In 1995, Cambridge University Press published in its Journal of Economic History an article by John R. Garrett titled, "Monetary Policy and Expectations: Market-Control Techniques and the Bank of England, 1925-1931". Garrett begins by referencing Richard Sayers who, as the official Bank of England historian with full access to confidential archives, revealed in a 1976 book titled, "The Bank of England 1891-1944," that the Bank had influenced interest rates by manipulating reported gold flows between 1925-1931. Based on such enigmatic evidence, Garrett (1995) "models expectations manipulation as a monetary policy channel," and shows that "gold flow falsification was over two-thirds as effective as an open-market operation."
As Garrett noted, "These results contradict accepted new classical models and suggest that credibility benefits from new classical policy are small." The enigma within a paradox relates to the concept of 'rational expectations' as described below:
Following the twists and turns in this "riddle, wrapped in a mystery, inside an enigma" is the implication that the 'rational expectations equilibrium' paradox is being turned back on itself by the central banks themselves. It is not just that central banks are using game theory to manage expectations (and by implication models based on rational expectations), the 1925-1931 Bank of England episode illustrates a situation where economic reality was changed by a central bank despite it being based on a lie. In Garret's words:Our working paper investigated various models which deal with the potential sources of return to speculators in the futures market, including one of our own which exemplifies the complexity of these markets. Admittedly, models are only an abstraction from reality. Expecting such models to be exactly right is unreasonable, and it is generally understood that neoclassical economic theory has inherent limitations related to the analysis of markets within the context of “rational equilibrium systems.” Such systems are based on perfect competition, and assume markets naturally return to equilibrium after a disturbance. Hence, modern finance seeks to maximize utility and/or profits in a world of constraints based on the choices of “rational” economic agents. By definition then, these models relegate speculators to the role of that very agent which maintains equilibrium. Yet a survey of real-life speculators reveals that these practitioners do not as a general rule use academic models in their day-to-day trading decisions. Paradoxically, this same group plays a key influence upon the selfsame futures data from which such models are constructed. So if the data series is assumed to represent equilibrium and “the future is merely the statistical reflection of the past,” then one could inversely argue that perfect competition and rational expectations minimize these models’ usefulness as a mechanism from which to make speculative decisions. In other words, rational expectations compel such models to simply validate that current price data is equal to equilibrium, unless the opposite is true—that markets are in fact imperfect and rational expectations is untenable, which in turn undermines the veracity of these models. [Source: The Search for the Beta of Commodity Futures]
The article "Priceless: How The Federal Reserve Bought The Economics Profession" adds support to this idea of an enigma within a paradox, and lends credibility to concerns of economic/market groupthink. In the words of Morpheus: "I imagine that right now, you're feeling a bit like Alice. Hmm? Tumbling down the rabbit hole?"Markets can not tell when a central bank is lying. They then have the option to accept all or reject all forecast information emanating from the central bank. Under such circumstances the credibility model asserts that private financial markets reject all central bank information. This is possible because the financial markets' private information is assumed to be almost com- plete. However, the results presented here contradict this assumption and lend support to the opposite case: the markets' private information is so incomplete that they can not dispense with central-bank sources. The implication for the credibility model is devastating because perva- sive ignorance and uncertainty allow the central bank to maintain its position as a disseminator of forecast information even if the central bank is guilty of extreme dishonesty, as under Norman. Under these circumstances monetary policy will be an effective instrument to stabilize the economy against both money demand and real shocks, which contradicts the core result found in the large and influential credibility-model literature.
John Garrett - Monetary Policy and Expectations
References:
Garrett, John R. (1995) "Monetary Policy and Expectations: Market-Control Techniques and the Bank of England, 1925-1931" The Journal of Economic History, Cambridge University Press, Sept. 1995, pp. 612-636
Frankfurter, Mack and Accomazzo, Davide (2007) "Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures" (December 31, 2007). Available at SSRN: http://ssrn.com/abstract=1029243
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