Gaps between perceptions and reality, although having no basis in mainstream economic theory, could nevertheless have serious economic consequences..

In a previous article we argued that perceptions (of serious economic problems) could become self-fulfilling prophesies. This would be very serious indeed if those perceptions were just that, perceptions (we have a feeling they’re not, sorry).

Even if the perceptions have a sound basis in reality, they have the potential to reinforce the economic downturn, but at least that would constitute rational economic behaviour, adaptation to changing economic circumstances.

Now, lets consider another situation in which a gap between perception and reality might become harmful to the economy.

First up, the effectiveness of monetary policy. This is crucially affected by the credibility of the policy makers. If economic agents detect a gap between their talk and their propensity to act, monetary policy becomes a lot less effective. Let’s discuss.

Central banks face an awkward choice between combating inflation, which requires higher interest rates and tighter monetary conditions, and combating the worsening economic problems, which requires maintaining low rates, or even lower ones and looser monetary conditions (more money creation by the Fed).

What can the central banks do? Not a whole lot. A strategy we liked was proposed by Melvyn Krauss, who suggested that the ECB (European Central Bank) should concentrate on figthing inflation and the Fed should keep the economy from collapsing. A division of labour of sorts.

This is a good idea (and more importantly, it’s happening) as the economy is a bigger problem in the US, and inflation is the bigger problem in the EU. But, as we will argue shortly, there are a couple of other reasons for this efficient division of labour.

A strategy which is often applied by many central banks to moderate the rather steep trade-off between fighting inflation and fighting the recession is the use of words. Basically, what central banks try to do is to talk inflation down. How are they doing that?

Basically, it’s a kind of impression management, uttering tough talk like saying thinks like you’re pursuing a “strong dollar policy” (despite all evidence of the contrary). It’s basically signaling potential actions, but for these signals to have any effect, they need to be credible.

Signaling is supposed to work by reducing inflationary expectations. If economic agents become convinced that policy makers in central banks mean business in the fight against inflation, they will factor in the increasing likelihood that, if inflationary problems become serious, central banks will take the necessary action (tightening monetary conditions by, for instance, increasing interest rates).

The effectiveness of such signaling thus crucially depends on central bank credibility. This, in it’s turn, will depend on some of the following:

• Most importantly, the track-record of previous central bank actions. If economic actors assess whether a central bank means business when it talks tough about inflation, the best place to look for evidence is what they’ve done in similar circumstances in the past. It’s here that the ECB has an edge over the Fed, hence another reason we promised above that the division of labour between both banks (one, the ECB, concentrating on the fight against inflation, the other in keeping the economy alive).
• The mandate of the central bank. The ECB mandate is considerably more hawkish on inflation (containing provisions like inflation being their only concern, and against monetary financing of fiscal deficits). The Fed is instructed to fight both inflation and economic downturns, leaving it with a lot of discretionary powers in case those objective become contradictionary, as in the present circumstances
• One could appoint a terribly conservative person to be the head of a central bank, an inflation hawk. Remember the fight over who was going to be the first ECB president (the late Wim Duisenberg won the day, as he was seen as being more in tune with the hawkish Bundesbank tradition, over the current president Jean-Claude Trichet)? Here, there is not a whole lot of difference between the ECB and the Fed
• One crucial factor to consider is the central bank’s dependence on the political system. It has often been argued (and there exist a good deal of empirical support) that making central banks completely independent of politics would enhance their ability to fight inflation, and hence enhance their credibility. Why? Basically, politicians want to be reelected, it might not be opportune for them to embark on hard anti-inflationary policies (which have a habit of increasing unemployment and even create recessions), especially if elections are due. This can better be ‘outsourced’ to a technocratic, independent central bank (as long as the president does not get fired for it, which can be easily remedied by giving him a fixed term mandate)
• Economists have even come up with innovative schemes, like tying pay to the success of the fight against inflation. To our knowledge, this hasn’t been tried yet, but it’s typical of how economist think.