Last November John Hempton wrote an amusing post arguing that Ben Bernanke’s problem was that the Fed’s credibility was too high, thus creating a liquidity trap, and to solve this Bernanke should do something crazy like appear on television wearing a Hawaiian shirt and smoking a spliff.
John Kay’s latest FT column looks at the problem of credibility, although more in a fiscal than a monetary context. As he points out, we frequently hear now that credibility is the problem besetting heavily-indebted governments. Credibility is seen as a kind of panacea but Kay points out it’s only a very recent concept in economics: not in Keynes, not in Smith, not in Marshall. It dates back to a 1979 article by Finn Kydland and Edward Prescott, he says, who won a Nobel economics award for their work on the subject.
Kay says it’s a sensible idea: households and businesses want price stability, and therefore a strong and independent central bank is needed to curb the tendencies of politicians to over-promise. But he says its mantra-like ubiquitousness goes too far:
Modern economics reframed the issue in the language of credibility: the key to price stability is the credibility of the plan for price stability. Arguments based on faith are impossible to refute: if magic fails, it is because we do not believe enough in magic, if credibility fails to bring about the desired outcome, it is because our commitment is too weak to establish credibility. Since the only markets in which you can immediately see prices adjusting to economic events are securities markets, these markets’ movements provide the test of credibility.
The problem is that bond market participants are not all-wise and all-knowing. Financial market participants’ knowledge of public finances depends on “conventional wisdom and on what they have just read in the FT or seen on CNBC”. (Ahem.) Meanwhile, he says, “Ordinary people’s expectations are derived from Fox News and tabloids.”
What this means is that a doctrine arising from the need to ensure stability ends up actually threatening stability:
The credibility the models describe is impossible in a democracy. Worse, the attempt to achieve it threatens democracy.
Kay points to Greece and the Lib Dems, and other examples are not hard to find.
And in what countries might this credibility exist? There was a popular argument around a few years back that the “state capitalism” embodied by the likes of Russia and China might hold some advantages over western democracies with their profligate ways. Yet there’s not only growing scepticism over China’s increasingly odd economic data and poor corporate governance; there’s always the ever-present fear that a slowing of growth might allow frustrations to boil over. And among the resource states, even the rulers of the non-democratic Gulf countries are having to pay a high price to keep their populations happy. It’s not without its costs but fortunately for them, they don’t need to convince bond markets of their credibility…
The dogma of ‘credibility’ endangers stability – FT
Buy Ben Bernanke a marijuana pipe and an Hawaiian shirt – Bronte Capital
Of emporers and kings – The Economist