It’s worth thinking about where we are in the Great Recession, relative to the same time period in the Great Depression:
1.a October 1929, stocks crash on sharply falling expectations of NGDP growth.
1.b October 2008, stocks crash on sharply falling expectations of NGDP growth.
2.a Early 1931, stocks rise on signs of recovery
2.b Early 2010, stocks rise on signs of recovery
3.a May 1931, stocks fall as European banking/sovereign debt crisis begins
3.b May 2010, stocks fall, as European banking/sovereign debt crisis begins
Let’s hope the European debt crisis doesn’t get as bad as in 1931, or if it does, let’s hope the Fed offsets the effects of the crisis as they should have done in 1931, but didn’t. Today’s 4% drop in stocks suggests that the market is not particularly optimistic on either score. Because Bernanke is such a distinguished scholar of the Great Depression, I thought it would be interesting to contemplate what he would have done if Obama had appointed him to head the Fed. First let’s consider his recommendation to Japan (from 2003) once they entered the liquidity trap:
What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap (Bernanke, 2000). The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.”
“A concern that one might have about price-level targeting, as opposed to more conventional inflation targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation objective. Is there not some danger of inflation overshooting, so that a deflation problem is replaced with an inflation problem? No doubt this concern has some basis, and ultimately one has to make a judgment. However, on the other side of the scale, I would put the following points: first, the benefits to the real economy of a more rapid restoration of the pre-deflation price level and second, the fact that the publicly announced price-level targets would help the Bank of Japan manage public expectations and to draw the distinction between a one-time price-level correction and the BOJ’s longer-run inflation objective. If this distinction can be made, the effect of the reflation program on inflation expectations and long-term nominal interest rates should be smaller than if all reflation is interpreted as a permanent increase in inflation.”
Of course the US is different from Japan, we have a higher inflation objective. Here is Bernanke in 1999:
Perhaps more salient, it must be admitted that there have been many periods (for example, under the classical gold standard or the price-level-targeting regime of interwar Sweden) in which zero inflation or slight deflation coexisted with reasonable prosperity. I will say more below about why, in the context of contemporary Japan, the behavior of the price level has probably had an important adverse effect on real activity. For now I only note that countries which currently target inflation, either explicitly (such as the United Kingdom or Sweden) or implicitly (the United States) have tended to set their goals for inflation in the 2-3% range, with the floor of the range as important a constraint as the ceiling(see Bernanke, Laubach, Mishkin, and Posen, 1999, for a discussion.) Alternative indicators of the growth of nominal aggregate demand are given by the growth rates of nominal GDP (Table 1, column 4) and of nominal monthly earnings (Table 1, column 5). Again the picture is consistent with an economy in which nominal aggregate demand is growing too slowly for the patient’s health. It is remarkable, for example, that nominal GDP grew by less than 1% per annum in 1993, 1994, and 1995, and actually declined by more than two percentage points in 1998. (emphasis added.)
OK, so let’s review the Bernanke strategy:
1. When entering a liquidity trap, set an explicit price level target path, not a memory-less inflation target.
2. Commit to make up for any overshoots or shortfalls.
3. Have prices rise 2-3% a year in the US, avoiding undershooting just as strenuously as overshooting.
4. These criteria imply that prices should grow at least 2% over one year, 4% over 2 year, and 6% over three years. If prices actually rise 4.3% over 3 years, you’d shoot for 3.7% inflation over the next 12 months, to get back on track.
The Fed focuses on core inflation. The CPI core was 216.783 in September 2008, when the crisis began (nothing in my subsequent argument hinges on this exact date being chosen.) In April 2010 the core CPI reached 220.768, or 1.82% above the Sept. 2008 level. If the CPI had grown at 2% per year, then by last month it should have reached 3.19% above the September 2008 level.
Thus over the next 12 months the Fed needs to try to get the core price level at least 5.2% above the September 2008 level. This means we need to aim for 3.4% inflation over the next 12 months.
So the goal is clear; how do we get there? Bernanke’s no magician, surely he wouldn’t have been able to find a way to make monetary policy more expansionary, in an environment where rates had already reached zero? Au contraire (again from the 1999 Bernanke paper):
The second argument that defenders of Japanese monetary policy make, drawing on data like that in Table 3, is as follows: “Perhaps past monetary policy is to some extent responsible for the current state of affairs. Perhaps additional stimulus to aggregate demand would be desirable at this time. Unfortunately, further monetary stimulus is no longer feasible. Monetary policy is doing all that it can do.” To support this view, its proponents could point to two aspects of Table 3: first, the fact that the BOJ’s nominal instrument rate (column 1) is now zero, its lowest possible value. Second, that accelerated growth in base money since 1995 (column 4) has not led to equivalent increases in the growth of broad money (column 5)—-a result, it might be argued, of the willingness of commercial banks to hold indefinite quantities of excess reserves rather than engage in new lending or investment activity. Both of these facts seem to support the claim that Japanese monetary policy is in an old-fashioned Keynesian liquidity trap (Krugman, 1999).
It is true that current monetary conditions in Japan limit the effectiveness of standard open-market operations. However, as I will argue in the remainder of the paper, liquidity trap or no, monetary policy retains considerable power to expand nominal aggregate demand. Our diagnosis of what ails the Japanese economy implies that these actions could do a great deal to end the ten-year slump.
So Bernanke would shoot for 3.4% inflation, and he’d find the tools necessary even if nominal rates were stuck at zero. You might wonder if shooting for 3.4% inflation would cause the public to lose confidence in the Fed. No worries:
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.
Unfortunately, the Ben Bernanke I have described here is not in charge of the Fed. Instead, we have a Fed that has recently tightened monetary policy so much that inflation expectations are running about 1% over 2 years and 1.6% over 5 years. Not only are we not getting back on the 2% minimum inflation trajectory recommended by Bernanke, but we are falling further and further behind. The ECB is making the same mistake, which is putting tremendous pressure on the weaker members of the eurozone.
I wish someone would find the man who wrote the 1999 paper cited here and put him in charge of the Fed.
Update 5/24/10: Welcome WaPo readers. This is a shorted version of a much more complete analysis of Bernanke’s 1999 views here and here. The differences are startling. BTW, I hope these posts don’t sound too sarcastic. I like and respect Bernanke–I am just trying to use humor to make what I think is an important point.