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Book Review: Central Banking in Theory and Practice


Central Banking in Theory and Practice
by Alan S. Blinder (Cambridge, Mass.: The MIT Press, 1998); 92 pages; $20.

In one of the most insightful passages in The Wealth of Nations, Adam Smith argued:

“The statesman, who should attempt to direct private people in what manner they ought to employ their capital, would not only load himself with a most unnecessary attention, but assume an authority which can safely be trusted, not only to no single person, but to no council or senate whatsoever, and which would nowhere be so dangerous as in the hands of a man who had the folly and presumption enough to fancy himself fit to exercise it.”

Such hubris can be found on practically every page of Alan Blinder’s recent book, Central Banking in Theory and Practice. Originally delivered as the 1996 Lord [Lionel] Robbins Lectures at the London School of Economics, the ideas in the three chapters making up the volume precisely reflect the type of mentality about which Adam Smith wished to warn us.

Alan Blinder is a professor of economics at Princeton University. He has co-authored with William Baumol a widely used principles-of-economics textbook. He is an articulate and prominent New Keynesian economist. And he recently served as vice chairman of the Board of Governors of the Federal Reserve System. Indeed, he epitomizes in many ways John Maynard Keynes’s own ideal of a policymaker: highly intelligent; seemingly unbiased and dispassionate, while possessing a strong sense of doing service for “the public interest”; and persuaded that, while there are important strengths in the private-enterprise system, government intervention in the market is essential to maintain economic stability and growth.

Professor Blinder conveys just the right amount of modesty in admitting the limits of both economic theory and historical evidence to prevent any impression of ideological dogmatism. But just below the surface, he suffers from that “pretense of knowledge” that Friedrich A. Hayek pointed out almost always underlies the thinking of the social engineer and the political manipulator of the market.

Starting from the assumption that society needs a central bank to keep the market economy on a stable trend of full employment, low inflation, and economic growth, Professor Blinder explains what he considers the way a central banker should operate. To begin with, he should realize that he is pursuing multiple goals at the same time, so they will have to be balanced against each other. Second, he must have an econometric model (a statistically constructed conception of market interrelationships) to project into the future, to estimate both where the economy seems to be going and what the impact would be if policy tools at the Federal Reserve’s disposal were applied in various quantitative ways.

He admits that no one knows the “correct” statistical model of a modern complex market economy. The interrelationships are too intricate and the quantitative interconnections are constantly changing owing to shifts in various factors on both the supply and demand side of the market. So his answer is simply to simulate through the computer as many of the different econometric models as possible, exclude any extreme results, and then operate on the basis of an average of all the rest.

The fundamental problem, of course, is that policies are then being implemented on the basis of an aggregated average of numerous other averages that are summarizing all the individual market decisions and relationships that are really at work in a constantly changing market process. Any change in central-bank monetary policy guided by such an average of many other averages must necessarily affect the numerous individual price, wage, resource-using, and production decisions in ways that distort market information on the basis of which the millions of people in the economy are actually attempting to bring their supply and demand activities into balance with others in the arena of exchange. Thus, it is inevitable that the monetary policy meant to keep the economy on an even keel will, in fact, destabilize the market.

In the second chapter, Professor Blinder asks what policy instrument the central bank should focus on in trying to influence the “path” the economy will follow. True to his Keynesian moorings, he discounts giving any primary attention to the money supply. Instead, he says that the Federal Reserve should target short-run interest rates, which the Fed can more or less directly influence by adding to or subtracting from the bank reserves upon which the commercial banking system extends loans to the market.

The essential error in this policy perspective is that it almost totally disregards the fact that interest rates are real phenomena, just like all the other prices and wages in the market. Interest rates, when not manipulated by political authorities and central banks, affect the real forces of supply and demand between savers and borrowers. And as such, interest rates are meant to keep investments in balance with the available savings. Central-bank monetary manipulations, therefore, always threaten to push investment decisions out of balance with the actual savings in the economy, and as a consequence, bring about dangerous mis-directions of resources in the production sectors of the economy.

Finally, in the last chapter, Professor Blinder makes the case for central-bank independence. By “independence,” he means the power to implement monetary policy. The goals of monetary policy, he believes, ultimately must be decided in the democratic arena of the political process. Since politicians can be swayed by the temptations of short-run vote getting, the central bank, once given its marching orders concerning the goals to follow, should have the autonomy to implement that policy according to how the wise and dispassionate central bankers think it should be done.

Aren’t central bankers influenced by political agendas or ideological biases? Not according to Blinder. From his two years on the Board of Governors of the Federal Reserve System and from his interaction with the central-bank managers of the major nations of the world, Professor Blinder now knows that they are generally just like him: only concerned with the public interest and the common good. They are like modern “philosopher-kings” only wanting to do right for all of us. And in their hands can be trusted the smooth operation of the monetary order of America.

It is a shame that those who are invited to deliver the Lord Robbins Lectures at the London School of Economics never seem to take the time to acquaint themselves with the writings of the economist in whose honor they are asked to speak. Though he was not an advocate of extreme laissez faire, Lionel Robbins, especially in his writings in the 1930s, always emphasized the dangers from government mismanagement of money and the monetary system. Robbins, therefore, advocated a market-based monetary system such as a gold standard precisely because men, no matter how well intentioned they may think themselves, could not be trusted not to abuse and distort the natural working of the market order. It is too bad that the late Lord Robbins was not in the audience when Alan Blinder delivered his lectures to correct his hubris and pretense of knowledge.

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    Dr. Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).