I’ve been rereading Larry Ball’s impressive and disturbing what-happened-to-Ben-Bernanke analysis — an analysis that, I happen to know, has caused much consternation in some circles. (“Surely it can’t be just groupthink! There must be very good reasons the Federal Reserve hasn’t done more!”)
And I think there’s a way to further refine Mr. Ball’s analysis, published on Feb. 28 on Vox, the Center for Economic Policy Research’s online policy portal — a way that makes more sense of Mr. Bernanke’s retreat from earlier positions, albeit one that still doesn’t cast a very flattering light on the Fed.
Mr. Ball, a professor of economics at Johns Hopkins University, starts from what many of us had already noted: The former Fed chairman’s harsh early-naughties critique of the Bank of Japan’s inadequate response in the face of the zero lower bound — its “self-induced paralysis” — applies with almost eerie precision to the Bernanke Fed. So the question is: What happened?
Mr. Ball gets much more specific by pointing to an apparent shift in 2003, following a Federal Open Market Committee discussion of policy at the zero bound.
As Mr. Ball parses it, before that meeting Mr. Bernanke endorsed at least as possibilities:
- Targeting long-term interest rates
- Currency depreciation
- Money-financed deficit spending
- A Krugman-style inflation target
After 2003, however, his menu seemed to have been reduced to:
- Guidance on future short-term rates (the rates the Fed sets)
- Purchases of long-term bonds and other nonconventional assets
- “Oversupplying reserves” — that is, just pushing up the monetary base
Call these Menu A and Menu B. Mr. Ball speculates about why Mr. Bernanke was willing to give up on Menu A, and lays it down to small-group sociology; what he doesn’t say, unless I’ve missed something, is what defines the difference between Menu A and Menu B.
Well, here’s my take: Menu A involves the Fed’s setting targets that can be achieved only if the markets believe that it will persist with unconventional policies even as the economy recovers; ordering from Menu A requires, as I put it lo these many years ago, that the Fed “credibly promise to be irresponsible.”
Menu B, on the other hand, involves more or less mechanical actions that the Fed can definitely take.
Or if you like, Menu B is about instruments; Menu A is about targets that the Fed might not succeed in hitting. Now, what I just said about Menu A may not be totally obvious, so let’s go through the list.
First, what does it take to target long-term interest rates? Since long rates are mainly determined by the expected path of short-term rates (but over a long horizon), it means making a more or less credible commitment to keep short rates low even when times look better. So it’s a credibility thing.
Currency depreciation is much the same thing: the value of a currency depends largely on investors’ comparisons of expected returns over a longish horizon. So again, you can only keep your currency weak if you can credibly commit to low-interest policies far into the future, or otherwise the markets will defy you (see what’s happening in Japan!)
Skipping ahead, inflation targeting — which was my original contribution here — is, of course, about credibility since you don’t have immediate leverage over inflation while the economy is still depressed.
And what about money-financed deficits? This sounds at first like something you can just do, not a commitment issue.
But here’s what you should ask: How do you know whether a deficit is money-financed? As long as you’re in a liquidity trap, it doesn’t matter at all what it says on the zero-interest pieces of paper you issue. What matters is what happens after you emerge from the liquidity trap, and that depends on how the central bank acts: does it withdraw the monetary base it created when the economy was depressed, or does it let it stay out there and cause some inflation?
In other words, you don’t know whether a deficit was really money-financed or not until the zero bound is no longer binding, and hence the effectiveness of allegedly money-financed spending depends on expectations — again.
All this stands in sharp contrast to Menu B. True, short-rate expectations are about the future — but they’re about the near future, so there’s much less of a credibility issue. Having the Fed say that it will probably keep rates low until 2014 in the face of a depressed economy is very different from having it say that it will keep rates low until inflation hits 3 or 4 percent.
So now we can ask, why has the Fed been willing to go for Menu B but not Menu A?
Well, Mr. Bernanke answered that question — not about himself, but about the Bank of Japan, which back in 2001 he described as being unwilling to announce a target it wasn’t sure it knew how to achieve.
He castigated the Bank of Japan for this attitude — for being unwilling “to try anything that isn’t absolutely guaranteed to work.”
And then he became a central banker himself.
You can see where I’m going here. Menu B is, if you like, safer for the Fed than Menu A, because it is defined in terms of actions rather than results; the Fed can point to what it is doing, rather than announce a target for long-term rates or inflation that it might fail to hit.
So Menu B serves institutional objectives better.
Unfortunately, it doesn’t do the job for the economy.
To be fair, we don’t know that Menu A would, in fact, be sufficient. But Bernanke the Younger would have said that this was no reason not to try.