How to Make Central Banks More Accountable for Passive Tightening

Yesterday we learned that despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now. In the Eurozone, ECB president Jean acknowledged the Eurozone economy faces “particularly high uncertainty and intensified downside risks” yet chose, along with the rest of the ECB authorities, not to further loosen monetary policy. Across the Atlantic, Fed Chairman Ben Benarnke gave a speech where he too acknowledged the economy was surprisingly weak. He then noted that the “Federal Reserve has a range of tools that could be used to provide additional monetary stimulus” that he and other Fed offiicials “will continue to consider… at our meeting in September…” In short, both central banks have decided to sit on the sidelines for now despite the ability and need to do more.

There is a term for this. Its called a passive tightening of monetary policy. It occurs whenever a central bank passively allows total current dollar or nominal spending to fall, either through an endogenous drop in the money supply or through an unchecked decrease in velocity. This failure to act when aggregate demand is falling has the same impact of the stance on monetary policy as does an overt tightening of monetary policy. Bernanke has made this point himself recently as a justification for maintaining the size of the Fed’s balance sheet. The passive tightening of monetary policy is like school crossing guard who could have but failed to stop a student from running into traffic. Though the guard didn’t cause the student to cross into traffic, he still bears responsibility for failing to save the student.

Now the damage done by a passive tightening is no different than that of an overt tightening. The only difference is that the public is more aware of the overt form. Consequently, the ECB and the Fed are not questioned for the harm they cause by allowing such passive tightening of monetary policy. Thus, most people observing the economic problems in Europe and the United States never connect the dots between these central bank’s inaction and what they are witnessing. This allows the central banks to be conservative, play it safe, and not be held accountable for their passive tightening.

There is a way to change this. Introduce a market for nominal GDP futures contracts. It if were a deep and liquid market, it would provide real time analysis on market expectations of future nominal spending. And since the market’s forecast of future nominal spending affects current dollar spending, it would provide real time analysis on how a central bank is actively and passively shaping the current stance of monetary policy. For example, if a nominal GDP futures market existed currently for the U.S. economy it would probably indicate a sharp tightening of monetary policy. The public would then interpret this as a dereliction of duty by the Fed.

Such a market would instantly asses the nominal spending impact of any speech, news, action, or inaction taken by the central bank. The Fed would not have the luxury to sit on the sidelines. Having the Fed’s performance judged in real time would make it far more accountable. This is why Scott Sumner has been arguing for it for so many years. And this is why we need it so badly today.

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