The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.Compare this to the Bernanke of yesteryear:
With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the BOJ would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. (And, as I will argue, the Bank does have tools to move the economy.) But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does. The alternative is that the private sector be left to its doubts about the willingness or competence of the BOJ to help the macroeconomic situation.The Japanese situation is close to my heart. I received most of my macroeconomic training while I was studying in Tokyo, and was there when Bear Sterns went bust (the ensuing appreciation of the Yen against the Dollar sent me home earlier than expected). It was a fascinating time to be studying macro, not least of all because it seemed like all the economic policy-makers were forgetting everything that I was learning. After the Bear Sterns episode, I overheard a fellow econ student ask another, "Do you think America's gonna go down the same route as Japan?" The other student said, "No, we've learned from Japan." But have we?
In the late 1980s Japan experienced one of the most fantastic stock market and real estate bubbles in history. One of my favorite factoids is that at the height of the mania, the few dozen acres of land around the imperial palace in central Tokyo was valued higher than all the real estate in California (a state roughly the same size as all of Japan). Banks spent all their deposits speculating in the markets and lending to anybody with a pulse, cuz everything was making money. When it all came crashing down in 1990 all the major banks had bullet holes in their balance sheets. To prevent an avalanche of bankruptcies, the government stepped in to recapitalize the banks, but all the money went to covering up holes, lending more and more to insolvent firms so they wouldn't have to write off the loans and take the up front loss. During all this, the BOJ's response was lethargic, and inflation expectations fell off a cliff. Japan experienced deflation throughout most of the 90s, and besides a good 5 year run in the mid-00s, their economy has never recovered. Any of this sound familiar?
I've lost several nights worth of sleep over the last couple years wondering what the hell Bernanke is thinking. His and most other economists' diagnosis of the Japanese Slump was that the BOJ failed to maintain stable, positive inflation expectations, that all the efforts to hold up the banks, to boost demand through fiscal policy were for naught. So what did he do as soon as there was a financial crisis on his hands? Let inflation expectations collapse, and call for trillions of dollars to be poured into banks' coffers and public works projects.
So why'd he do it? I've heard several ideas, none of which sit too well with me. One is that the Fed's recent rapid increase of the money supply, insufficient as it is, has scared lots of Congressmen who don't understand how monetary policy works, and who have started putting pressure on the Fed. True, lots of legislators have been making noise lately about the inflationary seeds we're sowing, but I find it hard to believe any Congressman cares more about 10% inflation tomorrow than 10% unemployment today. Maybe the only thing more outrageous than Bernanke's behavior is Congress's decision to reappoint him. Would Congress have canned him if he'd done what was necessary to maintain 2% inflation, thereby keeping unemployment below 6% and the recession very mild? Maybe, but I kinda doubt it.
Another idea is regulatory capture. When you're head of the central bank, you hang out with lots of bankers. And when you hang out with lots of like-minded, rich, powerful people, you start thinking like them. Obviously the execs at Citi, BoA, Chase, etc. wouldn't very well have preferred the plan Bernanke supported for Japan: let all banks that need to die, and simply open the floodgates of the money supply to compensate, so they convinced him that they were too important to let go. "Just give us a little more money, you know we're good for it! And try to keep inflation down real low or we won't be able to make money holding government bonds. Like, 0% would be sweet." I could see this being the case for Henry Paulson, who came from the world of investment banking and wouldn't wanna kick some of his old friends out in the street, but Bernanke's an academic, he's only been on speaking terms with Wall Street for a few years and has written extensively on what to do when they start causing trouble. It's hard to believe he could've been converted to the dark side so quickly.
The American economy is more resilient than Japan's, but I still worry we're in for a similarly long stretch of anemic growth because of our monetary authorities' inability to keep steady hands in the face of calamity. Why every economist in America isn't calling for Bernanke's head right now is itself a minor tragedy worth exploring, but I'll save that for another post.
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