The Myth of the Omnipotent Central Banker

The Alchemists: Three Central Bankers and a World on Fire. BY NEIL IRWIN. Penguin Press, 2013, 400 pp. $29.95.

Central bankers have always carried a mystique far beyond justification. Even as their policies and procedures have become markedly more transparent, the air of secrecy and power about them persists. And the ongoing financial crisis has brought their activities to the center stage of both economic policymaking and political attention, even as the crisis has revealed many inherent limitations of monetary policy and economic forecasting more broadly.

Indeed, central bankers should be far humbler today than they were in recent decades, when some claimed credit for the so-called great moderation, the period of reduced economic volatility that lasted from the late 1980s to the early years of this century. It is now clear that the prosperity and stability much of the world enjoyed during those years were largely the result of good luck. Nevertheless, monetary policy is a powerful tool, even if it is less powerful than many think.

The journalist Neil Irwin’s book The Alchemists: Three Central Bankers and a World on Fire thus has an unfortunate title. Central bankers are hardly inconsequential, but their policies cannot transform economic fortunes as an alchemist turns dross into gold. This limitation notwithstanding, Irwin’s book is an excellent account of how central bankers have responded to the financial crisis, scrupulously reported and full of clear explanations of events and economic concepts. On the whole, it is an incredibly valuable book for all economically concerned non-economists. As someone who knows well the three central bankers that the book features -- Ben Bernanke, the chair of the U.S. Federal Reserve; Mervyn King, the former governor of the Bank of England; and Jean-Claude Trichet, the former president of the European Central Bank (ECB) -- I can attest that the narrative has more than just a ring of truth. It gets the individuals, the circumstances surrounding their decisions, and their motivations right and also presents them fairly. Irwin’s volume will have lasting value for a wide range of audiences, including students and elected officials, but it will make its greatest contribution as a corrective to the many unfounded or simply crazy ideas about monetary policymakers’ intentions and impact.

THE HUMAN ELEMENT

There have already been a number of very good journalistic treatments of the financial crisis, such as David Wessel’s In Fed We Trust and Carlo Bastasin’s Saving Europe, which achieve the impressive feat of getting the macroeconomics correct while remaining comprehensible. The Alchemists does this and then some, providing an international perspective. Looking at three central banks is better than looking at one to underscore just how much the success of monetary policy and financial intervention depends on national institutions, politics, and circumstances. Irwin stresses how much the top central bankers seem to belong to a common club, but the general impression that the reader receives is one about the diversity of their approaches and concerns, even as they responded to parallel challenges.

One of the most important aspects of The Alchemists is that it dispels the widespread notion that central-bank policy is driven by highly technical models or subtle, well-planned conspiracies. Monetary policymaking may be more conceptual than striking budget deals or writing financial regulation, but it is far from mechanical. Irwin explains about as accurately as possible just how many disparate factors influence the monthly decisions of the U.S. Federal Reserve’s Federal Open Market Committee, the Bank of England’s Monetary Policy Committee, and the ECB’s Governing Council.

It is important to bear in mind, as Irwin makes clear, that these are all truly committees. The chair has varying degrees of influence in each one, but in all three, multiple voices debate and independently vote -- as the former Bundesbank president Axel Weber proved in May 2010 when he refused to support bond buying in Greece. (Or as I did during my time on the Monetary Policy Committee when I pushed for more quantitative easing in 2010–11, against some of my colleagues’ wishes to raise interest rates.) Even when there isn’t open dissent, policy committees at central banks are subject to the same dynamics as any other committee, with members digging in their heels on their positions at repeated meetings, issues coming up over and over again without resolution, and people using rhetorical tactics to try to win over their colleagues.

The reason for all this disagreement is that macroeconomic forecasts are not just inherently imprecise but also somewhat judgmental. Central banks do not possess models that simply spit out forecasts. Thankfully, Irwin describes in detail the processes by which forecasts and recommendations are made at the various banks, such as the production of the Teal Book, which presents the Federal Reserve staff’s outlook and forms the basis for the Federal Open Market Committee’s deliberations. Such model-based exercises are useful as the starting point for conversations, because they force committee members to spell out their positions and identify where their assumptions differ. And they are easily worth the thousands of hours they take to produce, given that their analyses can help the committee select better policies. But as Irwin accurately portrays, the staff forecasts are just the start of the conversation, and they rarely determine policy decisions.

The view central bankers have of the national and global economies is partial, often misleading, and constantly in flux. Important economic data are compiled with a lag, and the figures are subject to radical revisions long after decisions have to be made. Once decisions are made, moreover, monetary policies can take a year or two to have their full impact -- typically well after the next few rounds of decisions have already been finalized. Given all the other factors at play, it is exceptionally difficult to assess even in hindsight the impact monetary policy has on an economy. (That is why Thomas Sargent and Christopher Sims won the Nobel Prize in Economics in 2011 for their contributions to “identifying the effects of monetary policy shocks.”) In truth, central bankers possess hardly any inside information that the markets and the media do not have access to -- save for an understanding of how they themselves think about data.

Ultimately, of course, policymakers cannot interpret data without choosing a theoretical framework as their guide, but even here, disagreement reigns since there is no single consensus theory of macroeconomics. Irwin captures nicely the difficulties of making macroeconomic assessments in real time in his chapters about the Federal Reserve in the 1970s and the Bank of Japan in the 1990s. Anguish, agony, and aggravation are part and parcel of a central banker’s job. Being a voting monetary policymaker is a rare privilege, but it can and should be trying for one’s intellect and one’s ego.

THE ELECTED AND THE SELECTED

The Alchemists delivers a good picture of how politics enters monetary policy decision-making: it is always there in the background, occasionally distracting and forcing tactical changes, but decisive only when the committee chair wants it to be. Other reviewers have justly praised Irwin’s recounting of how the Federal Reserve Bank presidents intervened in the negotiations over the Dodd-Frank financial reform legislation to save the Fed’s role in supervising smaller banks. Yet as much as anything, the tale reveals that the monetary policy decisions made by the Federal Open Market Committee during this period came out where the intellectual debate led; that is, they were not altered to preempt congressional actions regarding the Fed’s structure.

Politics was critical, however, in the dealings of the Bank of England in 2010 and of the ECB in 2010–12. During those periods, the leaders of the two central banks chose to risk their reputations in public debates over government deficits and fiscal policy -- something that Irwin shows Bernanke carefully avoiding on the other side of the Atlantic. When the ECB changed presidents in November 2011, from Trichet to Mario Draghi, interest-rate increases that had been enacted the previous spring were quickly reversed with cuts -- despite greater political pressure on the newly installed and Italian Draghi than there had been on the French Trichet to toe Germany’s anti-inflationary line.

Irwin smartly spends a lot of his later chapters, particularly those dealing with the euro crisis, on the interaction between fiscal and monetary policy (as well as on the broader interaction between elected politicians and unelected central bankers). This uneasy dynamic remains a major issue today and the subject of great concern on both sides of the Atlantic. In the United States, some worry that the Federal Reserve is doing too much and letting Congress and the Obama administration off the hook for budget failures, while in Europe, some fear that the ECB is usurping democracy by imposing austerity over the heads of elected officials.

Irwin depicts the wide differences in opinion among economists and policymakers over how central bankers should react to elected officials’ failure to make hard budget choices. These differences, it turns out, do not always line up neatly with partisan affiliations. To his credit, Irwin stays within the bounds of journalistic neutrality on this issue. Although one can pick up signs that he believes Bernanke was right to stay out of the U.S. fiscal debate and that King, by contrast, overstepped during the 2010 British election and the early days of David Cameron’s tenure as prime minister, these signs are far from overt. Irwin’s treatment of the dilemmas imposed on the ECB by fractured European decision-making illustrates well the challenging interplay between central bankers and politicians.

GETTING THE DOSAGE RIGHT

Despite its international perspective, The Alchemists reveals, perhaps inadvertently, a critical truth: central banks focus primarily on their own economic domains, and cross-border policy cooperation is rare. Irwin narrates vividly how the major central banks came together in October 2008 for the first coordinated interest-rate cut in history and how the Federal Reserve assisted partner central banks that were running low on dollar reserves. These highly constructive actions were taken jointly, but they were unprecedented in the history of central banking, and they were taken in response to unprecedented circumstances. Accordingly, they did not set a new precedent for central-bank cooperation.

Although he exaggerates the commonalities among the three central bankers, Irwin accurately portrays their rotating sense of frustration after these initial coordinated successes. First, the rest of the world was annoyed by the Federal Reserve’s willingness to let quantitative easing drive down the value of the dollar, irrespective of what that meant for small economies (which subsequently faced massive inflows of capital). Next, the Fed and other central banks became exasperated with the ECB for its refusal to take seriously, let alone resolve, the euro crisis. I remember feeling an incredible sense of powerlessness and anger during the summer of 2011, as European officials seemed to be fiddling while Rome, Madrid, and Athens burned, when everybody could see that the peripheral countries’ problems would eventually become the United Kingdom’s, and even the United States’, problems, too. Having shared bottles of Burgundy in Basel or thesis advisers at Harvard or MIT did not prevent central bankers from going their own ways without regard for the spillover effects on others. That may have been the right approach, and it was certainly the one most likely to be seen as legitimate by their respective national electorates, but it was hardly a demonstration of the kind of community that Irwin evokes.

Finally, it is important to revisit the book’s title, which delivers a misleading picture. Especially in the first part of the narrative, a history of central banking from the mid-seventeenth to the early twenty-first century, Irwin portrays the creation of credit and the ability of central banks to stop financial panics as akin to alchemy -- a magical process of making something valuable out of virtually nothing. This is unfortunate. All around the world, money and credit are as old as civilization. Central banking is a valuable institutional innovation, much like organized police forces and democratically elected assemblies, but it is hardly magic.

This lack of magic cuts both ways: monetary policy should be neither feared as something mysterious and incomprehensible, accessible only to a few masters, nor relied on as a silver bullet. One can learn a good amount of monetary economics from Irwin’s book, but it is important not to buy into its awestruck tone.

That’s why I would have titled the book The Pharmacists instead. The role of a central banker, after all, is not so different from that of a pharmacist: with a limited medicine cabinet, and restricted by law from exceeding certain bounds, both must make sense of scrawled prescriptions from differing specialists, decide what side effects to take into account, and then ultimately dispense the proper dosage of medicine to their customers, all without knowing or controlling everything else the patient is consuming. The best they can hope for is that the patient recovers steadily over time, with a minimum number of negative side effects.