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This short book offers a useful lesson in central banking. No one could deliver it better than Alan S. Blinder. As he notes with unusual immodesty, "there must be relatively few people who have been as deeply immersed in monetary policy from both the academic and central banking side as I have." (That was of course before Ben Bernanke became chairman of the Fed). The author's conviction is that both theory and practice could benefit from greater contact with and greater understanding from the other. So what does academic theory has to offer and how does it contribute to the central banker's toolbox?
First, modern macroeconomics provides a mode of thinking about the future that is known to economists as dynamic programming. The technique uses a lot of equations, but the underlying idea is very simple. At each point in time the central bank must select a plan for now and for the future that will produce the best available time-path for output and inflation. Unless you have thought through your expected future actions, it is impossible to make today's decision rationally. Of course, by the time period t+1 the policymaker will have new information and may wish to correct his or her plan. The idea is not to lock the central bank in a position it will later regret, but to maintain flexibility while making the best use of available information. The underlying rationale is quite intuitive: think about a person tinkering with the thermostat in a hotel room. The probability is that she will overshoot the desired temperature, and will then have to set a new target again, whereas she should have anticipated the curve path followed by the temperature right from the start. This is known to economists as the difference between adaptative and rational expectations. But of course you do not have to be a skilled economist to practice the art of dynamic programming: like an experienced billiard player who does not understand the laws of physics, a skilled practitioner of monetary policy may follow an intertemporally optimal strategy intuitively and informally.
To this practical lesson Alan Blinder adds a second one, identified formally by William Brainard in 1967: when uncertainty is present, it is better to err on the side of caution. Monetary policy operates in an uncertain world. As the author remarks, "we do not know the model, and we do not know the objective function, so we cannot compute the optimal policy rule." Although central bankers "don't have the luxury of ignoring econometric estimates", they cannot put monetary policy in automatic piloting. You cannot replace the central bank by a computer and throw away the key. The author's recommendation is: "use a wide variety of models and don't ever trust any of them too much." The conservative streak that he sees as a requisite for central banking also fits well with the mode of decision by committee. "While serving on the FOMC, the author notes, I was vividly reminded of a few things all of us probably know about committees: that they laboriously aggregate individual preferences; that they need to be led; that they tend to adopt compromise positions on difficult questions; and--perhaps because of all of the above--that they tend to be inertial." But the group nature of FOMC decisions creates what amounts to an internal system of checks and balances: decisionmaking by committee, especially when there is a strong tradition of consensus, makes it very difficult for idiosyncratic views to prevail. There is a rich tradition of optimal decisionmaking design that goes back to Condorcet. Although monetary economics seldom refers to this literature, the author's own hunch is that "on balance, the additional monetary policy inertia imparted by group decisionmaking provides a net benefit to society".
Alan Blinder is also critical of a large body of recent academic research which has, in his view, made insufficient contact with reality. The monetarist school had some basic intuitions right, but wrongly recommended to focus monetary policy on the money supply, precisely at a time when monetary aggregates were becoming more unstable. Targeting the interest rate thus won by default the debate on the choice of monetary instrument. As a former governor of the Bank of Canada put it, "We didn't abandon the monetary aggregates, they abandoned us." Central bankers also had to abandon the Phillips curve that posited a trade-off between inflation and unemployment, but not for the reasons put forth by those who argued that time inconsistency will lead to an inflationary bias. These economists, Blinder argue, are barking at a nonexistent tree, and the inflationary bias is nowhere to be seen. If there is a bias, it is in the strong anti-inflationary stance of most central bankers, who stand out as conservative policymakers. Some of the economists's proposals, such as linking central bankers's pay to performance, are completely unrealistic. In fact, the author notes, "nations and households seem to find simple, practical ways to cope with a wide variety of potential dynamic inconsistencies--ways that bear little resemblance to the solutions suggested by theorists."
The last chapter on central bank independence raises an interesting puzzle. "When you think deeply about the reasons for removing monetary policy decisions from the 'political thicket', you realize that the reasons apply just as well to many other aspects of economic policy--and, indeed, to noneconomic policy as well." Issues of reputation, credibility, and time inconsistency do not provide the answer: based on these arguments, there would be a good case for making foreign policy independent from the executive branch. In a Foreign Affairs essay published in 1997, Alan Blinder argues provocatively that government has become "too political": Washington could learn from independent agencies like the Federal Reserve and, among other things, shift responsibility for tax policy from the politicians to the experts. These views are not reflected on this short essay, which concentrates on monetary policy. But by his tone, the author demonstrates that he is capable of rigorous reasoning allied with original thinking.