As a department chair at a university, you learn that a promise from the Dean or anyone else in the administration is good for about five years. That’s approximately how long Deans last, on average, and when a new Dean arrives past commitments are not necessarily honored. Promises from administrators are not credible no matter how much assurance is given that a commitment is permanent.
Politicians are subject to the same type of credibility problem that plagues academic administrators. To what extent can Obamacare, or anything else, be regarded as a permanent change in government policy? A new president or a new Congress can potentially undo any legislation, administrative rule, or anything else enacted in the past.
But politicians have an additional credibility problem over and above their inability to make long-run commitments. Little of what politicians say can be trusted even during the years they are in office. And with Trump saying whatever comes to his mind, or whatever a particular audience wants to hear, his erratic behavior, and his tendency to contradict himself, who knows what to believe? Nothing is credible until it happens, and even then it might be reversed.
Credibility is essential in both monetary and fiscal policy. It is easily lost, and once it is gone it takes a long time to rebuild. Monetary policy provides a good example. During the inflation problems that plagued the 1970s, the Fed promised again and again that it would get the situation under control. Then the next year inflation would be even higher than it was before.
People quickly learned that the Fed’s promises about inflation, and by association anything else, were meaningless. It’s like a spouse who promises to be home at a particularly time, and then consistently shows up hours late. After awhile, those promises mean nothing. Even if the behavior does change it will take a long time for trust – credibility – to be restored and a lingering doubt may always be there.
The Fed finally began rebuilding its credibility when Volcker took control in 1979. The Fed tightened monetary policy under Volcker and that led to the 1982 recession. The Fed was heavily criticized, but its political independence allowed it to endure and the policy turned out to be a success. After that, during what is known as the Great Moderation from the early 1980s through 2007, inflation continued to fall and it eventually leveled off around the Fed’s inflation target.
The Fed had finally gained credibility about its inflation promises, but it took decades. Even now many people –- especially those who remember the 1970s – do not fully trust the Fed to keep inflation under wraps. All of the fears about out of control inflation hyped during the Great Recession testify to that (though in many cases the criticism leveled at the Fed was politically motivated).
Why should we care about the credibility of monetary and fiscal policymakers? For fiscal policy, economic theory tells us that temporary changes in government spending will have a larger impact on the economy than permanent changes. But if Congress announces that an increase in spending is a temporary measure that will be reversed when the recession ends (we promise!), will people believe it?
If not, if most people believe that once government spending is put into place it never goes away (which is a myth), then fiscal stimulus will not be as effective as it could be. Conversely, if the government announces a permanent reduction in the size of government, will anyone believe that whatever cuts are made are truly permanent? If not, if people believe that cuts to spending will likely be restored at some point, perhaps when the other party takes back control of government then the cuts will have a more severe impact on the economy than they would otherwise.
Credibility is just as important, if not more so, for the Fed. When the Fed has credibility, its ability to keep inflation on target is enhanced. And if inflation does go up, credibility allows the Fed to bring it back down without creating a deep recession. I expect, but can’t be sure, that when the time comes Trump will replace Janet Yellen with someone who is at least competent, though I will likely disagree strongly with his or her views on policy. But what will happen with the other six members of the Board of Governors?
There are currently two openings (Republicans refused to confirm Obama’s nominees for these positions), and if recent history is any guide Trump, like Obama and Bush, will appoint most if not all of the Board by the time his term ends. Will he appoint people who are at least competent, or, like so many of Trump’s other appointments to important government positions, will they be cronies with little or no experience who are being rewarded for their loyalty?
Will they be politically independent or beholden to whatever monetary policy changes Trump wants? If they are both lacking in experience and unwilling to go against Trump’s wishes, which seems to me a very real possibility, will anyone have confidence in the Fed? Will it be able to keep the credibility it worked so hard to establish and protect?
I don’t have much faith in Congress when it comes to fiscal policy (or anything else). The little faith I once had that Congress would at least set aside politics and do what’s best for the economy during a severe economic crisis was shattered by Republican obstructionism during the Great Recession. But at least we’ve always had a relatively politically independent Fed that kept its eye on what’s best for the country rather than on winning the next election.
The Fed has made mistakes -- nobody and no institution is perfect -- but for the most part it’s done an admirable job over the last few decades of managing monetary policy (its handling of regulatory policy is another matter). If Trump compromises the independence and competency of the Fed, we will lose the only effective policymaking body we have left, and the next recession will be more severe than it needs to be. We know who will be hurt the most if that happens, and it won’t be the people still smiling about the huuuge tax cuts they got from Trump.