Tying your own hands – 5/8/2023 – Why? Economês in good Portuguese

Minister Simone Tebet said, in a recent interview, that now the Central Bank would have no more excuses for not reducing the interest rate. However, this speech, precisely, presents a reason for this.

In Homer’s Odyssey, upon returning home from a long ten-year journey, Ulysses and his crew pass through an area inhabited by sirens, whose song is beautiful but fatal. Ulysses wants to hear him out, but he doesn’t want to die; the solution to the dilemma is to tie yourself to the mast, so that the temptation to throw yourself overboard does not materialize. For sailors, the recipe is ear wax (look how important and outrageous income inequality was at that time!).

Hence the expression “tying one’s own hands”, which if not properly entered the literary canon, has enjoyed tremendous success in economics texts at least since 1983, the year of publication of “Rules, Discretion and Reputation in a Model of Monetary Policy”. , article on the time inconsistency of monetary policy written by Robert Barro and David B. Gordon, still famous economists.

The temptation of monetary policy is to promise low inflation rates without delivering them a posteriori. Why? Because once economic agents form their expectations about prices and these are embedded in wages, rents and interest rates, the government can pressure the monetary authority to surprise a little upwards, leaving inflation looser. This in the short term generates a fall in the public debt (because real interest rates are lower), an increase in investment and an increase in employment (because real wages are lower).

In other words, with the laxity of the Central Bank, a small burst of growth may occur. But it’s chicken flight. Short. People learn the trick and then what happens is the worst of all worlds, the sum of all fears! The economy ends with higher inflation and not even a chicken flight occurs. Hence the need for some expedient à la Ulysses.

In most countries that faced high inflation due to crooked monetary policies, the radical and efficient solution was to give them up completely. The subject adopts the dollar, the German mark, the euro, directly or indirectly by fixing the exchange rate at an immutable parity. Inflation starves to death, disappears. But it is an extreme remedy, and the side effects soon appear: with a fixed exchange rate, external deficits grow and may become unsustainable, for example.

Another possibility successfully adopted by several countries around the world is to isolate the Central Bank from political pressures, granting it operational independence. Not in terms of goals, but in terms of not interfering with the task of pursuing them. And give him a clear mandate, and charge him to comply with it.

Who establishes these objectives is not the Central Bank, but the Parliament or the Executive, democratically elected. With this arrangement, which of course can vary in implementation details from country to country, the problem of temptation is controlled, inflation is anchored at low levels most of the time, and everyone (with the possible exception of opportunistic politicians) wins.

Several members of the government and the governing party have been attacking the Brazilian Central Bank, in a pressure never seen in the history of the Republic, for the immediate reduction of the interest rate. This is interfering with operational independence. It is untying the knot that prevents Ulysses from throwing himself into the sea and meeting his own death.

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