Here are some very recent pronouncements from the Fed and the BOJ.  See if you can figure out which is which:

Central Bank A:

“It is a critical challenge for XXX’s economy to overcome deflation and return to a sustainable growth path with price stability,” the XXX said in a statement after a regular two-day policy meeting.

.   .   .

The XXX said it “does not tolerate” a situation in which the country’s main price index remains flat or decreases on a yearly basis.

Central Bank B:

The public’s understanding of the XXX’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity.

.   .   .

The XXX has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations.

Hmmm.  The first part of each quotation mentions stable prices.  That sounds more like the BOJ, which favors zero inflation, rather than the Fed, which hints that it would like something closer to 2% inflation.  On the other hand the second part of central bank A’s quotation implies they actually do want something more like slightly positive inflation, not stable prices.  So maybe A is the Fed.

The second part of central bank B’s quotation mentions that people have been pressing them to set a higher inflation target.  Of course we all know that many American economists (including Krugman and Bernanke) continually pressed the BOJ to adopt a higher inflation target as a way of getting out of its liquidity trap.  So I am going to guess that central bank A is the Fed, and central bank B is the BOJ.

Oops.  I just checked and it appears I got the two central banks mixed up.  Well you can’t really blame me; these days it is becoming increasing difficult to distinguish between the Fed and the BOJ.

I am pretty sure the liberal bloggers won’t like John Allison’s interview.  Next to Allison, I’m practically a socialist.  I’ll start off with what I liked, and then discuss what I didn’t like.

Allison was clearly out to pin the blame for the current crisis on the government:

The government owns the monetary system in the US. In 1913, the monetary system was nationalized. If you’re having trouble in the monetary system, by definition, it’s a problem of government policy.

.   .   .

I think getting rid of deposit insurance would be wonderful. In fact, 10, 15 years ago, the financial services roundtable actually went through an exercise looking at a cross guarantee program among the large financial institutions. I believe that if we put that program in place, similar to what happens with the insurance industry, what the brokerage industry has, we would never have had, even with the Federal Reserve, even with Freddie Mac and Fannie Mae, we certainly wouldn’t have had a misallocation of the magnitude we had. Deposit insurance played a huge role in the big failures, in the Golden West, in the Countrywides, in Washington Mutual, etc., etc. And the reason for that is the FDIC, this is my experience of that career, in good times, they don’t really impose any kind of discipline, and then in bad times they overreact. Right now, the FDIC is tightening like crazy, making it much harder to make loans.

.   .   .

If we had a co-insurance pool, where the banks really were taking the risk, we would be far more disciplined to make sure the companies that were in our co-insurance pool had enough capital and had the proper kind of risk standards. So I’d vote to get rid of FDIC insurance, not that we don’t need it, we need some kind of insurance, but I think it ought to be an industry-based, industry-controlled pool where we would have a huge motivation to discipline all the participants in the pool.

I am increasingly of the view that moral hazard is the central problem with our financial system.  This is partly because I was already leaning that way, and partly because I found Charles Calomiris’s recent interview on EconTalk to be quite persuasive.  Most people don’t think of it this way, but in 1934 we essentially nationalized the liabilities of the entire banking system.  We teach our students that when you deposit $5000 in your bank account you are actually loaning $5000 to that bank.  Not true.  You are loaning $5000 to the Treasury, and they are re-loaning the funds to the bank.  And the Treasury absorbs the losses if the bank defaults. 
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A recent WSJ article provided Bernanke’s response to this question by Brad DeLong:

D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

1.  First of all, if the Fed really wanted to anchor expectations they would announce an explicit target.  The 3% target suggested by DeLong may or may not be optimal.  Most economists prefer a slightly lower figure, but given how the Fed has shown itself incapable of operating in a zero rate environment, it is equally plausible that the trend rate should be higher.  But the Fed refuses to set any explicit target.

2.  The Fed itself called for fiscal stimulus last year.  Isn’t the purpose of fiscal stimulus to increase aggregate demand?  And doesn’t higher aggregate demand increase inflation, at least in the long run?  So if Bernanke is opposed to higher inflation, why did he advocate fiscal stimulus?  And if Bernanke no longer thinks the economy needs more aggregate demand, why not just tell Congress that the economy needs no more stimulus, because there is plenty of demand out there?  And what is causing the high unemployment?  Maybe “recalculation” as Kling argues, or maybe perverse government incentives, as Casey Mulligan argues.  Bernanke is certainly entitled to his opinion.  Bu does anyone think he would dare offer those opinions to Congress?  So he hides behind the phony risk of high inflation, just as the Fed did in the early 1930s.  The same Fed that Bernanke claims caused the Great Depression.

3.  Why not level targeting?  Bernanke says it works in theory.  In 2003 Bernanke said Japan should adopt level targeting.  Bernanke’s former colleague Woodford says we need it right now, and indeed anytime we are in a liquidity trap.  So where is Bernanke’s leadership?

4.  Why the focus on long run inflation expectations?  Sure, they are reasonably well-behaved.  But the real problem is the very low inflation since mid-2008, and the low expected inflation over the next two years.  These low inflation expectations are consistent with an economy suffering from a severe demand shortfall in the near term.  And not just according to my model, but according to the sort of new Keynesian model that Bernanke has used his entire professional life.

5.  The Fed currently has no explicit inflation target.  How would setting such a target “cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.”  That makes no sense at all.  Again, maybe 3.0% isn’t the right target.  But the Fed has to ask itself these questions:

a.  Do we want a higher level of AD?

b.  If so, what sort of inflation would result from the optimal level of AD?

c.  Then set an explicit target at that level.

If the optimal rate of inflation is exactly the same as the current expected rate (which is implied by his answer) then is the Fed is implicitly claiming that additional AD would be unwelcome in an economy with 10% unemployment, an economy where this year’s NGDP will fall at the fastest rate since 1938.  Does the Fed really want to say that additional AD would be unwelcome?  They can’t have it both ways.  If we need additional AD, then we need higher inflation expectations.

I found this answer infuriating because he danced around all the important issues.  He talked like we were back in the 1970s, when the biggest challenge was getting a lower level of actual and expected inflation.  Bernanke doesn’t seem to realize that inflation targeting is not a one way street, it doesn’t mean always targeting inflation at current rates or lower.  If you are serious about inflation targeting and have a symmetrical response function, then by necessity there will be times when you wish inflation to be a bit higher.  And if this is not such a time, a year when we have experienced the first deflation since 1955, then will there ever be a time when the Fed tries to boost inflation expectations?  If not now, when?

PS.  I don’t always agree with DeLong, but this was a great question.  Appropriately direct and to the point.

PPS.  Several people have asked my about Bernanke being named Time magazine’s Person of the Year.   This AP news story called it Time’s “highest honor.”  It is amazing how few people know that the designation is not an honor, it merely indicates who was most influential.  Apparently Time thought he did a good job, but past winners include people like Hitler, Stalin and Khomeini.  On the other hand Osama didn’t get named in 2001, so perhaps Time has chickened out on giving the designation to the most influential person, fearing a loss of subscriptions when bad guys are “honored.”   In any case, the whole process is just as ludicrous as the Academy Awards and Nobel prizes for Peace and Literature.

Update:  Here are comments from Free Exchange and DeLong.

HT:  Ian

Update#2:  A commenter mentioned Will Wilkinson’s post, which is much better than mine.  If only we could combine my knowledge of monetary policy with Will’s writing skills.

The universe shrank by 95% this year.  At least according to a recent theory of gravity by a distinguished Berkeley physicist:

HoYava’s theory has been generating excitement since he proposed it in January, and physicists met to discuss it at a meeting in November at the Perimeter Institute for Theoretical Physics in Waterloo, Ontario. In particular, physicists have been checking if the model correctly describes the universe we see today. General relativity scored a knockout blow when Einstein predicted the motion of Mercury with greater accuracy than Newton’s theory of gravity could.

Can HoYYava gravity claim the same success? The first tentative answers coming in say “yes.” Francisco Lobo, now at the University of Lisbon, and his colleagues have found a good match with the movement of planets.

Others have made even bolder claims for HoYava gravity, especially when it comes to explaining cosmic conundrums such as the singularity of the big bang, where the laws of physics break down. If HoYava gravity is true, argues cosmologist Robert Brandenberger of McGill University in a paper published in the August Physical Review D, then the universe didn’t bang””it bounced. “A universe filled with matter will contract down to a small””but finite””size and then bounce out again, giving us the expanding cosmos we see today,” he says. Brandenberger’s calculations show that ripples produced by the bounce match those already detected by satellites measuring the cosmic microwave background, and he is now looking for signatures that could distinguish the bounce from the big bang scenario.

HoYava gravity may also create the “illusion of dark matter,” says cosmologist Shinji Mukohyama of Tokyo University. In the September Physical Review D, he explains that in certain circumstances HoYava’s graviton fluctuates as it interacts with normal matter, making gravity pull a bit more strongly than expected in general relativity. The effect could make galaxies appear to contain more matter than can be seen. If that’s not enough, cosmologist Mu-In Park of Chonbuk National University in South Korea believes that HoYava gravity may also be behind the accelerated expansion of the universe, currently attributed to a mysterious dark energy. One of the leading explanations for its origin is that empty space contains some intrinsic energy that pushes the universe outward. This intrinsic energy cannot be accounted for by general relativity but pops naturally out of the equations of HoYava gravity, according to Park.
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I am getting whiplash trying to keep up with Krugman.  Four days after insisted in a NYT Op-ed that monetary policy was our only hope, and endorsed a major program of QE, he has again reverted to the view that monetary policy is ineffective once rates hit zero.  Seems my “vindication” was too good to be true.  We’ll get to monetary policy eventually, but first I’d like to examine the way that Krugman interprets a recent study by Eggertsson.

Gauti Eggertsson is in the process of presenting a new paper on fiscal policy; the paper is here. In his presentation “” though not in the paper “” he offers great phrase: the “paradox of toil.”

According to his paper, when you’re in the liquidity trap, certain kinds of tax cuts have perverse effects. Cutting taxes on capital income, for example, encourages more saving “” which is a bad thing, because we’re suffering from the paradox of thrift. In fact, reduced taxes on capital income actually end up reducing investment.

So what’s the paradox of toil? If you cut taxes on labor income, this expands labor supply “” which puts downward pressure on wages and leads to expectations of deflation, which increases the real interest rate, which leads to lower output and employment.

I am going to skip over the so-called paradox of thrift, which as all good monetary economists know is really about an increase in the demand for money, not saving.  Let’s focus on the assertion that a cut in the payroll tax can increase labor supply, and thus shift SRAS to the right, and yet still decrease employment.  How is that possible?  It is possible because Gauti Eggertsson assumes the AD curve is upward sloping when rates are stuck at zero.   Could something like this happen?  I suppose anything is possible.  But if you look closely at Eggertsson’s paper, it isn’t very likely.  And if you look at the evidence from when interest rates actually were near zero, there is overwhelming support for downward sloping AD curves.  But first, let’s see what makes Eggertsson’s model tick:

Figure 5 clarifies the intuition for why labor tax cuts become contractionary at zero interest rates while being expansionary under normal circumstances. The key is aggregate demand. At positive interest rates the AD curve is downward-sloping in inflation. The reason is that as inflation decreases, the central bank will cut the nominal interest rate more than 1 to 1 with inflation (i.e., φπ > 1, which is the Taylor principle; see equation 6). Similarly, if inflation increases, the central bank will increase the nominal interest rate more than 1 to 1 with inflation, thus causing an output contraction with higher inflation. As a consequence, the real interest rate will decrease with deflationary pressures and expanding output, because any reduction in inflation will be met by a more than proportional change in the nominal interest rate. This, however, is no longer the case at zero interest rates, because interest rates can no longer be cut. This means that the central bank will no longer be able to offset deflationary pressures with aggressive interest rate cuts, shifting the AD curve from downward-sloping to upward-sloping in (YL,πL) space, as shown in Figure 5. The reason is that lower inflation will now mean a higher real rate, because the reduction in inflation can no longer be offset by interest rate cuts.
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