Overhauling the Central Banks

Inflation targeting helped cause—and intensify—the global financial crisis. What we can do about it.

Ever since the first signs of the global financial crisis emerged in 2007, the central bankers of the developed world, principally the U.S. Federal Reserve, the European Central Bank (ECB) and the Bank of England, have been making policy on the run; they try one expedient after another while insisting that nothing has really changed.

Emergency measures—liquidity injections, quantitative easing and massive bailouts—have staved off disaster, though perhaps only for a limited time. But as long as central banks pretend that we are just about to return to precrisis normalcy, there will be no sustained recovery from the slump that is now more than four years old.

Central banks failed spectacularly in the lead-up to global financial crisis. Their failure was centred on what most central bankers still regard as the great achievement of the 1990s, the shift to “inflation targeting,” in which the sole objective of monetary policy was to keep inflation in a specific range, typically close to 2 percent. Unlike most other central banks, the Federal Reserve does not announce an inflation target, but in practice it has adopted the same policy.

Inflation targeting led central banks to ignore the unsustainable bubbles in speculative real estate that produced the crisis and to react too slowly as they became evident.

Worse still, in the postcrisis environment, inflation targets no longer promote stable economic growth. Instead, low inflation has been a drag on growth. But with inflation under control, central bankers like former ECB president Jean-Claude Trichet describe their own performance as “impeccable,” even as the economies and currencies they manage appear headed for collapse.

This system is clearly unsustainable. But what is the alternative? One popular idea begins with a change of target: instead of inflation, some propose nominal GDP (the most commonly used measure of national output, valued at current prices).

The idea combines a target rate of inflation (say 2–3 percent) with an estimate of the medium-term real economic growth required to maintain full employment (again 2–3 percent is a plausible estimate). The aim would be to keep the value of GDP, expressed in current dollars, on a growth path consistent with these targets, or an average annual rate somewhere between 4 and 6 percent.

This change would have several effects. First, it would restore the balance that used to prevail in monetary policy before the 1990s, when central banks were explicitly required to pursue full employment as well as price stability. At a minimum, this would force central banks to admit that their current policies are failing, a key to any progress.

Second, because the target would apply to the level of nominal GDP, its adoption would require central banks to catch up the ground lost over the last few years of depressed growth and generally low inflation. That would permit a temporary increase in inflation, which is necessary if growth is to be restarted against a crushing burden of debt.

Third, the adoption of a nominal GDP target, by committing central banks to an expansionary policy, would have self-fulfilling effects on expectations. In contrast, past measures expanding credit were undermined by fears—later justified by events—that they would be wound back as soon as the immediate crisis was over.

Last but not least, a nominal GDP target would create room for fiscal policy as well as monetary policy. Today’s austerity policies are counterproductive; they should be abandoned and replaced with a combination of short-term fiscal stimulus and long-run measures aimed at sustainably balancing budgets. This can only be achieved if central banks cooperate with progrowth fiscal policy instead of counteracting it in the name of inflation targets.

Abandonment of inflation targeting would be an admission of failure. But central banks have failed disastrously, and admitting this would be the first step towards a sustainable recovery.

Nominal GDP targeting would maintain and even enhance the transparency of a system based on targets, while restoring the balance missing from a monetary policy dominated by the goal of price stability.

John Quiggin is a professor of economics at the University of Queensland, Australia and adjunct professor at the University of Maryland, College Park.