(Wellesley College, Public domain)
CE Financial Observer: Central banks are attempting to „manage” the business cycle in order to eliminate crises. But isn’t this task too ambitious?
Professor Daniel Sichel: The question of the role of central banks remains open. I believe — and just to be clear, I say this as a former employee of the Board of Governors of the Federal Reserve System — it is better that they exist than if they didn’t exist at all. The economy would be worse without them. The alternative to a system based on central banks is private creation of money, and I don’t believe that this would work. Besides, before the creation of central banks crises had happened more 0ften than after they were established.
The real impact of central banks on the incidence of crises is still the subject of an economic debate. What is certain, however, is that central banks make serious mistakes.
Of course they do. The biggest of them was the Fed’s inadequate response to the Great Depression of the 1930s, or the fact that they failed to predict the recent financial crisis and prevent its outbreak. But I think that the Fed and other central banks learn from such events. These lessons enable them to operate better afterwards. It seems to me, for example, that were it not for the steps taken by central banks in the crisis of 2008, the downturn would have been much more serious.
Are you talking about the policy of quantitative easing?
Among other things.
Well, I know some economists who claim that by undertaking such activities the central banks themselves are sowing the seeds for subsequent crises. One example could be the reduction of interest rates in response to the dot-com bubble of 2001, which later contributed to the emergence of a real estate bubble. Don’t you agree?
I believe that the seeds of crises are sown by long periods of prosperity and stability. Such as the one that we experienced from the mid-1980s, until the first years of the new millennium. In good economic times, all market participants become too complacent. This applies to entrepreneurs, consumers, and regulators. It is the complacency which makes us ignore the danger signals that is the real source of crises. Along with insufficient knowledge.
Let’s take the low interest rates following the bubble in the internet market which you’ve mentioned. Where did they come from? At that time, in the Unites States, people feared that just like Japan the country would fall into the trap of deflation, which is as dangerous as inflation. From the point of view of today’s knowledge, where we have access to revised data on the price levels at that time, we know that these fears were unfounded. But from the point of view of the knowledge that we had at that time, they were perfectly reasonable. We can also ask whether another crisis really wouldn’t have occurred if the interest rates had been reduced in a slightly less radical manner? Econometricians have calculated that it wouldn’t have made much difference at all. The cause of the crisis was something other than the monetary policy. In addition to the aforementioned complacency, there were also all these new types of debt-based derivatives which concealed the risk in the system.
Derivatives are very frequently mentioned in the diagnoses of the recent crisis. They represent financial innovation. Today, we also have a lot of innovation in finance, such as the blockchain technology and cryptocurrencies. Some also consider them to be dangerous. What methods should we use to distinguish between good and bad innovations in finance?
Appropriate regulations are crucial. Firstly, the regulations should motivate market participants to produce good, productive innovations. They should provide the right incentives for that. Secondly, the regulations should be simple and tight enough to ensure that they don’t provide an incentive to develop products aimed at circumventing the law. Many of the pre-crisis derivatives were such innovations, where the intention of their creators was to deceive, to steer clear of the regulator’s watchful eye, to take advantage of legal loopholes. In this way, they concealed the risks that they carried.
But risk is not bad in and of itself. It is the essence of market activity.
That’s right. But it’s bad to conceal risk. The regulatory reform in the United States was supposed to make it more difficult to hide the truth about the offered products.
Was it successful?
To a large extent. Either way, we have to remember not to go to the extremes. Innovations are also necessary in finance. Besides, it is in the nature of financial markets to search for new ways to make a profit. The regulators should simply try to keep up with the changes. The cryptocurrencies that you’ve mentioned, and especially blockchain, are very interesting and promising innovations that could facilitate the conduct of market transactions and their verification. We shouldn’t stifle them.
Even if the cryptocurrencies try to compete with traditional money?
I don’t think this would happen. Money has three main functions — it is supposed to be a store of value, a unit of account, and a means of exchange. Cryptocurrencies do not work in all of these three fields. This is because their quotations are too unstable and due to their very nature there cannot exist an institution stabilizing their exchange rate. In the case of paper money, prices are stabilized by central banks. In fact, when it comes to settlement purposes, cryptocurrencies are currently only useful for people who want to avoid the supervision of the authorities.
Will central banks not issue their own cryptocurrencies?
I don’t think so. There’s no need for that. It is clear, however, that the broadly understood digital revolution is also affecting the sphere of banking and finance, and this cannot be ignored.
In 1997, you published a book on the impact of computers on productivity.
Yes. Or to be more precise, the lack of such impact. I was expanding on Robert Solow’s remark that computerization can be seen everywhere but in productivity statistics.
Has the digital revolution, and above all the internet and mobile solutions, already become visible in such statistics?
First of all, it is a very difficult methodological task to capture the impact of technological changes if they are of a qualitative nature. It is easy to show, for example, that performing a given task, say, transcribing and editing an interview, takes you half as much time as before, but it is harder to show that this happened as a result of access to better software, and not because you have learned to be more focused on your work. Given phenomena only start becoming visible to statisticians after they have reached a sufficiently large scale and after a sufficiently long period of time has passed. When it comes to the digital revolution, it is still rather poorly visible in the productivity statistics, but let’s not be fooled! The effects of the popularization of the Internet could become visible in a manner similar to the emergence of personal computers. In 1997, this market was still statistically unnoticeable, but that changed three years later, when I was publishing another work in this area. But it is true that in 1997 I failed to predict the increase in the importance of computers.
Many economists make forecasting errors.
That’s true [laughs]. I think that the digital revolution will become fully visible in productivity statistics within the next couple years.
And what about the negative impact of this revolution on productivity? Will the statistics also account for that? Constantly browsing Facebook and staying up all night to play video games in the multiplayer option are probably the bad sides of the digital revolution, right?
Every technological change has its good and bad sides. But the fact that new technologies are also providing a new kind of entertainment is not necessarily a bad thing. When personal computers were first introduced, the expenditures on games also accounted for a significant portion of consumer spending on software. When the telegraph was invented, most messages were trivial in nature. Utility and entertainment are not mutually exclusive. In fact, they are rather inseparable.
One of the sources of the previously mentioned dot-com bubble was the blind fascination with new technologies and the assumption that we know the direction in which they will be developing. Is it easier to identify trends that really matter in 2018 than it was two decades ago?
It is still difficult to clearly identify technologies that will have a large and positive impact on economic growth. We’re mostly talking in generalities that these will be robotics, 3D printing, artificial intelligence, without pointing out specific applications. And when we do point them out, we are often wrong. This is the nature of innovations — we don’t know which of them really are groundbreaking and sometimes we end up going down blind alleys. That was the case with the dot-com companies, but it was also the case with airlines in the 1920s. At that time, there was a boom in this market and everyone wanted to own the shares of aviation companies, which were mainly carrying mail back then. One company completely unrelated to aviation industry even changed its name to one that contained the word „Airlines” and the prices of its shares immediately spiked. And then there was the crash of 1929.
You have worked not only at the Board of Governors of the Federal Reserve, but also at the United States Treasury Department. There is much talk about the impact of politics on the economic decisions made by such institutions. Have you ever felt that economic theory is not the only thing that matters there?
What counts at the Fed is above all the substance and not the politics. Of course, it does happen that politicians try to influence central bank governors, like Reagan, who was urging Paul Volcker not to raise the interest rates, but these are exceptions. When I started working at the Fed, fresh after graduating from Princeton, I thought that I would experience some enlightenment there, but it struck me how little central bankers really know about the economy and how much humility is required in such work.
Is it also the case at the Treasury Department?
No. Politics is much more important there. Let’s face it, it’s about satisfying the wishes of the incumbent president. This does not mean, however, that substance and economic theory do not matter at all. After all, when I worked at that office, the Deputy Secretary of the Treasury was Larry Summers, who is one of the world’s greatest economists.
Some people point out that in the public financial institutions there are too many people linked to the world of high finance, which in a way corrupts them. Have you noticed such a phenomenon?
It is obvious that if only former Goldman Sachs employees worked at the Fed or at the Treasury Department, then even if their decisions were solely based on good intentions, they would still be warped in some way by a specific way of looking at the world. Institutions need to have a diverse personnel, and I think that this is now recognized more broadly. This is confirmed, for example, by the new nominations for the heads of the Federal Reserve branches. The new presidents come from different backgrounds and have pursued different types of careers.
Finally, I would like to ask about America’s national debt. It now exceeds 105 per cent of GDP. Some people claim that the United States could borrow money indefinitely by printing more banknotes. Is that true?
No. With the USD as the global reserve currency, we are in a privileged position. But this does not mean that we escape the laws of economics in this way. Ultimately, every debt must be paid back, and the American authorities should finally acknowledge this fact.
Haven’t they done so already?
I don’t think so. In any case, no one is doing anything about it.
Professor Daniel Sichel is an economist, lecturer at the Wellesley College, and the former employee of the Federal Reserve, United States Department of the Treasury, and the Brookings Institution.