Imagine two central banks. One is hyperactive, respondingaggressively to events. While it certainly cannot be accused of ignoringcurrent developments, its policies are widely criticized as storing up problemsfor the future.
The other central bank is unflappable. It remains calm in the face ofevents, seeking at all cost to avoid doing anything that might be construed as encouragingexcessive risk-taking or creating even a whiff of inflation.
What I have just described is no mere hypothetical, of course.It is, in fact, a capsuledepiction of the United States Federal Reserve and the European Central Bank.
One popular explanation for the two banks’ differentapproaches is that they stem from their societies’ respective historicalexperiences. The banks’ institutional personalities reflect the role ofcollective memory in shaping how officials conceptualize the problems that theyface.
The Great Depression of the 1930’s, when the Fed stood idlyby as the economy collapsed, is the molding event seared into the consciousness of every Americancentral banker. As a result, the Fed responds aggressively when it perceiveseven a limited risk of another depression.
By contrast, the defining event shaping European monetary policy is the hyperinflation of the1920’s, filteredthrough the experience of the 1970’s and 1980’s, when central banks wereenlisted once again to finance budget deficits – and again with inflationaryconsequences. Indeed, delegatingnational monetary policies to a Europe-wide central bank was intended to solveprecisely this problem.
It is not only in central banking, of course, that we seethe role of historical experience in shaping policymaking. President LyndonJohnson, when deciding to escalate US intervention in Vietnam, drew an analogy with Munich, whenthe failure to respond to Hitler’s aggression had catastrophic consequences. Aquarter-century later, President George H.W. Bush, considering how best to rollback Iraq’s invasion of Kuwait, drew an analogy with Vietnam, where the absenceof an exit strategyhad caused US forces to get boggeddown.
But a key conclusion of research on foreign policy is thatdecision-makers all too often fail to test their analogies for “fitness.” Theyfail to ask whether there is, in fact, a close correspondence betweenhistorical circumstances and current facts. They invoke specific analogies not so much because theyresemble current conditions, but because they are seared into the public’sconsciousness. As a result, analogicalreasoning both shapes and distorts policy. It misleads decision-makers, as it did bothJohnson and Bush.
The same dangers arise for monetary policy. For the Fed, itis important to ask whether the 1930’s, when its premature policy tighteningprecipitated a double-dip recession, really is the best historical analogy toconsider when contemplating how to time the exit from its current accommodating stance.Certainly, the Great Depression is not the only alternative on offer.
The Fed might also consider policy in 1924-1927, when lowinterest rates fueled stock-market and real-estate bubbles, or 2003-2005, wheninterest rates were held down in the face of serious financial imbalances. At aminimum, the Fed might develop a “portfolio” of analogies, test them forfitness, and distill their lessons, as President John F. Kennedy famously didwhen weighing his options during the Cuban missile crisis in 1962.
Similarly, the ECB might consider not only how monetaryaccommodation allowed governments to run large budget deficits in the 1920’s,but also how central bankers’ failure to respond to the financial crisis of the1930’s fed political extremism and undermined support for responsiblegovernment. Again, rigorous analysis requires testing these historicalanalogies for fitness with current circumstances.
Anyone who does so will find it hard to defend the ECB andits stubborn inaction in the face of events. There is exactly zero evidence inEurope today that inflation is just around the corner. And, if current Europeangovernments are not committed to austerity and fiscal consolidation, then whichgovernments are?
When I consider the European economy, the ECB’s failure toprovide more monetary support for economic growth appears to be directlyanalogous to Europe’s disastrous monetary policies in the 1930’s. The politicalconsequences could be similarly devastating. Europeans should ponder why theinflationary 1920’s, rather than the politically catastrophic 1930’s, havebecome the historical lodestarfor current monetary policy.
On the other hand, when I contemplate the US economy, Iconclude that recovery from the Great Depression, and not 1924-1927 or 2003-2005,is the episode that most closely resembles current circumstances. Only in the1930’s were interest rates near zero. Only in the 1930’s was the economydigging itself out from a major financial crisis.
Then again, perhaps it is to be expected that I find theanalogy with the 1930’s compelling. That was the defining episode for Americanmonetary policy. And I am, after all, an American.