In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting. But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?
It is with regret that we announce the death of Inflation Targeting. The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2008. That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.
Inflation Targeting was born in New Zealand in March 1990. Admired for its transparency and accountability, it achieved success there, and soon also in Canada, Australia, the UK, Sweden and Israel. It subsequently became popular as well in Latin America (Brazil, Chile, Mexico, Colombia, and Peru) and in other developing countries (South Africa, South Korea, Indonesia, Thailand and Turkey, among others).
With November’s election fast approaching, the Republican candidates seeking to challenge President Barack Obama claim that his policies have done nothing to support recovery from the recession that he inherited in January 2009. If anything, they claim, his fiscal stimulus made matters worse. And, despite recent improvement, the level of unemployment indeed remains far too high.not blame George W. Bush for the recession that began two months after he took office in 2001. There hadn’t yet been time for bad policies to damage the economy.)
My preceding blogpost, the Hour of the Technocrats, was inspired by the recent accession of Mario Monti and Lucas Papademos, both professional economists, to the prime ministerships of Italy and Greece, respectively. Today we turn to the U.S., where the political process seldom views academic credentials benevolently.
In the United States, Senator Richard Shelby scorned President Obama’s 2010 nomination of Peter Diamond, an eminent MIT Professor of Economics, and prevented his confirmation as a governor of the Federal Reserve Board. The Alabama Senator farfetchedly claimed that the nominee was not qualified, and persisted despite the coincidence that Diamond won the Nobel Prize in Economics soon after his nomination (deservedly). But, then, Shelby was holding up an astounding 70 of President Obama’s nominations, just to try to get two pork projects in his home state funded. Diamond finally withdrew in June 2011, because Shelby and other anti-technocratic Senators had blocked the confirmation process for 14 months and were clearly going to continue to do so. Diamond, like Axel Weber in my preceding blogpost, was comfortable foregoing the limelight.
The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2. Ben Bernanke and his colleagues are right not to give in to these attacks.
Critiques seem to be of four sorts. (Some are mutually exclusive.)
1) “QE is weird.” Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations. This has been a bold strategy, which nobody would have predicted 3 or 4 years ago. But it has been appropriate to the equally unexpected financial crisis and recession. Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past. It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.” The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s. But as an economic historian, Bernanke had just the broader perspective that was needed. Thank heaven he did.
In 2008, the global financial system was grievously infected by so-called toxic assets originating in the United States. As a result of the crisis, many have asked what fundamental rethinking will be necessary to save macroeconomic theory. Some answers may lie with models that have in the past been applied to fit the realities of emerging markets — models that are at home with the financial market imperfections that have now unexpectedly turned up in industrialized countries.The imperfections include default risk, asymmetric information, incentive incompatibility, procyclicality of capital flows, procyclicality of fiscal policy, imperfect property rights, and other flawed institutions. To be sure, many of these theories had been first constructed in the context of industrialized economies, but they had not become mainstream there. Only in the context of less advanced economies were the imperfections undeniable. There the models thrived.
Some conservatives are attacking current U.S. monetary policy as being too expansionary, as likely to lead to excessive inflation and debauchment of the currency. The Weekly Standard is promoting a letter to Fed Chairman Ben Bernanke that urges a reversal of its policy of QE2, its new round of monetary easing. The letter is signed by a list of conservatives, most of whom are well-known Republican economists, some associated with political candidates. Apparently the driving force is David Malpass, who was an official in the Reagan Treasury, and he is taking out newspaper ads later this week. This follows similar attacks on the Fed by politicians Sarah Palin, Mike Pence, and Paul Ryan.
Robert Zoellick put a few sentences about gold toward the end of a column in today’s FT that are drawing a lot of attention. I doubt very much if the World Bank President has in mind a return to the gold standard, but goldbugs and critics alike are talking as if he does.
Even if one placed overwhelming weight on the objective of price stability — enough weight to contemplate a rigid straightjacket for monetary policy — gold would not be a suitable anchor. The economy would be hostage to the vagaries of the world gold market, as it was in the 19th century: suffering inflation during periods of gold discoveries and deflation during periods of gold drought. This is well-known. I am confident Zoellick understands it. (He and I were in the same macroeconomics seminar at Swarthmore College in the 1970s.)
Alan Greenspan was right to raise the question “How do we know when ‘irrational exuberance’ has unduly escalated stock prices?”, which is what he actually said in 1996. But he was wrong to conclude subsequently that monetary policy should ignore asset prices (or even that it should take asset prices into account only to the extent that they contain information about future inflation, as the Inflation Targeters would have it). More specifically,
(1) Identifying in real time that we were in a stock market bubble by 2000 and a real estate bubble by 2006 was not in fact harder than the Fed’s usual job, forecasting inflation 18 months ahead;
(2) Central bankers do have tools that can often prick bubbles; and
(3) The “Greenspan put” policy of mopping up the damage only after run-ups abruptly end probably contributed to the magnitude of the bubbles ex ante, while yet being insufficient ex post to prevent the crisis from becoming the worst recession since the 1930s. All three points run contrary to what was conventional wisdom among monetary economists and central bankers a mere two years ago.
The National Journal asks views on a recent proposal for financial reform:
“The Dodd bill on financial regulatory reform embraces a supposed solution to the ‘Too Big To Fail’ conundrum: Contingent Convertible Bonds, or CoCos, which turn into equity once a bank’s capital falls below a certain level.”
I do think that measures such as the Contingent Convertible Bonds would be a useful step. Some argue that it would be hard to know when to invoke the contingency clause.It strikes me that this argument largely vanishes when one realizes that the clause would of necessity be invoked by the time we got to the stage of a Bear Stearns or Lehman Brothers bankruptcy. CoCos would not go very far in themselves toward comprehensive reform of the financial system, if that is the goal. But then no single policy measure would do that.I agree with Gillian Tett: “In theory, I think that CoCos certainly could be a useful additional to banks’ tool kits. However, in practice, the contagion risk suggests it would be dangerous to rely too heavily on an exclusive diet of CoCos for any policy ‘fix’.”