"Could A Determined Central Bank Fail To Inflate?"
My key reading of the Obama administration’s macroeconomic stabilization policy is that they failed to recognize the central role of the Federal Reserve. They reappointed Ben Bernanke, confident that this scholar of the Great Depression would take an activist stance and trusting that his status as a conservative Republican would give him cover to enact such measures. They were slugging in nominating people to serve on the Federal Reserve Board of Governors, and didn’t push for their confirmation when they did make nominees, thinking that these jobs aren’t important. They resolutely failed to speak out about monetary issues, trusting in the old gospel of independent central banking. And in June 2010, they proclaimed “recovery summer” basically assuming that the end of economic contraction and the return of growth guaranteed some kind of “catch-up” pace that would put us on a path back to full employment.
In his big look back at stimulus and stabilization policy, Ezra Klein reveals some of the policy thinking that drove this. It’s an important issue, because the key theme of Ezra’s piece is the idea that policies that would have worked were politically impossible and policies that were politically possibly wouldn’t have worked. Where it comes to monetary stimulus, I think the administration sources who Ezra cites are simply mistaken.
He quotes both former Federal Reserve Vice Chair Donald Kohn and former NEC Chairman Larry Summers as expressing skepticism that it would be possible for the Federal Reserve to generate higher inflation expectations under conditions of depressed demand and slack output. It’s difficult for me to know how we would prove this one way or another, but I believe this view is mistaken. What’s more, I think it’s noteworthy that administration officials who say they believe this seem disinclined to follow this line of thought to its logical conclusion.
For starters, a little throat-clearing about the burden of proof. Many of the inflation skeptics have impressive resumes. What they don’t seem to have are empirical examples of central banks determined to raise inflation expectations and failing to do so. We don’t, unfortunately, have a directly parallel case to the current U.S. situation. But on my side I’ll cite as evidence the successful implementations of exchange rate policy by Sweden, Israel, and Switzerland during the current recession. Those, however, are small economy. So I’ll also cite FDR’s gold policy in the 1930s. That, however, was a gold standard. Then there’s QE 2. I would say we have examples of small open economies with determined policymakers doing this successfully. I would say we have an example of a large economy with determined policymakers doing this successfully under different historical conditions. And I would say we have an example of the Federal Reserving acting with only weak determination and achieving weak results. In my view that means our overwhelming presumption ought to be that a determined Federal Reserve system could increase nominal expectations, especially if the president and the treasury secretary supported that goal.
What’s more, it’s important to get a better understanding of why this would help the economy. The Obama administration seems to have thought of higher inflation expectations as useful primarily because they would help with the debt-deleveraging problem. That’s true. But there’s something more profound happening. Higher expected inflation lowers real interest rates and encourages investment. Higher expected inflation, at the margin, spurs consumption among households who aren’t debt-constrained. Most of all, higher expected inflation coordinates expectations so that households and firms expect higher levels of nominal spending and nominal income in the future, which encourages more real economic activity.
Now flip this around. What if I’m wrong. What if Michael Woodford and Paul Krugman and Lars Svensson and Scott Sumner are wrong? What if the academic writing of Christina Romer and Ben Bernanke is wrong? What if there’s something different about the 1930s and Switzerland and Sweden and Israel that means that in the United States you can’t spur higher inflation expectations as long as there’s all this slack in the economy? Well that’d be a pretty wild scenario. I first started to hear about this scenario back in late 2008 from folks who regarded themselves as well outside the mainstream of the economics profession. Their wacky idea was that faced with a deep recession, the government should basically just finance itself by printing money and not bother with the whole taxes thing. The natural counter to that argument was and is that such a policy would be highly inflationary. Personally, I’m old-fashioned, and I think it would be inflationary for the central bank to just print money at random to finance government operations. But by the same token, I have no doubt that a determined central bank can create inflation expectations. So bringing this back around to where we began, I think the Obama team made a huge mistake here and that most of the key players continue to be making the same mistake. Worse, a large fraction of the progressive community keeps making it along with them. But either the Fed could be doing a lot more to fix the economy, or else some really strange fiscal policy ideas need to be adopted.