Over the past decade, central banks have emerged from relative obscurity to global recognition as one of the most powerful institutions in the world-- powerful not only economically, but also politically, socially, and as forces for cultural and historical change. Associated with this new image are several ideas about central banks that, while often not clearly expressed, are nevertheless widely held. These ideas circulate in a sort of folklore or oral tradition. They exercise a significant influence on how central banks are perceived.
* Central Bank Omnipotence The first of these ideas is that of central bank omnipotence. There seems to be a general public perception that a central bank is responsible for controlling the business cycle and for ensuring an endless stream of prosperity. This isn't a view that is held by central bankers themselves, although they benefit to some extent if the public holds them in a sort of awed semiadulation.
We see this idea at play today. In the United States, for example, the Federal Reserve System is credited for the period of economic expansion and price stability that we have enjoyed for many of the past years. The Fed is also blamed for the recent economic slowdown; if only the central bank had loosened credit earlier, we hear, we would not have faced the layoffs, lack of consumer confidence, deteriorating corporate profits, and so on that were grist for business news over the past few years. But is the Fed really so powerful?
We can't easily determine the degree of central bank influence. No controlled experiments are available. However, there's reason to believe that central bank powers, although very large, are still significantly limited.
One object lesson on this is the role of the Bank of Japan (BOJ) over the past 15 years. Many have criticized the BOJ for contributing to, even creating, the bubble economy of 1987-1990, whose collapse was followed by more than a decade of economic stagnation in that country. A governor of the BOJ even accepted blame for the failure.
Yet my research suggests the Bank was not nearly as responsible as many think (see "The Role of a Central Bank in a Bubble Economy," by Geoffrey R Miller, in the Cardozo Law Review, 1996). It was highly constrained in its ability to act against the bubble economy, for several reasons. It wasn't clear, at least in the early years, that Japan was, in fact, in the midst of a speculative bubble; many argued that the upsurge in Japanese equity and real estate prices was due to economic fundamentals.
The bubble economy didn't show up in the wholesale or retail price indexes, so the Bank could not easily justify intervention as an inflation-control measure. Tools of monetary policy were too broad in scope to deal effectively with sectoral phenomena; the Bank's intervention was going to affect the economy as a whole rather than the limited areas of stock market and real estate prices. The Bank also had to take foreign relations into account, especially relations with the United States. BOJ credit tightening would have been seen by the United States as inconsistent with commitments the Japanese government had made to stimulate domestic spending in order to increase demand for U.S. goods. The United States was also very concerned that Japan not do anything to destabilize its stock market, given the perception after October 1987 that U.S. equity markets were fragile.
Finally, the BOJ had to deal with powerful figures inside Japan who were profiting enormously from the bubble economy. Anyone who owned land in Tokyo, and later throughout the country, saw his paper wealth skyrocket during this period. Investors got rich on stock market profits. People in industries such as construction, real estate development, securities brokerage, and so on earned fabulous sums and were quite liberal with campaign contributions. Some politicians also earned large amounts in the stock market. …