200 J.E. STIGLITZ

CENTRAL BANKING While the President is held accountable, his major tools for affecting the mac. roeconomy have been removed. Deficit stringency has removed the scope for dis- cretionary fiscal policy(though fiscal impacts played a role in the fine tuning of the 1993 deficit reduction plan; and the independence of the Fed has removed the Executive Branchs influence over monetary policy. Members of the Admin- stration did communicate privately, in weekly, sometimes daily, conversations We shared our views of what was happening to the economy but we did not always agree. And according to the rules of the game that we adopted, we did not participate in the public debate on monetary policy In a democracy, public discussion and debate about issues of central impor- tance, like the management of the economy, are essential. The Council of Eco- nomic Advisers did attempt to contribute to this discussion but obliquely, es- pecially in the Annual Economic Report of the President Today, I want to address two issues which I felt stifled from discussing more openly during my tenure at the Council of Economic Advisers. The first issue concerns the principles of monetary policy in a low-inflation environment such has prevailed in the United States for the past decade and half how should it set its targets? Should it seek to take pre-emptive strikes against inflation? Is it true that it cannot, or at least should not, wait to act until the white of the eyes of infilation' can be seen? The second issue is more fundamental: what should be the institutional arrangements by which monetary policy is set in a democratic independent should th what should be its governance? Who should choose those who essentially control the economy, and what characteristics should these decision makers have? Though I do not wish to give away my bottom lines, to pique your interest, let me hint at the conclusions i shall draw 1. Monetary policy matters, and the successful conduct of macropolicy in the postwar period has led to far greater stability of the economy. This is not to imply that American economic policy has been perfect- major mistakes, some arising from an imperfect understanding of the economy, have at times con- tributed to unnecessarily high unemployment or to the economy enjoying tronger boom than intended 2. In particular, I will argue that the strategies of opportunistic disinflation or pre-emptive strikes are based on a set of hypotheses about the economy for which there is little empirical support. I will argue, at least in the context of the American economy today, for an alternative, which I call cautions expan 3 Perhaps now that th he United States appears on the verge of fiscal surpluses there will be more ope for fiscal policies. But some of the budgetary processes designed to curb public profligacy may inhibit the effective exercise of countercyclical fiscal

While the President is held accountable, his major tools for affecting the mac￾roeconomy have been removed. Deficit stringency has removed the scope for dis￾cretionary fiscal policy ~though fiscal impacts played a role in the fine tuning of the 1993 deficit reduction plan;3 and the independence of the Fed has removed the Executive Branch’s influence over monetary policy. Members of the Admin￾istration did communicate privately, in weekly, sometimes daily, conversations. We shared our views of what was happening to the economy – but we did not always agree. And according to the rules of the game that we adopted, we did not participate in the public debate on monetary policy. In a democracy, public discussion and debate about issues of central impor￾tance, like the management of the economy, are essential. The Council of Eco￾nomic Advisers did attempt to contribute to this discussion – but obliquely, es￾pecially in the Annual Economic Report of the President. Today, I want to address two issues which I felt stifled from discussing more openly during my tenure at the Council of Economic Advisers. The first issue concerns the principles of monetary policy in a low-inflation environment such has prevailed in the United States for the past decade and half – how should it set its targets? Should it seek to take pre-emptive strikes against inflation? Is it true that it cannot, or at least should not, wait to act until the ‘white of the eyes of inflation’ can be seen? The second issue is more fundamental: What should be the institutional arrangements by which monetary policy is set in a democratic society? How independent should the central bank be? And if it is independent, what should be its governance? Who should choose those who essentially control the economy, and what characteristics should these decision makers have? Though I do not wish to give away my bottom lines, to pique your interest, let me hint at the conclusions I shall draw: 1. Monetary policy matters, and the successful conduct of macropolicy in the postwar period has led to far greater stability of the economy. This is not to imply that American economic policy has been perfect – major mistakes, some arising from an imperfect understanding of the economy, have at times con￾tributed to unnecessarily high unemployment or to the economy enjoying a stronger boom than intended. 2. In particular, I will argue that the strategies of opportunistic disinflation or pre-emptive strikes are based on a set of hypotheses about the economy for which there is little empirical support. I will argue, at least in the context of the American economy today, for an alternative, which I call cautions expan￾sionism. 3 Perhaps now that the United States appears on the verge of fiscal surpluses there will be more scope for fiscal policies. But some of the budgetary processes designed to curb public profligacy may inhibit the effective exercise of countercyclical fiscal policy. CENTRAL BANKING 201

JE STIGLITZ 3. There is a rationale for a degree of independence of the central bank, even in a democratic society. But the central bank must be accountable, and sensitive to democratic processes; there must be more democracy in the manner which the decision makers are chosen and more representativeness in the gov- ernance structure. The movement in the opposite direction in some places is particularly disturbing 2 MONETARY POLICY MATTERS: THE STABILIZATION OF THE POSTWAR BUSINESS CYCLE Before answering the two questions which are the focus of my concern today, I have to address a prior issue: Does monetary policy matter? For clearly, if mon etary policy has no effect, then the design of monetary institutions, the choice of monetary policy strategy, and the coordination of monetary and fiscal policy do not matter. I believe strongly that monetary policy does matter- and it was not just frustration with our inability to use discretionary fiscal policy combined with envy of the economic power of those sitting along Constitution Avenue in the Federal Reserve Board building that led me to this conclusion. This conclusion was based on theoretical work that I had done before entering governmentand recent empirical work by Francis Diebold and Glenn Rudebusch(1992), which we have confirmed and extended. Their findings have not received the attention they deserve, they shed light on a long-standing controversy about whether there are in fact business cycles or simply random economic fluctuations. Their some- what surprising conclusion is that there appear to have been cycles prior to the Great Depression, but that in the postwar period, these cycles- in the sense of regular periodic movements in output- have been eliminated. Before turning to the statistical results, let me comment briefly on the circumstances that led up to my work in this area Though we did not control monetary policy it was important for us to have views on where the economy was going and what we thought monetary policy should be. My friend Jacob Frenkel(governor of the Central Bank of Israel)once quipped that central bankers have a fascination with fiscal policy -they are al- ways willing to comment on the appropriate size of the deficit(zero), though they thought it inappropriate for the fiscal authorities to comment on monetary policy. By the same token, we had a fascination with monetary policy -and wished we could comment on it It is remarkable how little insight into these issues is shed by current macro- economics. One major school of thought, Real Business Cycles, argues that there is no involuntary unemployment. It was hard to tell that story to the president who was elected on a platform of Jobs, Jobs, Jobs!, or to the voters in Califor nia, when unemployment -they did not think it was just a superabundance of 4 See, for instance, Greenwald and Stiglitz (1990, 1993)

3. There is a rationale for a degree of independence of the central bank, even in a democratic society. But the central bank must be accountable, and sensitive, to democratic processes; there must be more democracy in the manner in which the decision makers are chosen and more representativeness in the gov￾ernance structure. The movement in the opposite direction in some places is particularly disturbing. 2 MONETARY POLICY MATTERS: THE STABILIZATION OF THE POSTWAR BUSINESS CYCLE Before answering the two questions which are the focus of my concern today, I have to address a prior issue: Does monetary policy matter? For clearly, if mon￾etary policy has no effect, then the design of monetary institutions, the choice of monetary policy strategy, and the coordination of monetary and fiscal policy do not matter. I believe strongly that monetary policy does matter – and it was not just frustration with our inability to use discretionary fiscal policy combined with envy of the economic power of those sitting along Constitution Avenue in the Federal Reserve Board building that led me to this conclusion. This conclusion was based on theoretical work that I had done before entering government4 and recent empirical work by Francis Diebold and Glenn Rudebusch ~1992!, which we have confirmed and extended. Their findings have not received the attention they deserve; they shed light on a long-standing controversy about whether there are in fact business cycles or simply random economic fluctuations. Their some￾what surprising conclusion is that there appear to have been cycles prior to the Great Depression, but that in the postwar period, these cycles – in the sense of regular periodic movements in output – have been eliminated. Before turning to the statistical results, let me comment briefly on the circumstances that led up to my work in this area. Though we did not control monetary policy it was important for us to have views on where the economy was going and what we thought monetary policy should be. My friend Jacob Frenkel ~governor of the Central Bank of Israel! once quipped that central bankers have a fascination with fiscal policy – they are al￾ways willing to comment on the appropriate size of the deficit ~zero!, though they thought it inappropriate for the fiscal authorities to comment on monetary policy. By the same token, we had a fascination with monetary policy – and wished we could comment on it. It is remarkable how little insight into these issues is shed by current macro￾economics. One major school of thought, Real Business Cycles, argues that there is no involuntary unemployment. It was hard to tell that story to the President, who was elected on a platform of ‘Jobs, Jobs, Jobs!’, or to the voters in Califor￾nia, when unemployment – they did not think it was just a superabundance of 4 See, for instance, Greenwald and Stiglitz ~1990, 1993!. 202 J.E. STIGLITZ

CENTRAL BANKING exceeded 10 percent. Another major school, new classical economics emphasis on rational expectations, argues that monetary policy is inef because the private sector would adjust its expectations and actions to undo any systematic monetary policies. If correct, concerns about policy coor- dination are not of much importance! And if correct, the myriad of economists, in government and business, and the multitude of reporters, who were engaged in trying to figure out what the Fed was about to do, are all behaving irrationally While these schools of thought might have little sway in the real world of govern- ment or business, they have had remarkable influence in academia over the past quarter century, especially in America. Both of these schools suggested that difficulties in the Council of hiring macroeconomists from academia who knew something about the economy was of no consequence: they would be wasting their time in any case. Needless to say, these were perspectives with which I had little sympathy As the economy continued the robust recovery from the 1990-1991 recession, I was asked by reporters with increasing frequency, did I expect the recovery to end. Their view was that the economy was perched on a knife-edge, ready to fal off into a recession on one side or rising inflation on the other. Furthermore, they seemed to believe that the longer an expansion lasted, the more likely there was to be a downturn. In contrast, I believed in Keynes' animal spirits, and believed that those animal spirits might be driven, if ever so gently, towards a more fa- vorable view of the economy, and hence stronger investment. The fundamentals of the Us economy were clearly sound, but I wanted to make a further argu- ment: that expansions do not end of old age, a popular way of saying that there was no such thing as a business cycle. The results in Figure 1 provide dramatic support for this argument as applied to the post-World War Il US economy -the probability of an expansion ending appears to be independent of its length. This result should not come as a surprise, if one makes three assumptions: monetary policy seeks to maintain expansions, monetary policy is forward-looking, and monetary policy is somewhat effective. For if there were any systematic time de pendency or dependency on time and other observable variables- the mon- etary authorities should seek to take offsetting actions. The result does not re- uire that the monetary authorities be perfectly efficient, only that any errors have no systematic component to them 5 In real business-cycle theory, monetary policy is not only not needed, but ineffective. In some variants of rational expectations models, monetary policy can have effects, but only to the extent tha the actions of the monetary authorities are imperfectly observed, or observed with a lag 6 Diebold and Rudebusch(1992)find no time dependence at all. Our results show a slight time dependence, which disappears once other, easily observed variables are taken into account. The ex- istence of some time dependence, even with an effective monetary policy, is to be expected, if there are variables or events (like large excess inventories)the occurrence of which increases with the length of the expansion, and if monetary policy cannot perfectly offset the effects. Effective monetary policy eliminates any systematic cyclical fluctuation associated with such variables ents

leisure – exceeded 10 percent. Another major school, new classical economics, with its emphasis on rational expectations, argues that monetary policy is inef￾fective, because the private sector would adjust its expectations and actions to undo any systematic monetary policies.5 If correct, concerns about policy coor￾dination are not of much importance! And if correct, the myriad of economists, in government and business, and the multitude of reporters, who were engaged in trying to figure out what the Fed was about to do, are all behaving irrationally. While these schools of thought might have little sway in the real world of govern￾ment or business, they have had remarkable influence in academia over the past quarter century, especially in America. Both of these schools suggested that our difficulties in the Council of hiring macroeconomists from academia who knew something about the economy was of no consequence: they would be wasting their time in any case. Needless to say, these were perspectives with which I had little sympathy. As the economy continued the robust recovery from the 1990–1991 recession, I was asked by reporters with increasing frequency, did I expect the recovery to end. Their view was that the economy was perched on a knife-edge, ready to fall off into a recession on one side or rising inflation on the other. Furthermore, they seemed to believe that the longer an expansion lasted, the more likely there was to be a downturn. In contrast, I believed in Keynes’ animal spirits, and believed that those animal spirits might be driven, if ever so gently, towards a more fa￾vorable view of the economy, and hence stronger investment. The fundamentals of the US economy were clearly sound, but I wanted to make a further argu￾ment: that expansions do not end of old age, a popular way of saying that there was no such thing as a business cycle. The results in Figure 1 provide dramatic support for this argument as applied to the post-World War II US economy – the probability of an expansion ending appears to be independent of its length.6 This result should not come as a surprise, if one makes three assumptions: monetary policy seeks to maintain expansions, monetary policy is forward-looking, and monetary policy is somewhat effective. For if there were any systematic time de￾pendency – or dependency on time and other observable variables – the mon￾etary authorities should seek to take offsetting actions. The result does not re￾quire that the monetary authorities be perfectly efficient, only that any errors have no systematic component to them. 5 In real business-cycle theory, monetary policy is not only not needed, but ineffective. In some variants of rational expectations models, monetary policy can have effects, but only to the extent that the actions of the monetary authorities are imperfectly observed, or observed with a lag. 6 Diebold and Rudebusch ~1992! find no time dependence at all. Our results show a slight time dependence, which disappears once other, easily observed variables are taken into account. The ex￾istence of some time dependence, even with an effective monetary policy, is to be expected, if there are variables or events ~like large excess inventories! the occurrence of which increases with the length of the expansion, and if monetary policy cannot perfectly offset the effects. Effective monetary policy eliminates any systematic cyclical fluctuation associated with such variables or events. CENTRAL BANKING 203

JE STIGLITZ 0% Probability 0 Months of Expansion Figure 1-Probability of an expansion ending, 1945-1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates 100% Probability I 0.2 0 Months of recession Figure 2- Probability of a recession ending, 1945-1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates

Figure 1 – Probability of an expansion ending, 1945–1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates. 100% Probability 0% Probability Figure 2 – Probability of a recession ending, 1945–1997 Note: Probability estimated using logit regressions on NBER Business Cycle dates. 100% Probability 0% Probability 204 J.E. STIGLITZ

CENTRAL BANKING From this perspective, downturns come as a surprise, an unexpected event not anticipated, or imperfectly anticipated, or whose consequences were not fully cal ulated, perhaps because of misunderstandings about the structure of the economy Monetary authorities seek to offset these effects, to restore the economy to its otential. In the short run, there is a tendency of monetary authorities to think of the downturn as a temporary deviation, which will correct itself shortly. Given the lags in the effectiveness of monetary policy, expansionary policies might then complement the natural forces of recovery, leading to inflation. Over time, if the downturn persists, political pressure -even on an independent monetary author ity -to do something mounts, the policy of doing nothing, or doing too little becomes hard to maintain. Moreover. information about the true nature of the downturn becomes more apparent This pattern is clearly evidenced in the series of pronouncements of the Fed Chairman between 1991 and 1993. Even as the National bureau of economic Research was about to declare that the economy was in recession in July 1991 the Fed Chairmans Humphrey-Hawkins testimony (which he is required to give before Congress twice a year) did not indicate that the Fed was worried about recession. 'To be fair, economic forecasters have almost always missed reces- sions.(Also, I should add parenthetically that one of the responsibilities of Fed officials is to maintain confidence in the economy. Private views may be more pessimistic than public pronouncements. Still, in this particular case, policy eemed to conform remarkably closely to the public pronouncements. Moreover, the Fed Chairman is a master of Fedspeak some say a modern version of a Iphic oracle which is designed to carefully calibrate what information is re- vealed and what is obscured rather than to provide complete enlightenment. This rovides plenty of opportunity for him to make announcements that bolster con- fidence in the economy while being sufficiently vague so that in retrospect they seem to provide keen insights into the workings of the economy regardless of As the downturn persisted the Fed continued to see it as an unexpected shock This viewpoint is evident in the Humphrey-Hawkins testimony from Febnt es, leading to a ' cyclical downturn that would respond to standard policies 1991 which reads nOnetheless, the balance of forces does appear to suggest that this downturn could well prove shorter and shallower that most prior post war recessions. An important reason for this assessment is that one of the most negative economic impacts of the Gulf war -the run-up in oil prices- has been reversed. Another is that the substantial decline in interest rates over the past year and a half -especially over the past several months- should ameliorate the contractionary effects of the crisis in the Gulf and of tighter credit availability 7 The prepared statement reads, 'On balance, the economy still appears to be growing, and the likelihood of a near-term recession seems low

From this perspective, downturns come as a surprise, an unexpected event not anticipated, or imperfectly anticipated, or whose consequences were not fully cal￾culated, perhaps because of misunderstandings about the structure of the economy. Monetary authorities seek to offset these effects, to restore the economy to its potential. In the short run, there is a tendency of monetary authorities to think of the downturn as a temporary deviation, which will correct itself shortly. Given the lags in the effectiveness of monetary policy, expansionary policies might then complement the natural forces of recovery, leading to inflation. Over time, if the downturn persists, political pressure – even on an independent monetary author￾ity – to do something mounts; the policy of doing nothing, or doing too little becomes hard to maintain. Moreover, information about the true nature of the downturn becomes more apparent. This pattern is clearly evidenced in the series of pronouncements of the Fed Chairman between 1991 and 1993. Even as the National Bureau of Economic Research was about to declare that the economy was in recession in July 1991, the Fed Chairman’s Humphrey-Hawkins testimony ~which he is required to give before Congress twice a year! did not indicate that the Fed was worried about recession.7 To be fair, economic forecasters have almost always missed reces￾sions. ~Also, I should add parenthetically that one of the responsibilities of Fed officials is to maintain confidence in the economy. Private views may be more pessimistic than public pronouncements. Still, in this particular case, policy seemed to conform remarkably closely to the public pronouncements. Moreover, the Fed Chairman is a master of Fedspeak – some say a modern version of a Delphic oracle – which is designed to carefully calibrate what information is re￾vealed and what is obscured rather than to provide complete enlightenment. This provides plenty of opportunity for him to make announcements that bolster con- fidence in the economy while being sufficiently vague so that in retrospect they seem to provide keen insights into the workings of the economy regardless of what happens.! As the downturn persisted the Fed continued to see it as an unexpected shock leading to a ‘normal’ cyclical downturn that would respond to standard policies. This viewpoint is evident in the Humphrey-Hawkins testimony from February 1991 which reads ‘@n#onetheless, the balance of forces does appear to suggest that this downturn could well prove shorter and shallower that most prior post￾war recessions. An important reason for this assessment is that one of the most negative economic impacts of the Gulf war – the run-up in oil prices – has been reversed. Another is that the substantial decline in interest rates over the past year and a half – especially over the past several months – should ameliorate the contractionary effects of the crisis in the Gulf and of tighter credit availability.’ 7 The prepared statement reads, ‘@O#n balance, the economy still appears to be growing, and the likelihood of a near-term recession seems low.’ CENTRAL BANKING 205

JE STIGLITZ was not until the economy was on its way to recovery, in February 1993 that the Fed finally recognized the 'economy has been held back by a variety of structural factors, '[emphasis added] most notably fundamental weaknesses in the financial system As the nature of the problem became clearer, and as the political pressure to do something mounted, monetary policy was eased 24 times, contributing to the recovery. The pattern evidenced in our most recent recession is typical, as con- firmed by the statistical data: Figure 2 shows that there is a strong time depen- dency in recovery TABLE 1- AVERAGE DURATION (IN MONTHS)OF US BUSINESS CYCLE EXPANSIONS AND RECESSIONS T Recession Expansio December 1854-August 1929 October 1945-March 1991 II Source: NBER These patterns are markedly different from those that prevailed before the Great Depression. Since World War Il, expansions are longer and recessions are shorter, as Table 1 shows. Figure 3 shows, using data for the United States for the period 1854 to 1918 that prior to the Great Depression, expansions did end of old age. The probability of an expansion ending increased markedly the longer the expansion continued, with a probability of approximately one-third in the sec ond year, increasing to two-thirds in the fourth. By contrast, recovery from a downturn seems to have been largely a random event, as Figure 4 shows. While some of these changes could have been accounted for by changes in the structure of the economy, I suspect that it is improved macropolicy(including automatic fiscal stabilizers) that accounts for much of the change Incidentally, these results strongly rebut the claim of Christina Romer (1986) that there is no evidence of improved macroeconomic performance in the post war period. Her argument relies on adjustments in output series which are debat able. Our methodology only requires qualitative assessments about whether the economy is expanding or contracting. Because it does not require measures for every subcomponent of GDP and because it can utilize data from other sources, the timing of expansions and downturns provides a far more robust way of as- sessing economic performance 8 In part due to the interaction of the 1986 tax reform which eliminated many of the tax subsidies to real estate that had been enacted in earlier legislation, with the regulatory forbearance that allowed the financial problems to mount, culminating in the savings and loan debacle in 1989

It was not until the economy was on its way to recovery, in February 1993, that the Fed finally recognized the ‘economy has been held back by a variety of structural factors,’ @emphasis added# most notably fundamental weaknesses in the financial system.8 As the nature of the problem became clearer, and as the political pressure to do something mounted, monetary policy was eased 24 times, contributing to the recovery. The pattern evidenced in our most recent recession is typical, as con- firmed by the statistical data: Figure 2 shows that there is a strong time depen￾dency in recovery. These patterns are markedly different from those that prevailed before the Great Depression. Since World War II, expansions are longer and recessions are shorter, as Table 1 shows. Figure 3 shows, using data for the United States for the period 1854 to 1918 that prior to the Great Depression, expansions did end of old age. The probability of an expansion ending increased markedly the longer the expansion continued, with a probability of approximately one-third in the sec￾ond year, increasing to two-thirds in the fourth. By contrast, recovery from a downturn seems to have been largely a random event, as Figure 4 shows. While some of these changes could have been accounted for by changes in the structure of the economy, I suspect that it is improved macropolicy ~including automatic fiscal stabilizers! that accounts for much of the change. Incidentally, these results strongly rebut the claim of Christina Romer ~1986! that there is no evidence of improved macroeconomic performance in the post￾war period. Her argument relies on adjustments in output series which are debat￾able. Our methodology only requires qualitative assessments about whether the economy is expanding or contracting. Because it does not require measures for every subcomponent of GDP and because it can utilize data from other sources, the timing of expansions and downturns provides a far more robust way of as￾sessing economic performance. 8 In part due to the interaction of the 1986 tax reform which eliminated many of the tax subsidies to real estate that had been enacted in earlier legislation, with the regulatory forbearance that allowed the financial problems to mount, culminating in the savings and loan debacle in 1989. TABLE 1 – AVERAGE DURATION ~IN MONTHS! OF US BUSINESS CYCLE EXPANSIONS AND RECESSIONS Time period Recession Expansion December 1854–March 1991 18 35 December 1854–August 1929 21 25 October 1945–March 1991 11 50 Source: NBER 206 J.E. STIGLITZ

CENTRAL BANKING 100% Probability Months of Expansion Figure 3- Probability of an expansion ending, 1854-1929 Note: Probability estimated using logit regressions on NBER Business Cycle dates These results, while they show convincingly that monetary policy matters and has been used to improve the overall performance of the economy, do not require us to believe that the monetary authority behaves perfectly or even that it is ef- ficient. I already discussed one example of a mistake: the Fed doing too little and acting too late to avert or minimize the depth and duration of the 1990-1991 recession. A second illustration is the current expansion which can be thought of s also partially attributable to mistakes, at least initially. There is a tendency to think of mistakes as one-sided- always working to the detriment of the economy t mistakes, by their nature, should be random, and in at least some cases work to the benefit of the economy. In this case, there were in fact two errors on the part of the Fed, with one more than offsetting the other Throughout the earlier 1990s, the Fed continued to have an overly pessimistic view concerning the nairu (non-accelerating inflation rate of unemployment) and the economys potential for reducing unemployment without inflation increas- ing. But they also continued to underappreciate the role of financial markets and continued to fail to understand key aspects of banking behavior. Had they better understood these factors, given their beliefs about the nairU and given their strong aversion to inflation, they would have prevented the unemployment rate from declining below 6.0 percent to 6.2 percent. It might have been a long time

These results, while they show convincingly that monetary policy matters and has been used to improve the overall performance of the economy, do not require us to believe that the monetary authority behaves perfectly or even that it is ef- ficient. I already discussed one example of a mistake: the Fed doing too little and acting too late to avert or minimize the depth and duration of the 1990–1991 recession. A second illustration is the current expansion which can be thought of as also partially attributable to mistakes, at least initially. There is a tendency to think of mistakes as one-sided – always working to the detriment of the economy. But mistakes, by their nature, should be random, and in at least some cases should work to the benefit of the economy. In this case, there were in fact two errors on the part of the Fed, with one more than offsetting the other. Throughout the earlier 1990s, the Fed continued to have an overly pessimistic view concerning the NAIRU ~non-accelerating inflation rate of unemployment!, and the economy’s potential for reducing unemployment without inflation increas￾ing. But they also continued to underappreciate the role of financial markets and continued to fail to understand key aspects of banking behavior. Had they better understood these factors, given their beliefs about the NAIRU and given their strong aversion to inflation, they would have prevented the unemployment rate from declining below 6.0 percent to 6.2 percent. It might have been a long time Figure 3 – Probability of an expansion ending, 1854–1929 Note: Probability estimated using logit regressions on NBER Business Cycle dates. CENTRAL BANKING 207

JE STIGLITZ 100% Probabili Months of recession Figure 4- Probability of a recession ending, 1854-1929 bability estimated using logit regressions on NBER Business Cycle dates possibly never- before we learned about the economy's real potential. It was our good fortune that they did not see accurately where the economy was going To understand what happened- and why the Fed failed (fortunately) the strength of the recovery we need to return to the early days of the Clinton Administration. When the President took office in February 1993, he moved quickly to introduce a deficit-cutting budget. Eventually the Congress enacted a plan to reduce the deficit by $500 billion over five years(in contrast, the 1997 balanced budget legislation only cut the deficit by $200 billion over five years Old-style Keynesians warned that deficit reduction would undermine the fragile recovery. Those of us who believe that the markets were forward-looking, under- stood that credible, pre-announced deficit reduction would lower interest rates and thus stimulate the economy. What took us all by surprise was just how much it 9 Indeed, I have argued that there is a reverse hysteresis effect: as the unemployment rate is re Iced, previously marginalized workers are drawn into the labor market, develop and maintain worker and job search skills that might otherwise have atrophied, and the economy's NAIRU is thereby ac- tually lowered. If this is the case, then the 'mistake of allowing the unemployment rate to fall below 6 percent was actually crucial in the economy's longer-term improved performance. See Stiglitz

– possibly never – before we learned about the economy’s real potential.9 It was our good fortune that they did not see accurately where the economy was going! To understand what happened – and why the Fed failed ~fortunately! to see the strength of the recovery – we need to return to the early days of the Clinton Administration. When the President took office in February 1993, he moved quickly to introduce a deficit-cutting budget. Eventually the Congress enacted a plan to reduce the deficit by $500 billion over five years ~in contrast, the 1997 balanced budget legislation only cut the deficit by $200 billion over five years!. Old-style Keynesians warned that deficit reduction would undermine the fragile recovery. Those of us who believe that the markets were forward-looking, under￾stood that credible, pre-announced deficit reduction would lower interest rates and thus stimulate the economy. What took us all by surprise was just how much it was stimulated. 9 Indeed, I have argued that there is a ‘reverse hysteresis effect:’ as the unemployment rate is re￾duced, previously marginalized workers are drawn into the labor market, develop and maintain worker and job search skills that might otherwise have atrophied, and the economy’s NAIRU is thereby ac￾tually lowered. If this is the case, then the ‘mistake’ of allowing the unemployment rate to fall below 6 percent was actually crucial in the economy’s longer-term improved performance. See Stiglitz ~1997!. Figure 4 – Probability of a recession ending, 1854–1929 Note: Probability estimated using logit regressions on NBER Business Cycle dates. 208 J.E. STIGLITZ