What Do Central Banks Do?

Article excerpt

The standard assumption is that central banks help stabilize the economy and improve economic performance. Textbook analyses of monetary policy seem to suggest this is an easy task, and examples like Alan Greenspan's stewardship of the U.S. economy appear to support this view. A deeper look, however, suggests a more cautious conclusion.

In the real world, stabilizing an economy requires accurate forecasts of where the economy is headed. Yet not only are forecasts subject to substantial uncertainty; there are "long and variable lags" in the impact of central bank actions. Thus, interventions can take hold just when policy should push in the opposite direction. Add to this the possibility of mistaken understanding or inappropriate objectives by central banks, and it becomes apparent that activist monetary policy can harm rather than improve economic performance.

The track record of central banks supports this concern. Most famously, the Fed failed to expand the money stock at a reasonable pace from 1929 to 1933, thereby contributing to the Great Depression. Around the world, numerous central banks have caused hyperinflation followed by economic collapse. And in less extreme situations, central banks have adopted bad policies due to faulty perceptions of the economy or flawed understanding of appropriate targets.

At the same time, economies without central banks or an independent monetary authority have performed well. The U.S. had no central bank before 1914, yet average economic growth was robust. Individual states within the United States do not control their own monetary policies, yet their economies progress nonetheless. …