Comment in the FT by Professor Stephen Cecchetti

Published in the Financial Times on May 11, 2005

Stephen Cecchetti Professor at the Brandeis International Business School

Federal Reserve Chairman Alan Greenspan's recent remarks about the need to reform social security and return the US government budget to a sustainable long-term path reminded me of an apocryphal story involving a more cautious Mr Greenspan. He speaks regularly with financial journalists. His comments are strictly off-the-record and not for attribution. One day, a journalist asked Mr Greenspan about the foreign exchange value of the dollar. After being reassured more than once that the session was indeed off-the-record, Mr Greenspan responded. "No comment."

Recently, central bankers have been loosening their lips on topics that are not directly related to their brief. European central bankers have voiced support for the enforcement of the European Union's stability and growth pact; Russian and Chinese central bankers have talked about the value of their currencies; and South Korean central bankers have said they might diversify some foreign currency reserves away from the US dollar.

When central bankers talk, people listen. When the Korean bankers talked, the dollar fell. This brings up an important question: what should they say and when? Should the chairman of the Fed comment on social security and tax policy? How about the value of the dollar? No central bank governor can speak publicly in a personal capacity. They speak for their institutions, always. All central banks take care to speak with one voice when discussing policy. So no one inside the Fed, for example, would publicly contradict Mr Greenspan on any subject.

As a rule, central bankers restrict their comments to areas of direct responsibility: monetary policy. But there are many opportunities when they choose not to speak, even though they are very knowledgeable. Before becoming chairman of the Federal Reserve Board, Mr Greenspan both served as President Gerald Ford's chief White House economist and headed a committee to review the social security system. He knows quite a bit about the foreign exchange value of the dollar and does speak about it in private with his colleagues at the Fed. In public, he defers to the US Treasury Secretary.

Central bankers in countries where customs are different do regularly comment on exchange rate policy. After all, a country with open capital markets cannot control both its exchange rate and its domestic interest rate. Financial markets force that difference in interest rates in two countries to equal the expected movement in the exchange rate between their currencies. So, where interest rate policy is made by an independent central bank, exchange rate policy is, too.

What about fiscal policy? Profligate government spending can lead to inflation. Large public debts and deficits put pressure on monetary authorities to inflate. The comments of Jean-Claude Trichet, president of the European Central Bank, about the need for enforcement of the agreement that eurozone governments restrain their deficits are clearly justified on this basis. Central bankers have an obligation to speak out when faced with a fiscal policy decision as obviously at odds with monetary policy objectives as this one.

The recent experience in Argentina proves the point. During 2001, the governments of the Argentinean states exhausted their ability to raise revenue through either taxation or borrowing in financial markets. To meet their obligations, they printed low-denomination bonds that looked just like cash. By issuing their own money, regional fiscal authorities subverted the central bank's authority and made it impossible for monetary policymakers to control domestic inflation. Again, this is such bad fiscal governance that central bankers have a duty to say so.

But questions about how big the government should be, what it should do and how it should be financed are for elected officials to answer. In order to insulate them from political pressure, which almost always leads to inflation, central bankers are appointed and not elected. They are given the very narrow and powerful job of running monetary policy. And with this comes the responsibility not to comment in public on policies outside their authority.

On matters of tax and expenditure policy, central bankers, including Mr Greenspan, should tread carefully. When politicians' actions threaten price stability, then central bankers have an obligation to speak. Otherwise, and regardless of how knowledgeable they may be on the topic, they should remain silent.

Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.