I have a friend who teaches development. He tells me that he would often run into the following problem. He’d carefully work through the logic of some argument, explaining how A implies B, and B implies C. The student would nod his head in agreement. At the end he’d say; “So here’s the policy implication, right?” And the student would shake his head and say; “No, you don’t understand, China is different.” (BTW, it could have been any country.)
Both Paul Krugman and I have felt this frustration when looking at the actions of the Fed, ECB, and Bank of Japan. It goes sort of like this:
You say inflation is currently below target. “Yes”
You say inflation is expected to remain below target for years to come. “Yes.”
You say output is below the natural rate. “Yes”
You say output is expected to remain below the natural rate for years to come. “Yes.”
Ergo monetary policy should be made more expansionary. “No. You don’t understand, this cycle is different.”
I’ve racked my brains for an answer. So has Krugman. Once I even delved into pop psychology, arguing that monetary policymakers needed to have a relentlessly logical attitude in applying theory to policy. No common sense judgments about whether interest rates “seemed to low.” I argued this was similar to the autistic cognitive profile–blocking out any extraneous factors.
Stefan Elfwing just sent me a Google translation of an article on Lars Svensson, which led me to recall all this frustration:
Lars EO Svensson wants the federal funds rate is 1.75 percent in three years, not 3.8 percent as the Riksbank’s majority wants.
He was also against the latest interest rate rise from 0.50 to 0.75 percent.
His colleague on the Executive Board, Karolina Ekholm, voted for the increase but also want a lower interest rate over the next few years because of the doubts that exist about the global economy.
For Lars EO Svensson is the “obvious” to select a rate and interest rate forecasts that are considerably lower than the Executive Board a majority of four members chosen because it gives better effectiveness.
Our forecasts for CPIF inflation below the target most of the period and resource utilization is low. If the interest rate path is lower we get a better effectiveness.
That sounds very logical. So why don’t his colleagues agree?
Lars EO Svensson has repeatedly asked his colleagues on the Executive to explain why they disagree with, he has asked them to point out errors in their reasoning. The answers are lacking.
Unfortunately I don’t speak Swedish, and I think something got lost in translation. But I gather the other members of the board have not been able to point out errors in Svensson’s logic.
He points out that although the Finance Committee stated that it would be desirable that the Riksbank is very clear about why various policy decisions taken or not taken.
I am surprised by the disagreement about some things that should be obvious, for example, that one should not raise rates when the forecast for inflation and resource utilization is too low.
That’s why transparency is so important. It isn’t because a central bank doesn’t know what it should be doing; it’s needed to make sure the central bank in fact does do what it knows it should be doing.
Lars EO Svensson has been accused of being an academic theorist who hide behind their models and research reports. Especially when he, in the midst of financial crisis, would have zero interest, and led a discussion about having a negative interest rate.
I see no contradiction between theory and practice. Monetary policy should not be controlled by the brain without the ghosts of the facts and analysis.
I guess Svensson’s fellow board members did not benefit from being educated by John Stuart Mills’ father:
I recollect also his indignation at my using the common expression that something was true in theory but required correction in practice; and how, after making me vainly strive to define the word theory, he explained its meaning, and shewed the fallacy of the vulgar form of speech which I had used; leaving me fully persuaded that in being unable to give a correct definition of Theory, and in speaking of it as something which might be at variance with practice, I had shewn unparalleled ignorance. In this he seems, and perhaps was, very unreasonable; but I think, only in being angry in my failure.
The last interest rate path should not uncritically be taken as a starting point. Any interest rate decision should stand on its own and not lean on the previous.
In a post entitled “Losing Face” I showed that central bankers don’t like to admit that their previous policy decision was wrong.
Although my colleagues do not seem to want to listen to his argument, he has not tired of sitting on the Executive Board.
Not a minute have I regretted that I took the job. It was a challenge I could not say no to. I got the chance to turn 15 years of research in practice.
All six members have an individual responsibility to make independent decisions and justify them.
My job is to do what I do and continue to do so.
Lars Svensson is one of the few policymakers who will come out of this debacle with his reputation intact. I’m surprised Krugman hasn’t mentioned him in his blog posts. (They are colleagues at Princeton.)
PS: Two Swedish posts in one day! What other American blog provides such complete coverage of Nordic events? My half Swedish–half Norwegian grandmother would have been proud.