Critiquing “Orthodox” Central Banking

Modern mainstream economic recommendations for central banking encourage a strict monetary policy remit of singularly managing inflation through the policy interest rate. [e.g. Woodford; 2004] The justification for this position mainly arises from New Consensus Economic’s abstract micro-foundations methodology and the practical inhibitor of the Lucas Critique. By complying with this simplified framework, orthodox central bankers believe their modern practices have a supposed universality of applicability that defends their narrow intentions and renders creative thought unnecessary .

Yet, even a simple analysis of the methodological idiosyncrasies of the mainstream practice immediately expose the limitations of its recommendations. Furthermore once heterodox economic opinions are introduced to recount theoretical oversights and contrasting suggested practices, it becomes apparent that the supreme universality claimed by the orthodoxy collapses. Additionally, political economy evidence of monetary policy from central banks around the world illustrate the feasibility and greater beneficial capacity of contrary practices – especially for developing nations and during times of economic stress.

Orthodox Monetary Policy: The Recommendation

In the modern era of central banking subsequent to the Bank of England’s famous “Never explain, never apologise” persona of the 1930’s and the Great Depression, monetary policy interaction focused dually on “nominal anchoring” and “the stability of credit”. [Leijonhufvud; 1998]. That is, managing inflation and the availability of credit in the economy. During 1950’s-early 1980’s, Central bankers across the world worked closely with ministries of finance to actively (and perhaps haphazardly) manage economies with pseudo-Keynes logic from formalised interpretations such as the Hick’s IS-LM model and the Mundell-Fleming IS-LM-BP model.

However in the post-Bretton Woods landscape, where the strict commodity money discipline of the Gold Standard is a distant memory, modern monetary policy has been absolved of the formal responsibility of managing credit availability and solely targets inflation using ‘scientific’ calculations.

The theoretical explanation of the relief of 50% of central banks’ traditional monetary remit lies in the solidification of the orthodoxy’s broad arrival to New Consensus Economics (NCM). This period was practically initiated by New Zealand’s central bank in the 1990, and soon followed by Chile, Canada, the UK, Spain, Brazil, Finland, the Philippines – among others.

NCM’s abstraction heartily assumes that the real economy behaviourally maintains an Intertemporal General Equilibrium. Identikit rational individuals with objective foresight operate in a perfectly competitive environment, thereby uniformly creating optimal pricing for assets and goods throughout the economy. The only differentiating characteristics between economies are the availability of physical and human capital – financial sector structure is a neutral issue whilst path dependency issues are irrelevant.

In this universal framework central bank intervention to actively manage the real economy or credit availability is unnecessary, because the heroic perfect actors and the supporting environment constantly and consistently allocate optimal credit allocations and real output. “Attempts to regulate real activity are as endless as they are futile. The bank has no power over real rates of interest and no sensible purpose would be served by attempts to regulate the volume of credit.” [ibid.]

Inflation retains its position of ongoing concern only because the maintained influence of the Philips Curve in the research project’s framework. Arguably, this is because of the political intuitiveness of the principle that there is a static trade-off between inflation and unemployment, and in spite of its flawed origins and weak-to-poor statistical evidence. Furthermore it does fit well in NCM’s static analytical methodology, disengaging dynamic considerations, and hence continues to influence regardless of its paucity.

The problem with only focusing on Real Inflation

It is clear that the model guiding orthodox monetary policy lacks the energy to accurately portray reality. Thus the standing critique that such a failing limits the capacity of useful advice for the actual policy. Others have better charted the wider insufficiencies of the orthodoxy’s methodology and practice (e.g. Fine and Milonakis; 2009), as such we shall not focus much further on that here. However we will return to the explicit monetary policy / central banking issues that arise.

Targeting real inflation, whilst meritorious in principle, involves significant practical issues that cracks the supposed universality of its effectiveness. Giving nominal values greater consideration is unlikely to weaken the given performance of monetary policy and is likely to improve its capacity.

Firstly, the objective is singularly focused upon targeting the aggregate “Real” rate of inflation and not nominal. Mainstream proponents suggest that this is because economic agents (their super-agents) only base economic activity upon real variables, having the purity of thought to not be distracted by nominal trifles. As raised by Keynes however, nominal changes do affect behaviour and decisions, and often drastically. Few actors can feasibly recalculate real values on the fly as accurately as suggested, nor as consistently as needed.

Furthermore, most imperfect real actors do not actually concern themselves with the aggregate real rate of inflation at any given time. Individuals focus on the inflation of their personal basket of goods, which may vary drastically from the aggregate real level of inflation. [Wray; 2007] This is particularly important in heavily class stratified economies, where particular inflation rates may only effect certain classes of baskets. This causes dynamic effects in society that are extremely difficult to model/predict/weight and as such suggests that the true effectiveness of central policy based upon the aggregate figure alone may be insufficient.

Additionally, even the orthodoxy’s ‘scientific’ methodology contained by the Taylor Rule inherently contains projection issues. It uses approximations of historic/current inflation to calculate real inflation, then builds an ex-ante approximation of a forward facing policy interest rate. The extent to which something built to fight an unknown future using a largely unrepresentative past is unlikely to completely and universally achieve its goal. And once market sentiment is considered, reaction to ex-ante policy rates will create even greater dynamic unforeseeable results.

A broader potential

The best example of such an approach in recent years comes from the People’s Bank of China (PBoC). The PBoC uses: multiple policy interest rates, Required Reserve Ratios, Overnight rates, ‘Guidance’, and Repo rates and Open Market Operations – all in concert to govern the economy. The goals of the PBoC also takes a heterodox classic Keynesian theme with a dual targeting of price stability and economic growth.

Evidence in the post Global Financial Crisis world also illustrates that first world nations are not beyond diverging from orthodox theory in an attempt to achieve economic goals – in this setting to explicitly stave of the lingering threats of economic calamity. The US, UK and Japan have all engaged in significant Open Market Operations, in the form of Quantitative Easing, to support super easy monetary policy. Although such policies have had great unforeseen international implications, the point being made here is that central banks may need to aggressively deviate from mainstream monetary recommendations as the orthodoxy’s policy does not maintain its sufficient universality to manage economies.

Orthodox monetary policy is singularly focused, a laser targeting into an oncoming mirage. However central banks have frequently illustrated that policy can achieve multiple goals when differentiated tools are utilised. Keenly, this practically illustrates that else wise following orthodox recommendations insufficiently maintains economic stability and feasible desirable objectives. The increase in number of tools used in collusion can help a central bank better manage multiple factors of a dynamic economy better than a single tool managing a single target. Still, the effectiveness of the approach is dependent on the ability of authorities to centrally manage multiple tools cohesively.


Leijonhufvud, A. (1998). Monetary theory and central banking. Universita degli Studi di Trento.

Milonakis, D., & Fine, B. (2009). From political economy to economics: Method, the social and the historical in the evolution of economic theory. Routledge.

Woodford, M. (2004). Inflation targeting and optimal monetary policy. Review – Federal Reserve Bank of Saint Louis, 86(4), 15-42.

Wray, L. Randall (2007). A post-Keynesian view of central bank independence, policy targets, and the rules-versus-discretion debate, Working papers. The Levy Economics Institute, No. 510

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