This has been a banner week for the world economy, inspired largely by events in the United States.
In Washington, the first congressional testimony from Janet Yellen in her position as new Federal Reserve Board chairwoman reassured and impressed two notoriously petulant audiences: Tea Party congressmen, who had assembled a posse of hostile witnesses to attack the Fed’s “easy money” policies; and panicky Wall Street investors, who had spent the previous month swooning on fears that monetary policies might not be easy enough.
The significance of Yellen’s testimony lay not in the fact that she was a bit more “dovish” than former Chairman Ben Bernanke, or seemed more committed to the new central bankers’ fad for “forward guidance,” as opposed to “quantitative easing.” More striking, if subtle, was the change in economic philosophy that Yellen represented.
Bernanke, despite his radicalism during the financial crisis, was philosophically an orthodox monetarist, who followed his mentor Milton Friedman in believing that the main job of a central bank is to stabilise inflation. For monetarists, consistently hitting an inflation target is, in normal circumstances, a sufficient criterion of monetary policy success. They believe that using monetary policy for other economic objectives, such as stimulating growth or creating jobs, is doomed to failure and ultimately leads to galloping inflation.
Once inflation is stabilised, monetarists explain, the “real” economy should be left to market forces. These determine the optimal levels of unemployment and growth that a low-inflation economy can achieve.
Yellen’s testimony, in contrast, revealed Keynesian thinking, which views monetary policy as just one instrument, if perhaps the most important, in a complex macro-economic toolbox that has to be used proactively to achieve a broad range of both monetary and real objectives. Not just moderate inflation, but also full employment, strong growth, financial stability and perhaps even better income distribution.
Keynesians disagree with the monetarists’ view that inflation control should always be a higher priority for the central bank than full employment.
More fundamentally, Yellen seems to believe along with many modern Keynesians, that because monetary policy must deal with many conflicting objectives, central banks must adopt a “control engineering” approach. Instead of trying to hit a single inflation target precisely, they should try to keep numerous economic variables—unemployment, growth, capacity utilisation, financial leverage—within tolerable limits, focusing most attention on whichever variable is veering furthest away from the acceptable range.
Before the 2008 fiscal crisis, many investors and business leaders would have been