The Central Banking Confidence Game

Monetary policy, at heart, is largely about confidence. Yes, the main tool that a central bank has at its disposal is the level of overnight interest rates, but the level of overnight interest rates, in and of itself, has relatively little direct impact on an economy. Two things are more important: liquidity (how easy it is to borrow money), and longer-term interest rates. And both of them are essentially a function of confidence – specficically, confidence in the long-term health of the economy.

Now it's true that central bankers alone can't guarantee the long-term health of the economy. There are a myriad of other factors over which they have little if any control and which also help determine the health of the economy, including fiscal policy and geopolitical decision-making both in their own country and in other countries. But the general idea is that central bankers look at the net effect of all those factors and then make their own, final adjustment on the interest rate front to bring the economy to its optimum level.

It's an almost impossible job, and very smart and able central bankers like Paul Volcker have failed at it. Weirdly, however, in recent years central bankers worldwide seem to have become vastly more successful at their jobs. And it's not because they all discovered the Secret Potion of Monetary Policy, or sold their souls to the devil in exchange for long-term sustainable growth with low inflation. Rather, the Great Moderation helped to keep growth up and inflation down, and in turn helped to convince the financial world that central bankers knew what they were doing. And if the financial world thinks that you know what you are doing, that turns out to be at least as important as actually knowing what you're doing.

If the financial world thinks that you know what you're doing, that means that it thinks that you and your successors are going to be able to keep inflation under control for the next 30 years. In turn, that means long-term interest rates will be nice and low. Furthermore, if long-term interest rates are low, and inflation is under control, and the prospects for the economy look rosy, then people will be much more willing to lend money than if they fear recession and/or inflation. So liquidity improves, as well.

Which brings me, finally, to Alan Greenspan and Ben Bernanke. There's a lot of Greenspan revisionism going on right now, with people changing their minds and deciding that the Maestro wasn't nearly as good as they thought he was. They're right, and not only because no one could have been as good as they thought he was. But the fact remains that while Greenspan was chairman of the Fed – at least until his final years – he did an absolutely magnificent job of persuading everybody that he knew what he was doing. Which, of course, is often as important, or more important, than actually knowing what you're doing.

There's good reason to believe that Bernanke is the other way around: he's good at what he does, but he's bad at persuading the markets that he's good at what he does. As Yves Smith says:

That's the real difference between Greenspan and Bernanke. Greenspan wasn't a very good Fed chairman (I am permitted to say that, since I first publicly got on his case in 2000), but he had the media eating out of his hand. He may have stumbled into his Wizard of Oz act, but the impenetrable statements and the aura he created that he alone could read the economic tea leaves was a brilliant bit of showmanship. I can't help but think that his girlfriend, later wife Andrea Mitchell was instrumental in his success. Bernanke, by contrast, is concerned with the substance of his role, and less attentive to the theatrics. That will impair his effectiveness, particularly if he takes an unpopular course.

There's one problem with all this, however. The best way to become a popular central banker is to cut rates. What happens if you do that and it turns out that you cut to much? You end up with temporary popularity even as you bequeath nasty bubbles to your successor. In turn, your successor could cut rates as well, and become just as popular, but at the risk of compounding your error. It's not easy, being Ben Bernanke.