The Quiet Revolution: Central Banking Goes Modern

Business Economics, July, 2004 by Edmund A. Mennis

The Quiet Revolution: Central Banking Goes Modern

By Alan S. Blinder. 2004. New Haven, CT: Yale University Press. Pp. 119. $28.00 hard cover.

What procedures should a modern central bank follow in setting monetary policy? The answer to this question is important, because these procedures underlie monetary policy and are very much related to changes of substance. Relative to the literature on the substance of monetary policy, the literature on procedure is relatively sparse. This little book, which contains three lectures that were given as a part of the Arthur M. Okun Memorial Lecture Series, covers both procedures and substance.

Alan Blinder is currently the Gordon S. Rentschler Memorial Professor of Economics at Princeton University. He also served as a member of the Council of Economic Advisers 1993-94 and from 1994 to 1996 was Vice Chairman of the Board of Governors of the Federal Reserve System. Professor Blinder thus offers practical experience, a solid academic background, and a clarity of writing that make these lectures unusually useful for anyone interested in the formulation of monetary policy.

Blinder's central theme is the quiet transformation that has been going on in the way that central banks worldwide conduct their activities. He groups these changes into three categories: transparency, decision making, and relationship to the financial markets.

Under transparency, Blinder believes central bank policy actions should be made clear, have substantive content, and be open to public scrutiny short of being unnecessarily intrusive. The political argument for transparency is that the central bank with its broad powers should be held accountable to the creating legislative body.

The economic argument for transparency is that it enhances the efficacy of monetary policy. This is especially important when the central bank has multiple objectives, like those of the Federal Reserve to maximize employment and maintain price stability. As to what the central bank should reveal, Blinder lists the following: the goals of monetary policy; the methods of analysis; the decision making models; and immediate disclosure of decisions and votes, accompanied by a "balance of risks" statement.

On the subject of decisions by committees, Blinder believes that committee decisions move central banks from doing the bidding of the prevailing government to acting independently. The advantages of committee decisions are bringing together people with different decision making methods, different models, different forecasts, and support of or opposition to a strong chairman. This pooling of knowledge and information make policy less volatile and less extreme and is most useful when difficult decisions are required.

Blinder describes several types of committees: collegial (where the chairman forges a consensus), autocratic (where the chairman dominates), and democratic (where a majority vote rules). Blinder favors the collegial committee form, which benefits from diversity yet transmits a clear and transparent message.

On the subject of leading or following markets, Blinder believes that the central bank should be independent of the markets and not necessarily deliver the policy the markets expect or demand. He does not favor the older tradition that viewed the central bank as the stern schoolmarm that disciplined the markets when they got out of line, nor does he favor the central bank as an eager and respectful student studying at the market's knee. Blinder believes that markets have power and convey knowledge. However, the markets are poor predictors of either interest rates or exchange policy, because the market's time horizon is too short. The markets need to be led, not followed, in order to tame speculative market actions and counter herd behavior, fads, and fancies.

Throughout the book, Blinder presents interesting comparisons of the behavior of central banks world-wide, illustrating their move toward independence from political control and arguing that those who have made the most progress have conducted monetary policy with transparency and through committees.

How does the Federal Reserve System stack up in comparison with other central banks? Virtually all central banks now make immediate announcements of policy decisions, although the openness with which the decisions are made varies considerably. On committees, they vary from the fully autocratic method in New Zealand to the purely democratic method in the United Kingdom, with the United States about in the middle. And modern central banks "increasingly take not only information, but sometimes also advice, from the financial markets."

How does Blinder view the procedures and policies of the Greenspan Fed? On page 6, he states "... Alan Greenspan, whom I would rate as the greatest central banker in history ..." Nonetheless, Greenspan is taken to task for failing to meet Blinder's criteria. On the clarity test, Greenspan often failed. (But to this observer, Greenspan has moved openness and clarity further than any of his predecessors, and he can be forgiven if the markets choose to read into his statements more than he meant to convey.) On the committee level, again Greenspan is criticized as being "about as dominant a chairman as you are ever likely to see," to the point where committee members are reluctant to oppose his views. (This observer questions whether he has been more dominant than Burns or Volcker.) Blinder would much prefer a committee that is individualistic and diversified, "yet collegial and disciplined enough to transmit a clear and transparent message." He also is confident that the FOMC will become more democratic and less autocratic, once Greenspan retires.