The great bubble debate: can both sides be right?

• Author: Connolly, Bernard
• Position: Cover story

The publication of this year's Annual Report of the central banks' bank, the Bank for International Settlements, ruffled some distinguished feathers among the organization's membership. The Fed chair made a direct attack on the BIS (which she referred to somewhat dismissively as "certain quarters"), and Mark Carney, chairman of the Financial Stability Board as well as governor of the Bank of England, said that the BIS recommendations were made "in a vacuum" which ignored "economic and political realities." What had the BIS done to disturb the central banking consensus? It had implied that the major central banks' approach was wrong: more emphasis should be placed on maintaining financial stability--notably by avoiding the "reach for yield" and the bubbles it engenders--and less on getting inflation back up to a somewhat arbitrary target; in consequence the major central banks, the BIS said, were underestimating the risks of not "normalizing" interest rates quickly enough.

There is now, for the first time since the 1970 struggles between "Keynesians" and "monetarists," an intellectual debate going on within the monetary policy world. As Keynes said, it takes a theory to kill a theory, and the theory which the BIS report suggests (although it does not fully articulate) would kill the theory worshipped almost religiously by central banks--or at least by the industry of theoretical macroeconomists working in central banks.

But the political economy of the macroeconomics/ central banking industry will not permit the changeover in theory that is so obviously required after the dramatic failure of the central bank model, responsible at bottom for the global financial crisis (see my article in the Fall 2008 issue of TIE). It is sometimes suggested that the debate is between "Keynesians" (the central banks) and "Wicksellians" (the BIS), the former school being concerned with setting interest rates to stimulate economy so as to get back to full employment, the latter group with keeping interest rates in alignment with the "natural" rate that ensures monetary equilibrium, somehow defined.

That characterization is not correct, however. Both sides are "Wicksellian" (indeed, the supreme intellectual guru of the central banks, Michael Woodford, entitled his magnum opus Interest and. Prices in explicit homage to Wicksell, and Keynes himself was extremely "Wicksellian" in the Treatise). Both see the aim of monetary policy as being that of keeping market interest rates in alignment with the natural rate. However, the canonical central bank model, a Woodfordian elaboration of the so-called New Neoclassical Synthesis, sees the...