Buiter on the Politics of Normalization

Fed balance sheet, fiscal policy, LSAP, preferred credit allocation, Willem Buiter
Willem Buiter speaking at the Federal Reserve Bank of Atlanta https://i.ytimg.com/vi/E0Bbm6W1jXs/maxresdefault.jpg

WillemBuiterThe most stinging rebuke, as well as the  most public one, I ever received over the course of my academic career, was delivered to me in the pages of The Economic Journal.  It consisted of a  footnote to an article celebrating James Tobin's contributions to economics. The footnote offered a paper of mine, also published in the EJ, as a "striking example" of the "comeback" of models relying upon "ad-hoc, backward-looking, mechanical expectation formation models of the early 1960s…in the guise of adaptive learning rules."

What made my example especially egregious, in my chastiser's  view, was the fact that, though I referred to "adaptive learning," my argument was mainly couched in terms of static expectations — an especially naive sort.  To make matters worse, in defending my method, I referred to some other works that seemed to me to supply a rationale for such "naive" thinking in certain contexts.  By so doing, it seems, I was treating "appeal to higher authority (Marx, Keynes, Lucas etc.) [as] an acceptable substitute for empirical evidence or logical argument starting from reasonable primitive assumptions," thereby supplying "evidence of the immaturity of economics as a science."  Ouch!

In my defense, my topic was the transition from barter to fiat money, and despite the upbraiding I received I still think it perfectly reasonable to assume that, when some new technology is about to make its appearance, and especially when the first stages of its development are for the most part imperceptible (and money surely qualifies as such a technology), its development is likely to be quite unexpected.  And I didn't assume static expectations for the heck of it, or because I didn't realize that doing so was passé.  I assumed them in order to draw attention to their instrumental value and, hence, their possible relevance.  When static expectations or any of their somewhat more sophisticated counterparts, including adaptive learning, were assumed to operate in a monetary search framework, that framework yielded predictions much more consistent with historically-observed patterns of monetary development than it did if expectations were instead assumed to be strictly forward-looking and, in that sense, "rational."

But my main reason for bringing that whole business up isn't so that I can defend my poor old article.  It's to draw attention to the fellow who dressed me down for it.  For that fellow was Willem Buiter who, if you ask me (though admitting it only adds to my chagrin), is one of the best monetary economists around these days, and one whose writings deserve an even wider audience than the considerable one they already command.

As his unsparing (but mercifully brief) assault upon my article illustrates, Buiter doesn't go in for kid gloves, or for gloves of any sort: spotting what he believes to be a bad argument, he goes after it with bare knuckles, and more often than not lands a knockout punch.  Consider his trenchant critique of the fiscal theory of the price level.  Or have a look at his 2004 Hahn Lecture, in which he puts his dukes up against half-a-dozen "ghosts, eccentricities, mirages, and mythos" of contemporary monetary economics.  No, Sir: this is one monetary economist you don't want to mess around with.

Buiter is, on the other hand, a monetary economist whose work repays careful reading, and repays it at a decidedly positive real rate of interest.  I was reminded of this recently when, in the course of expanding upon my Congressional Testimony on Interest on Reserves, I came across a 2009 working paper by Buiter that I hadn't read before.  The question addressed by that paper — What obstacles stand in the way of central banks shrinking their swollen balance sheets and otherwise returning to conventional monetary policy? — makes it even more pertinent today than when it first appeared.  Yet because the paper was published as part of a somewhat obscure volume edited by the European Money and Finance Forum, it hasn't gotten much attention (Google scholar lists 13 citations, all to the working paper version).  That's a shame, for the paper is another good example of Buiter's ability to muster painstaking analysis in the service of blistering rhetoric, with devastating effect.

The gist of Buiter's argument is that, despite what monetary authorities in the U.S. and elsewhere may claim, "unwinding or reversing unconventional monetary policies," so as to reduce the relative size of central banks' balance sheets to pre-crisis levels, "is technically easy."  The real obstacles to such unwinding are, Buiter insists, political.  They consist, first, of a potential conflict between central bankers and fiscal authorities concerning "the role of seigniorage in closing the government's solvency gap," and, second, of the fact that any unwinding procedure "is likely to reveal the true extent of the central bank's quasi-fiscal activities during the crisis and its aftermath."

The conflict that constitutes the first of these obstacles arises because "the portfolio reshuffling that is the logical, unavoidable counterpart" to central banks' large-scale asset sales is likely to "create serious funding problems," especially for national treasuries.  In particular, to the extent that the sales reduce the central banks net interest income and financial surpluses, they must force associated governments to reduce their own deficits as well.  Unless such a program of deficit reduction is consistent with those treasuries own objectives, unwinding "could be delayed for years."

The extent of the delay will, of course, depend on central banks' ability to resist pressure from treasury authorities.  How great is that ability?  Not very, according to Buiter.  In the U.K., a Treasury unhappy with the Bank of England's aggressive pursuit of normalization might take control of monetary policy by invoking the Reserve Powers clause (section 19) of the 1998 Bank of England Act, allowing it to dictate policy provided that doing so is "required by the public interest and by extreme economic circumstances."  According to Buiter, its much-vaunted (if mostly mythical) independence notwithstanding, the Fed's constitution makes it even less immune to pressure from fiscal authorities than the Bank of England.

The second reason governments have for forestalling the unwinding of their central banks' unconventional policies — their desire to keep a cloak on those banks' quasi-fiscal activities — is so far as Buiter is concerned all the more reason for the general public to oppose any unnecessary delay:

The large-scale ex-ante and ex-post quasi-fiscal subsidies handed out by the Fed and to a lesser extent by the other leading central banks, and the sheer magnitude of the redistribution of wealth and income among private agents that the central banks have engaged in could (and in my view should) cause a political storm.

That the Fed and other central banks made the crisis an excuse for becoming quasi-fiscal agents in the first place was, in Buiter's opinion, inexcusable.  Like Bagehot (and Bernanke himself, to judge by the former Fed Chairman's utterances rather than his actions), Buiter believes that central banks have no business doing anything other than providing liquidity to illiquid but solvent financial institutions, "at a cost covering [their] opportunity cost of non-monetary financing":

Any action beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury.  The central bank should be involved only as an agent of the Treasury — an expert assistant.  It should not put its own conventional or comprehensive balance sheet at risk.

And why shouldn't a central bank take on quasi-fiscal functions?  Generally speaking, it shouldn't because doing so can impair its "ability to fulfill its macroeconomic stability mandate," and also because it may obscure responsibility and accountability "for what are in substance fiscal transfers."  In the U.S. case, Buiter notes, there is still another reason, and one that ought not to be dismissed lightly.  It is, simply, that the Fed's quasi-fiscal actions "subvert the Constitution, which clearly states in Section 8, Clause 1, that the power to tax and spend rests with the Congress."

That the Fed should have gotten away, not only with having allowed itself "to be used as an off-budget and off-balance-sheet special purpose vehicle for the Treasury," but also (until Bloomberg forced its hand after Buiter's article appeared) with refusing to divulge the details of its crisis-related fiscal transfers, seems almost incredible to the Dutch-born Buiter, who surrendered his Dutch citizenship in order to become a dual U.S.-U.K. citizen:

It is surprising that a country whose creation folklore attributes considerable significance to the principle of "no taxation without representation" would have condoned without much outcry such a blatant violation of the equally important principle of "no use of public funds without accountability."  This indeed amounts to a quiet coup by the central bank.

Would that more U.S.-born economists, including those who fell over each other in their rush to defend the Fed against any prospect of routine GAO "audits," took the Constitution's plain language as seriously.